Description

Howard Hughes was written up by Spence774 in November of 2012 when the stock was $72 / share – the stock is up >70% since, and yes, it is still a buy. 

If you know the story and are just looking for updated thoughts – you’ll find them at the bottom of the write up.  If you’re new the story and interested to learn more you can read on.

For a primer, it’s worth going back through Spence’s write-up and the comments section which will give you updated thoughts through the summer.  There are however, some major structural additions to the analysis that warrant the new write up.  In short, I believe HHC is conservatively worth $160+ in twelve months, and perhaps more importantly I expect that value (or NAV) to compound in the mid-teens in the medium term.

Before I get started with the updates and the catalysts, I want to discuss the problems with the investment so I can help you avoid a lot of work if any of these items are deal breakers for you:

1)      HHC generates almost no cash flow today (statement is a little unfair, but not much)

2)      All of the value is “on the come”, and realistically is two years away (most valuable assets haven’t been built yet)

3)      HHC is net long interest rates (a seemingly unpopular trade these days)

4)      The company is controlled by Pershing Square (soft control)

5)      The story is constantly evolving and requires significant work to get up to speed

Why you should want to do more work on HHC:

1)      From 2016 onward, this company will print money 

2)      The probability of success is high (and getting higher); the returns are compelling; and the time to realize value is getting shorter every day (three to four years there will be a value creating event)

3)      Interest rate risk is largely mitigated through conservative valuation and the pro-cyclical nature of the assets

4)      Having a smart capital allocator as the Chairman and two very capable and highly incentivized managers is a big positive, in my view

5)      If it were easy, it wouldn’t be cheap; and in two or three years, it’s going to be really easy (and hopefully, not cheap)

6)      As an add-on thought, Howard Hughes has a virtually unlimited landscape to invest capital at a ~10% unlevered cash on cash return.  These investments traditionally support high debt levels, which push equity returns into the mid to high 20%s.  Very few companies I follow have this kind of greenfield capital deployment opportunity, which in my mind is the real selling point for the stock.

Quick Background:

Howard Hughes is a collection of five ‘crown jewel’ real estate development assets.  The company was spun out of General Growth Properties in late 2010 as GGP was focusing on improving operating assets and shunning development.  These primary assets are supplemented by some smaller assets which have tremendous potential, but no near term development plans.  If you can get your arms around five assets, you should be able to value / underwrite the business.

Some color on each asset below - for more detail on the assets and pretty pictures, download the latest management presentation from a JMP Conference last year:

http://phx.corporate-ir.net/phoenix.zhtml?c=241177&p=irol-irhome

Go to the “Investors” tab at the top, and select the “October 1, 2013 JMP Presentation” to download it.

South Street Seaport:

HHC owns an essentially permanent lease underneath Pier 17 and the Uplands which are of the Seaport District in NYC.  The company has the right to lease two other buildings next to the Pier called the “Tin Building” and the “New Market Building”.

In the fall of 2013 the company broke ground on Phase 1 of a two phased redevelopment plan for the entire Seaport District.  Phase 1 will cost $425m to complete and will result in net operating income of $75 to $100m beginning in 2016.  That is an unlevered return (or development yield) of 17 to 23%.

Phase 2 is currently in negotiations with the city, which will likely take to the end of 2014 to formalize.  I believe the second phase will cost more (about $670m) and produce NOI of at least $60m (a yield of at least 9%, unlevered).

The Woodlands:

HHC owns the best master planned community in Houston called The Woodlands.  Historically, the owners of the Woodlands have focused on selling land for residential lots and commercial development.  HHC has decided to develop the real estate in Houston on its own.  Results so far are very encouraging with nearly half a million square feet of office space going up in 2013 (fully leased) and plans for another 7.3 million square feet planned through 2018.  Net, I believe these developments will cost about $2.7 billion to build (spent maybe $100m so far) and will have a development yield of about 10%. 

HHC does own about 3,000 residential lots in the Woodlands and prices have been skyrocketing (up 100% in 2013), but those lots will most likely be gone by the end of 2015.

Ward Centers:

The prize asset at HHC, 60 acres of prime waterfront land in the heart of Honolulu fully owned and fully entitled for commercial and residential real estate.  The opportunities for this project are virtually limitless.  Current plans include nearly 4,500 condo units over the next 10 years (~650 of which go on sale this month and begin construction in 2014), and nearly 1m square feet of office and retail. 

The full build out of Ward will take time and cost billions, but given the dynamics of the market in Honolulu in general and Ward in particular (ultra-premium market, 20% down prior to construction beginning) the risk is low and the returns are high.

Summerlin:

Summerlin is the nicest master planned community in Las Vegas.  It is due west of the strip and is where most of the well to do residents of Las Vegas live.  This asset has a lot of similarities with the Woodlands.  One major difference is the market in Houston is and has been on fire, and the market in Las Vegas is recovering.

Like the Woodlands, HHC has typically focused on selling land, primarily for residential development.  Also like the Woodlands, prices of land have skyrocketed there in the last year.  Unlike the Woodlands, prices are still well below peak.  Also unlike the Woodlands, the best lots have yet to enter the market – the far western reaches of Summerlin are completely undeveloped – they are elevated and offer the best views of the city / mesa off the Strip.

