Intro:

Gyrodyne is a name that many on VIC have become familiar with over the years, so although I have been involved for a long time, I won’t pretend to be the foremost expert on the board. There is already been continued discussion of this on the message board to Katana’s post on GYRO, but I thought given the change in the situation and in my opinion compelling risk/reward that Gyro deserved a new post that discussed it as a liquidation/pre deal arb. Because of the fact that it has already been posted a couple of times before, I am not going to spend too much time discussing the background of GYRO and instead focus on the current situation.

To summarize the thesis for people who want the quick and dirty, GYRO has up to 33% upside to fair value of net assets. I expect that gap to be at least partially closed over the next 6 months, generating a very attractive IRR and extremely limited downside due to the percentage of assets being held in cash. The stock has been beaten down by combination of CEO leaving over the summer, tax selling in December in advance of dividend/LT tax rate increasing, as well as lack of communication and a sale process that has been going more slowly than investors would expect. Based on discussions with the players involved, it would seem like the process is going as expected, but that maybe investors had too high expectations on how quickly it could be done-no REITs wanted to discuss a transaction with them before they got the money.

Background: Please see previous posts for background. All that is relevant on a going forward basis is that Gyrodyne had an eminent domain lawsuit against the State of New York that they eventually won and received funds for. They have to reinvest the proceeds by April 2014 or pay taxes on the part of the payment that has not already been dividended out. They now have a pile of cash, land and real estate.

Valuation:

The valuation on Gyrodyne assuming that the taxes can be avoided using 1031 exchange is really pretty simple. All they have is a large pile of cash, some medical buildings and the remaining acreage on Long Island that wasn’t seized by SUNY.

Everything is known except for the valuation of Flowerfield and the Medical Facilities. I value the Medical Facilities at an 9% cap rate, which is a discount to larger publicly traded comps but is deserved given the poor recent operating performance and sub-scale nature of the assets. Management seems to have a strategy to improve operating performance there, but I will wait and see. This is a large discount to the gross carrying value on the balance sheet.  Given the poor operational performance, I am inclined to think that the management team doesn’t have the expertise or the focus for these assets.

Flowerfield I value at $350k an acre or $75k an expected residential unit. After speaking with developers in the area, I used an assumption of $800k a unit and $50K for a builder to finish a given (water, sewer, topography etc). Then assuming a developer will pay 20% of eventual net proceeds including the cost to finish, I got to $100k per lot (750/5-50).  This is a slight discount to what other posts have suggested Flowerfield might be worth-there could be more upside given the recent elevated demand for residential development land. I am planning on touring the plot in the next two weeks, will keep the board updated with my viewpoints. If anyone has local real estate expertise, would always love other thoughts.

Please note below the liability for the incentive cash payments that some people were missing for a while in working out the valuation.

Returns:

Based on discussion with management, board etc, I would expect this process to move fairly quickly. Either they will find a buyer who is willing to buy Gyrodyne using equity as a “backdoor secondary” or they will reinvest the proceeds themselves. Either way all of the cash needed to be used March 30, 2014. I would expect a closing of the gap to value a lot sooner than that. Assuming a discount to $97.5 of fair value (probably warranted if they sell it), I would still expect very attractive IRR’s. I would be surprised if this drags on longer than summer of 2013. They have a monthly ticking fee with Rothschild, and they need to have time to bring in a Real Estate exec with experience to find buildings to purchase if they go that direction.

Current Situation:

Gyro has received payment from the State of New York for the eminent domain lawsuit. They have until April 30, 2014 to either invest that cash or to sell themselves to someone else who will invest that cash in order to affect a 1031 exchange. The company has consistently stated that they are attempting to get cash or marketable securities in the hands of its shareholders-in other words liquidation of some sort is the base case. Naveen Bhatia, who works in his day job at the investment firm 40 North Industries is running the process for the board. They have contracted with Rothschild to run the process-Bhatia has previously worked there a decade ago as an analyst. Bhatia has been on the board for 4 years-appointed with support of Bulldog which has been active in this name. I believe that he is running this process in a capable way; he will do the best to maximize value in a way that I would want as a shareholder. He got on the board at a young age, and I believe it is important to him that this situation is resolved in a positive way.

I see there are being two reasonable outcomes to the situation; they sell their shares in a stock for stock transaction to another REIT or bring in an exec to run GYRO and reinvest the proceeds itself. If you had asked me a few months ago, I would have said the second one would be a bad outcome but after the performance of GKK, I have a slightly different opinion currently. While I would still prefer the former, I can accept either.

If they do a stock for stock transaction, it would be a way for a REIT who is going to buy properties anyway to do a secondary deal without having to come to the market. REIT transactions are done on average at a high single discount to the unaffected trading price, so buying GYRO shares would allow them access capital at current prices (and possibly buy GYRO at a discount). This works out well for GYRO as long as the acquirer is liquid or if the acquirer is either trading at fair value or cheap. If we get an illiquid stock that seems expensive, that won’t be ideal. We have spoken to large REIT’s in the past who said that they in theory would be interested in this kind of transaction-but I don’t have a great sense of who the eventual buyer will be.

In terms of restarting GYRO as a REIT, that could make for a slightly longer time horizon to realize value. Prior to seeing what GKK (another special sit REIT that reorganizes to invest in real estate) has managed to do for its stock price, I would have been very against this. But I think if the board is very careful about who they bring on to run this, it could end up still being a good outcome for GYRO in terms of closing the gap to NAV. It will be key who they have run the company, I don’t think Gary Fitlin has the expertise or background to run this on a going concern basis.

Recent Negative Stock Drivers:

Below are the reasons why I think the stock has gone down, and why I don’t think it has much of a bearing on the current stock price. I had been worried about some of these issue myself, but have managed to get comfort from talking to the major players involved.

CEO Resigned: This was a sign to the market that this process was going to take longer than investors thought and has maybe been partially proven out. It appears that Maroney merely left because he had already qualified for the incentive payments and wanted to leave someone else to market the company. As I understand it, it was as a simple as he is 68 and didn’t contractually need to be involved in selling the company in order to still get paid.

Bulldog Sold Half Their Stake: Bulldog still has approximately 2% exposure to GYRO across their funds, but as I understand it they were trying to trim their stake ahead of negative tax consequences as well as take down their concentration. They had a very low basis in the stock, so it made sense for them to sell in advance of both the dividend (taxed at ordinary income rates) and long term rates going up. These are rational decisions for them, but don’t have any effect on the incremental buyer making a new purchase. Bulldog wrote up in August in their closed end fund that they believed GYRO was worth what is now equivalent to $76.70-96.70. From what I understand, that basic range hasn’t changed.

Pace of Sale process has been slow: Along with many on the board, I sort of assumed they would have a deal signed up right after getting the money. From what I now understand, investment banks didn’t want to engage with them until they actually had the money. As I stated before, I believe Bhatia is running the process well and is maximizing value. I do not get the impression that management expected it to go any faster than it has, so I wouldn’t take it as a negative signal.

Tax Selling: Anyone who had made a lot of money in the stock (and there were a lot of us) along with any fund with offshore holdings had a reason to sell in December. The stock has rebounded a bit, but there is definitely a slightly different shareholder base from a huge upside litigation to more of a liquidation.

Conclusion:

Gyrodyne is an interesting arb/liquidation with a great gross spread. If a deal gets done, it will happen in a way that gives the buyers from these levels an attractive gross spread. If the company needs to reorganize around the existing assets, the upside might be lower in the short term but I can’t see any meaningful downside. I have a high degree of confidence that this is an attractive entry point for new investors to GYRO.