Description

Summary

Forest City Enterprises (“Forest City” or “FCE”) is a diversified real estate company that owns and develops office, retail, multifamily, senior living, and other mixed use properties within the United States. While the company has historically operated as a C-Corp, management recently announced its intention to convert into a REIT structure by January 1, 2016. This has created an arbitrage opportunity as Forest City currently trades at a 25% discount to NAV based on publicly traded REIT valuations, with incremental upside of 20-25% from cost cutting opportunities. In addition to the company’s upcoming REIT conversion, management has also indicated its intention to undertake further steps to close the company’s valuation discount, including non-core asset divestitures, corporate structure simplification, and balance sheet deleveraging. Additionally, there is upside optionality from Forest City’s development projects held at cost and off-balance sheet assets.

REIT Conversion

Forest City has historically traded at a discount to public REIT valuations due to its status as a C-Corp, which has precluded a significant share of real estate investors (REIT funds and ETFs) from investing in the company. In addition, the absence of a regular dividend since its cancellation in 2008 has likely contributed to FCE’s depressed valuations when compared to yield oriented investment vehicles (REITs). Management’s recent announcement of FCE’s pending REIT conversion creates an opportunity to arbitrage this valuation disparity with limited downside risk. Based on stated NOI alone, I believe there is upside of 30%+ in reaching comparable valuations to REIT peers, with further optionality as laid out below:

o    Non-Core Asset Divestitures & Portfolio Simplification: Forest City currently owns several non-core, non-income producing, and off-balance sheet assets that management has targeted for divestiture. I believe the opaque and in some cases non-REIT nature of these assets have likely contributed to FCE’s depressed valuation and are ascribed minimal value by investors.

§  Forest City owns a 12.4% stake in the loss-making Brooklyn Nets basketball team that arose as a result of its involvement in the Atlantic Yards development project. I estimate Forest City’s interest in the team is worth between $120 to $200mm in a potential divestiture. If a Nets sale is consummated, it's likely that the Barclays Arena will get wrapped up in the deal which will generate incremental cash proceeds to FCE (~$300mm) and reduce the debt load. Despite news flow in January this year regarding Mikhail Prokhorov’s interest in a sale of his ownership in the team, recent press suggests he intends to maintain his majority stake. While this will likely dampen FCE’s ability to sell its stake at an attractive valuation, a completed sale will nonetheless reduce the company’s non-REIT asset exposure and clean-up the corporate structure.

§  The company owns a non-income producing development plot in Brooklyn that is currently carried at $10 – 15mm on the balance sheet. The property is currently being marketed for sale by CBRE and worth up to $120 – 180mm based on recent comparable transactions in the area.

§  As the master developer of the Stapleton urbanization project in Denver, FCE also holds rights to takeunder approximately 849 acres of land for development and sale. While the company currently holds ~$50mm of Stapleton land inventory on its balance sheet, I believe the remaining opportunity could create $100 to $215mm of incremental value.

§  The company is in the process of divesting its non-core apartment and office portfolio in Cleveland. A sale would allow them to high-grade their existing portfolio and reduce the overall leverage ratio.

o    Margin Improvement Opportunity: Forest City’s current blended NOI margins of 55 - 57% are significantly below the REIT industry average of approximately 65 - 70%. I believe a combination of the company’s historical focus on development projects, organizational complexity, and numerous senior positions held by members of the founding families have likely resulted in excess levels of operating expenses allocated to FCE’s income producing properties. (See the company’s management team web page to get a sense for the redundant layers of CFOs and management positions that permeate the organization.)

§  Notably, the company has hired Bain as a strategic advisor to review its margin underperformance. I believe this is important for two reasons: a) Bain is conducting a line-by-line, employee-by-employee analysis of the company’s cost cutting opportunities, and more importantly b) given FCE’s long history as a “family” company with extremely high employment tenures (in many cases over 20 years), hiring an advisor signals intent by management to effectuate change under the cover of Bain.

§  While FCE management has recently announced a cost cutting plan targeting $35 – 45mm of savings over time, I believe this estimate significantly understates the total opportunity. Management has hinted publicly that these estimates are conservative. Even adjusting for management’s announced savings and other comparability factors (ground rent, subsidized housing), FCE’s margins are 700bps below peers. At a conservative 6% cap, this margin opportunity represents ~$4.00 per share of upside on the stock.

§  The company’s recent reduction in development and construction activities without a commensurate decrease in development related expenses has also led to an increase in development overhead that is now expensed instead of capitalized, temporarily inflating current OpEx.

Valuation

My upside of ~30% (excluding NOI margin improvement) reflects valuation parity to public REIT comps and assumes an implied 5.7% blended cap rate on Forest City’s current property portfolio. Development and construction assets are held at cost. This does not reflect additional margin upside as laid out previously.

Although FCE trades at a significant discount to public REIT valuations, I do not believe current absolute valuations in the industry are compelling enough to justify a naked long investment. Given the diverse nature of FCE’s portfolio, I think shorting a REIT ETF should serve as a relatively good hedge.

Risks

• Persistent Valuation Discount: Excluding NOI margin upside optionality, roughly one-fifth of FCE’s current value is tied up in non-REIT assets including development projects, Barclays Center, the Brooklyn Nets, Stapleton, and fee-based property income. If management is unable to execute non-core asset divestitures, FCE may trade at a persistent valuation discount as a result of above normal leverage and exposure to non-REIT assets. Moreover, the company’s A/B share structure and diversified portfolio may cause the market to ascribe a discount to typical REIT valuations.
• Leverage: Forest City currently has a significant amount of leverage relative to REIT comps. In addition to the recent equity raise, management is targeting significant non-core asset divestitures as a means to deleverage the company’s balance sheet.
• Family Ownership: Forest City is family controlled⁽⁴⁾ with significant family presence within the management structure of the company. This poses a risk given the critical role of management (REIT conversion, asset sales, etc.) in addressing the current valuation discount. I believe recent management actions have largely been positive and targeted towards addressing FCE’s depressed valuation relative to public comps. In addition to initiating a REIT conversion process, management has also conducted approximately $500mm in non-core asset divestitures over the last two years, discontinued its non-core Land Development business (aside from Stapleton), and sold minority interests in development / other capital intensive properties to reduce both funding requirements and development / construction exposure. Management has also indicated its intention to continue non-core asset sales, reduce balance sheet leverage, and simplify the corporate structure.

 (4)     While the founding families together technically own <50% of voting rights, they have significant influence over the company through management and board representation.

Catalyst

REIT conversion, asset divestitures, margin improvement