The most important part of the Summerlin asset is the commercial development potential.  HHC is building a mall there (it’s a mall that GGP started, then abandoned in bankruptcy).  The mall already has anchor tenants and is slated for opening by the end of this year.  This is one of the lowest returning assets HHC is building, but it has strategic importance.  I believe the mall will cost about $390m to build and should generate NOI of $35 (unlevered return of 9%).  The mall is important because it is a draw – there are hundreds of acres right in the middle of Summerlin around the mall that HHC can use for office / retail / apartment / hotel development.  When the mall is finished, the plans for future build outs should start.

Bridgeland:

HHC owns a second development in Houston called Bridgeland.  The development is northwest of downtown Houston and due west of the Woodlands.  The asset gets very little attention today given how important development of the Woodlands has become, but over time Bridgeland will generate a tremendous amount of value for the company, particularly when a new highway connects the area to the energy corridor, which is due south of Bridgeland.  Looking at a map and talking to developers in the area, the area where Bridgeland exists is the next logical place for population growth, which is why the city is building the highway.

Eventually Bridgeland will have its own commercial development opportunities, but today it is just about the land – roughly 18,000 lots when fully built out that will sell for the next 20 years. 

Other Assets:

Howard Hughes owns a significant development opportunity in Columbia, Maryland which is current in the planning / zoning phase.  As of today there are some office developments and a new Whole Foods that has gone into land / buildings that Howard Hughes owns.  The company is working towards approval for a new Landmark Mall that could be the spark for future commercial development.  Little value today but potentially real dollars in the future

HHC is constructing a new outlet mall in New Orleans called Riverwalk.  The project is slated to be complete in about a year at a cost of $80m and an estimated 10% development yield.

HHC owns GGP’s headquarters in downtown Chicago called 110 N Wacker.  The lease to GGP generates $6m of NOI for the company but has no real (near term) development potential.

HHC owns some apartments in North Carolina and Virginia, both construction projects today that should be completed in 2015 and 2016.  The company also owns ~12 other real estate assets with $210m of book value, no debt, and minimal NOI.

Capital Structure:

Net Asset Value:

When all the dust settles Howard Hughes will be a REIT with a significant amount of land assets.  REITs are typically valued on cap rates & FFO, both of which require something HHC doesn’t have much of today, Net Operating Income.  To figure out the value of the assets, it’s important to know what the assets will become, when they will become it, how much it will cost, and what the right multiple is (or cap rate).  Going by major asset:

Seaport: 

Phase 1 costs $425m.  NOI at $75m using a 5.5% cap rate implies $1.36 billion in gross value, $940m (or $21.00 / share) in net value upon completion in early 2016.

Phase 2 costs $670m.  NOI at $60m using the same 5.5% cap rate implies $1.1 billion in gross value, $421m (or $9.50 / share) in net value upon completion in mid to late 2017.

Total cost of construction, $1.1 billion.  Total value post construction, $2.4 billion.  Net value to shareholders, $1.3 billion or $30 per HHC share.  These assets should produce $3.05 / share in unlevered cash flow annually or about $2.00 / share net assuming 100% construction financing at 5%.  The implied value is roughly 15x.

The Woodlands: 

There are too many projects planned here to list, but they are all explained through shareholder letters from the CEO (in early 2012 and 2013) and various press releases over the course of 2013.  I’m happy to give much more detail on all the projects if anyone is interested – let me know.

In short, HHC will have developed 8m square feet of office and retail, ~750 hotel rooms and ~2,700 apartment units in the Woodlands at a cost of $2.7 billion which should generate NOI of at least $300 million.  These projects are coming online now and should be done by the end of 2018.

Using cap rates of 7-8% you get to value of $4.5 billion gross, or $2.8 billion net ($63 per HHC share) on unlevered cash flow of $6.75 / share annually, or about $4.00 / share assuming 100% construction financing at 5%.  The implied value is roughly 15x.

Ward Village:

Eight condo towers with 4,500 units averaging sales per foot of $1,400 and a 1,300 ft2 condo average with 30% margins and some inflation over the next ten years implies about $3.4B in cash inflows staggered over the next 10 years. 

Add another roughly 1m square feet of retail and office that will cost $250m to develop and yield ~$45m in NOI (already does $20m) implies another ~$450m of value to the equity.

Call it $4B of value to equity, or $90 / share, which will be lumpy but should begin to be realized in 2016.  Much of the NAV here is gain on sale, but there is significant opportunity to expand the commercial opportunity above 1m feet. 

Summerlin:

Like Ward the vast majority of the current value lies in the land and the price / velocity of lot sales.  Assuming a 20 year selling period, current prices and a healthy discount rate (15%), I believe the land is worth about $1.1 billion today, or $25 / share. 

The commercial development potential is huge and largely unquantifiable today.  As of now, we only have enough information to value the Mall, which will cost $391 million to build and should generate NOI of $35m beginning in 2015.  At a 6% cap rate the gross value is $580m and the net value is $190m or about $4.25 / share. 

