Description

Forest City Enterprises (“FCE”) common at less than $6 creates the business for a $600mm market cap. In exchange for $600mm the shareholder gets two sources of value: 1. $170-200mm in trailing FCF (based on LQA) from portfolio of leveraged real estate (FCF is after paying all interest, recurring capex and corporate exp.); 2. Book value of $1.4bn in a group of development projects and land holdings – and a 23% ownership in the nets as a kicker.

FCE, founded in 1920 and headquartered in Cleveland, is engaged in real estate ownership, development, management, and acquisition. FCE is a real estate operating company involved in commercial and residential real estate through three business units: Commercial Group, Residential Group and Land Development Group. FCE owns, outright or with partners, 238 properties in 27 states (See “FCE Properties”). FCE is considered a premier developer, specializing in urban projects and innovative public/private ventures.

Commercial Group: Develops and owns regional malls, specialty/urban retail centers, office and life science buildings, hotels and mixed-use properties. Owns interests in 44 retail projects, 19 regional malls and 32 specialty retail centers in urban and suburban locations in 16 states amounting to 12.8mm gross leasable square feet. Owns interests in 47 office properties representing 13.1mm gross leasable square feet and 5 hotels with 1,823 rooms. The company is a build to suite office developer and focuses development in NY, Boston, Chicago, Washington DC, Albuquerque and Denver.

Residential Group: Develops and owns residential rental properties, including upscale and middle market apartments and adaptive re-use developments. The group also develops for-sale condo projects and owns interests in entities that develop and manage military family housing. Owns interests in 116 retail projects with 31,891 units in 20 states. FCE is also a member of various partnerships that own, develop and redevelop housing for the US Navy and Marines.  FCE has condo developments: 1100 Wilshire and Mercury in LA and Central Station in Chicago.  

Land Development Group: FCE acquires and sells land and development lots to residential, commercial and industrial builders. The company develops raw land into master planned communities and mixed use projects. Owns 10,497 acres of undeveloped land for commercial and residential development purposes in 11 states. In addition to owned land, FCE has the option to acquire 1,533 acres of development land at its Stapleton (Denver) project and 5,824 acres at its Mesa del Sol project (Albuquerque).

As seen below, FCE’s assets are well diversified by property type and geography.

Other

 FCE owns an approximately 23% interest in the NJ Nets. The Nets were purchased in connection with developing the Atlantic Yards in Brooklyn.

Financing

            FCE funds each of its owned properties and each of its development projects on a non-recourse mortgaged basis. From the perspective of the holding company, FCE’s approach to financing makes its operations safe when compared to operators who finance on a joint, blanket or guaranteed basis. FCE’s financing approach is safer than others because one bad property or bad development can not ruin or threaten the solvency of the holding company. Because FCE finances on an individual, property by property basis, the company is only at risk for the equity it has in any individual property or development. If the company undertakes developments that end up being losers, FCE would only lose the money they put into the deals, the holding company would have no obligation to satisfy the obligations associated with the problem deal. Similarly, If the company were unable to roll financing or if a building lost all of its tenants, FCE would only lose its equity in that/those individual properties. Given FCE’s financing approach the equity it holds in good deals will not be used to satisfy the creditors of deals or properties that deteriorate to the point were the creditor is impaired. FCE can be thought of as a holding company owning the equity of a number of leveraged projects/properties in which no one mistake can contaminate the portfolio. The Company’s financing approach makes its operations relatively safer than companies that choose to finances on a recourse basis.  

            FCE does guarantee completion of projects, giving the parent company exposure to cost over run risks. 

            Importantly, nearly all of FCE’s property level debt is held by real lenders (banks, plans and insurance companies) and not by CMBS structures. Realistically, banks/insurance companies do not want to own FCE’s properties and as long as the properties are cash flowing, banks will likely work with FCE to allow FCE to retain the property’s equity subject to the banks sweeping most/all of the property’s CF for a period of time. The only properties FCE is likely to lose are those that come up for refinancing and are currently held in CMBS structures.  

