Description

A REIT playbook opens with a chapter on the importance of asset gathering and ends with tips on how to execute successful equity offerings. The middle is filled with sections on pushing banks for higher leverage, paying retail investors large dividends, and issuing preferred shares when you need cash to fund operations. (Later editions of the playbook even include addendums with external management structures and real estate development platforms.) Investors like their steady dividends. Executives like their steady paychecks. Bankers like their steady fee streams.

What happens when you turn every chapter of the playbook upside down? You get something close to Franklin Street Properties:

• No dividends (reduced to $0.01 / quarter to comply with REIT rules)
• Ongoing, large-scale disposition activities (sold $852mm of assets, or 144% of the current TEV, since the end of 2020 with no acquisitions)
• Repaid 60% of its debt
• No share issuance or acquisitions since 2016
• Management acknowledges the large discount to intrinsic value, voluntarily cut their own paychecks, and board members are active in the open market buying shares

Unfortunately for FSP, a shrinking portfolio with no dividends is an outcast in the REIT community. It is an orphan security with no natural shareholder base. It was dropped by both the S&P600 and Russell earlier this year.

Fortunately, FSP has a shareholder-centric CEO who wants to close the gap to intrinsic value. I believe once the rest of the debt has been repaid, FSP will continue to sell the rest of the portfolio, in part or in whole, to return value to shareholders. I think FSP is worth 3x where it is trading today.

FSP is a small-cap office REIT based in Wakefield, MA. It owns a portfolio of 20 assets and the mortgage of an additional building in Indianapolis, IN. The assets are concentrated in Denver, Dallas, Houston, and Minneapolis. It owns primarily multi-tenant office assets in city centers and adjacent suburbs. It also has a large asset in both Atlanta and Miami.

Key FSP statistics:

• $1.81 / share price, trading at a ~75% discount to book value
• 71% occupied, 76% leased, with a run-rate of $67mm of NOI at current occupancy
• $400mm of debt, ~$583mm of TEV, which implies a $96psf valuation and 12% in-place cap-rate

Situation Overview:

The most important trend is that the management recognizes the disconnect between the share price and the intrinsic value of the assets, and they are doing something about it. Management has publicly acknowledged the spread since 2020 and has actively pursued an asset disposition strategy to realize the value of the assets in the private markets. Proceeds have been used to repay debt and a de minimum amount used to repurchase shares.

In the three years since the start of the disposition plan, FSP has sold $852mm of assets for a blended 5.8% cap rate and $220psf. In the latest quarter, management disclosed that they are in the process of selling another $163mm of assets for ~$250psf, all of which are under contract. Selling office assets in today’s environment is no easy feat, and the results to date speak volumes to the management’s successful execution.

Other trends worth noting:

• Unlike many of its office peers, operations have been improving in recent quarters:
  • FSP has large exposure to oil & gas tenants in Denver and Houston. Pre-COVID industry issues and post-COVID office trends caused occupancy to drop 16% from its high-80s historical average
  • Leased rates have improved in recent quarters and management noted that they are “seeing a rising pipeline in prospects for the first time in a long time that want full floors”
• Management voluntarily cut its paychecks in recent years. CEO George Carter forfeited his annual bonus for several years. The board also forfeited 25% of their cash retainer fees last year, resulting in a 13-14% reduction in their total annual pay
• Several board directors have been buying shares in the open market during the last few years, for an average of $3-5 / share. Two directors have purchased ~$3mm worth of shares each, at $2.86 / share and $3.69 / share average purchase prices. Another director purchased $153k worth of shares at $4.64 / share

Future of FSP and Valuation:

Management likely did not intend to sell this many assets. I suspect that they hoped a few dispositions could demonstrate the private valuations of the assets to the market, and close the share price gap to intrinsic value. When the share price did not improve, management continued this disposition plan because they knew this was still the right thing to do for shareholders.

When the interest rates rose and capital markets deteriorated, the disposition strategy shifted slightly. The top priority today is to use the proceeds to repay their lenders. With the current assets under contract and additional assets to be sold within the next year, I believe FSP will be close to debt-free. With debt out of the way, I believe the next focus will be returning value to shareholders through either a sale or liquidation. When asked for the plan after debt repayment, the CEO told me that “all options are on the table.”

FSP has historically achieved good results through the dispositions, but market conditions have changed. For the $852mm of assets sold to date, the selling prices were at an average ~29% premium to their book values. I took a detailed look at most of the large assets in the portfolio. After speaking with local brokers and looking at recent local precedents, I believe today’s value is likely much closer to book value than at a premium.

I believe the assets will sell for ~$778mm, net of debt repayment, which equates to ~$7.54 / share of value to shareholders. This will take a few years to achieve and in the interim, there will likely be frictional costs from brokers, lawyers, interest payments, and a small G&A load in the range of ~$1 / share.

In the end, shareholders will receive $6-7 / share of value, compared to the current share price of $1.81.

Catalyst

I believe once FSP sells the four assets under contract, the portfolio will be de-risked, and management will look for a liquidation or strategic alternative to close the gap to intrinsic value.

In addition, there could be an unsolicited bid for the portfolio. I heard FSP received an unsolicited bid as recently as two years ago but turned it down due to valuation.