Bridgeland:

Another pure land ‘gain on sale’ valuation assuming a 20 year selling period, current prices and a 15% discount rate gets you to $550m in current value, or about $12.40 / share.

As with the other MPC’s, the story here is more about the potential for future commercial development (like what happened with the Woodlands).  Any development here will take years to develop, but you’re paying nothing for it – and as we’ve seen in the Woodlands, when it happens the returns are huge.

Other Development:

The other projects have an estimated development cost of about $300 million, and should produce run rate NOI of about $45 million.  Using 6% cap rates on retail and 7% on office, I get to $550m of net value or about $12.25 / share to HHC by mid-2016. 

Lots of detail behind these numbers - happy to share if anyone is interested.

Other Non-Development:

Book value for these 13+ assets is $200m.  I just use that number and call it good.  That’s about $4.50 per share.

Add in another $15.50 / share for non real estate assets (including future cash from warrant exercises and $100m of off balance sheet DTA); subtract out $21 / share for taxes on land sales (that is a present value # using the same discount rates as on the land assets; assuming a 38% tax rate); you get to about $162 per share in present value of development assets.

 Again, if there is enough interest I’m happy to post my full NAV onto Google docs.  Just let me know.

How this should play out:

A lot of money will go into the ground over the next two years.  Starting in 2016, a lot of money will start coming out.  That is significant because 2017 is when management’s warrants (written up by Spence) are exercisable. 

At the end of 2017 I believe the cash flows will have begun to exhaust the DTA.  Management has said they plan to be tax efficient with the operating assets which implies a REIT structure (likely an early 2018 spin of commercial real estate). 

Land and condo sales are hugely cash flow generative, and my expectation would be that the after the capital used to develop commercial real estate is returned (through financing post construction completion), the excess cash will again be either returned to shareholders or used to fund incremental (highly lucrative) development activity.

The point is management is incentivized right alongside shareholders, and they have a very specific time frame when this story needs to play out (twelve months starting November 2017).

Just rolling forward what we know today, I believe the shares will be worth $230 to $250 when the warrants are exercisable (roughly a double in four years).

Why buy now?

There are three upcoming catalysts that could move the stock in the near term.

First, pre sales of Ward condos will go public starting in January.  Sales of Ala Moana condos this time last year sold out in 9 hours.  There are more condos for sale this go round, and the pricing is higher so they may take longer than 9 hours to sell, but my guess is there will be positive data points around the sales that will get people excited about what that project could be.

Second, and more importantly, the annual report should come out in late January / Early February.  The last two years have seen nice moves in the stock after the annual report and shareholder letter comes out.  The CEO generally gives a lot of color about the business and current plans in the letter, which so far have all been positive (and I would expect that to continue to be the case).

Finally, David Weinreb is speaking at the Harbor Investment Conference in NYC in February (on the 12^th).  Every time he gets in front of investors the stock goes up.  It happened at the Harbor conference last year.  It happened during the debt roadshow and after the JMP conference this year.  I expect nothing different from this discussion.

What has changed from summer 2013?

When 2013 began my estimate for NAV was $110 / share.  After the letter came out at the start of last year I spent a ton of time refining the NAV and was able to bring the estimate up to $120 per share.  By the end of last year, my NAV had climbed to $145 / share.  Today my guess on forward NAV is over $160.  There are three major changes, all of which have been positive.

First, the annual letter gave incremental disclosure about the Woodlands and office space in Hughes Landing and Town Center – both of which added about $10 / share to my NAV.

At the end of the year HHC signed a lease with Exxon for new office space in Hughes Landing – that is leading to two new buildings neither I (nor management) knew were going to be built at the start of the year.  That’s another $2 to $3 in found money to the NAV.

Second, land prices have been much better than I thought - partly because the market recovered, but mostly because the company switched to an auction system in the Woodlands and in Summerlin.  HHC is now auctioning the most desirable lots in both locations, which has led to significant price bumps in both place – net added about $5 to my NAV.

Third, the Seaport is a bigger project that I originally thought.  Management had been talking only about redeveloping the Pier until this past summer when they started discussing plans for the Uplands as part of Phase 1.  That doubled the cost, but also doubled the NOI and the value, adding about $8 / share to NAV.

In October, management disclosed some comparable rents in various NYC neighborhoods.  The lowest comparable was $230 per foot vs management’s discussion of $100 to $200 per foot.  I’m now using the top end of the range vs the prior midpoint adding another $8 / share to NAV.

Late last year Phase 2 plans for the Seaport were revealed to the public.  I went to the public presentation and learned the approximate size / scope of the project.  Running conservative assumptions through my NAV added another $10 / share in value.

Finally, another year has gone by, and because all of these assets are discounted annually, we picked up another year of value.  Adds another ~$10 / share in value.

The sum of these changes plus the incremental cash flows from higher NOI less the tax impact of higher land sales prices is a net NAV change of about $40 since July of 2013.

I’ll admit that my NAV is directionally correct and precisely wrong, but I think the more important point is that this management team continues to find ways to increase value – and that is VERY exciting given how much opportunity they have in front of them to put capital to work.

Catalyst