            Besides property level debt, FCE has $1.1bn of holding company debt. The nearest maturity is the revolver maturing 3/2010. At 10/31/08 FCE had unrestricted cash equal to 80% of the revolver outstanding. After the revolver, the next maturity is a convert due 2011 – no other holding company debt matures until 2014. Current cash and half of one year’s worth of stabilized property FCF is enough to cover the bank maturity. Two years of FCF will cover the convert, so, based on current balance sheet cash and 3 years of FCF, FCE should be able to cover all holding company maturities through 2014. I expect the return of debt financing before 2014.

            Besides the strength of the current non-recourse funding strategy and cash/cash generating ability at the holding company from current operations – a significant portion of FCE’s portfolio is still financeable (read saleable). FCE can sell multifamily residential properties because the gov. through FNM/FRE has ensured funding for such assets.

Development Commitments

            At 10/31/08, FCE had less than $20mm of equity commitments on developments. Management has ceased all new development.

Projections

            Rents will likely go down or remain flat on renewing leases, and vacancies will likely go up as the economy cause businesses to fail and consumers/renters to remain under pressure. The company’s current developments will produce poor IRRs over the near term and the company will be unable to pursue much new development for a period of 1-2 years. FCE may even lose a few building as they come up for refinancing or development is completed and the company is unable to find take-out financing for maturing construction loans. 

            Management

The Ratner, Miller and Shafran families control FCE thought super voting B shares and have family members in virtually ever important management position in the company. The Families’ reputation is excellent. They built a wonderful business over three generations, growing from a local (Cleveland) lumber business into one of the nation’s larges owners and developers of high quality commercial and residential real-estate. The company remained relatively disciplined during the recent bubble, sold properties, extended non-recourse debt and avoiding overly costly land acquisitions. Management is generally consider among the class acts in the industry and are aligned with shareholders, through ownership of roughly 30% of FCE’s economics.  

Valuing FCE

The value of FCE at any point in time is driven by the value of:  1) stabilized properties (based on replacement cost, NOI or FCF); plus 2) the value of its undeveloped land in the Land Development Group; plus 3) the value of its active development projects; plus 4) the value of other assets including the NJ NETS; plus 5) the value of future or shadow development to the extent one believe that future development will be delivered at attractive ROI. For our purposes we will only consider values from sources 1-4 above.

The last component of value, #5 above, allows FCE the potential for going concern value. Most real estate investments (particularly REITs) are mostly static pools (absent acquisition/divestment) and only worth the value of their existing properties. To the extent that FCE has the sustainable ability to recycle capital in a tax advantaged manner into genuinely attractive developments, FCE has going concern value in excess of its liquidating NAV. 

Ignoring the potential for going concern value --- FCE appears to be able to meet all holding company maturities through 2013. FCE might lose some properties on which non-recourse mortgage debt come up for refinancing over the next 3 years. Assuming FCE loses all properties that have to be refinanced over the next 3 years – FCE’s common will have the right to between $120-150mm of annual FCF from the remaining stabilized properties and still have an interest in $1.4bn of development and land assets.   Everyone can make their own assumptions, but assuming the developments are worth book and the FCF is worth 10x, then FCE’s common will be worth between $25-35 per share in 3 years.

If inflation hits or if the company is able to keep all of its properties, the common could be worth much more.

A note on GAAP vs. Economic Reality at FCE

FCE’s operations are a combination of development, asset purchases and sales and stabilized properties. The combination of activities leads FCE’s GAAP results to confuse more than clarify economic reality. In order to allow for appropriate analysis, FCE provides supplemental financial filings that break its operations in to four segments: Stabilized Properties, Development Activities, Land Bank and Other. In each segment the company owns some properties outright, owns a majority interest in some properties that are consolidated and owns a minority interest in some properties that are unconsolidated. In order to adequately consider all of the company’s sources of value we must add the results of the properties that are consolidate (less the minority interest owned by others in such properties) to the company’s net share of the economics/NOI/EBDT in the properties that the company has a minority interest in and are unconsolidated. When talking about FCE’s results, I am talking about Pro-Rata Consolidated results, calculated as follows:

70% + of FCE’s Economic value is driven by properties in which they have 100% interest.

Catalyst