Description

I recommend the purchase of the Series C cumulative preferred stock issued by Hudson Pacific Properties (HPP).  These are a PA security for most, as the Series C shares trade at a rate of approximately 30,000 shares per day.

The Series C preferred stock has a liquidation preference of $25.00 per share and a cumulative 4.75% dividend paid quarterly.  Purchasing the preferred is a mean reversion bet, specifically, a bet on (1) stabilization and recovery (though not necessarily to pre-Covid levels) of the West Coast office and studio/sound stage market and (2) a decline (though not to ZIRP-era levels) in interest rates and capitalization rates.  Selling the Series C preferred in five years at a price of $17.50 yields an IRR of 17%, while selling at $20 yields an IRR of over 20% and selling at $25 (possible in the event of a change in control) yields an IRR of over 26%.  In the meantime, you are paid over 8% per year to wait.

Business Overview.

HPP is a West Coast focused real estate investment trust that owns and operates office properties and owns, operates, and develops studio properties (stages, sound stages, and production support facilities).  HPP's office properties generate 82% of its revenue and essentially all of its NOI, while the studio properties generate 18% of HPP's revenue.

HPP owns directly or through joint ventures 44 office properties comprising over 13 million square feet.  HPP's office properties are located primarily in the San Francisco Bay Area, Los Angeles, and Seattle.  As of March 31, 2024, HPP's office portfolio was 80.5% leased.

Through a joint venture with Blackstone, HPP owns studio properties comprising approximately 47 sound stages and 1.7 million square feet.  HPP's studio properties are located primarily in Los Angeles, and also include development projects in New York and London.  HPP's studio properties were

77% leased for the twelve months ended March 31, 2024.  HPP has a 51% ownership stake in the primary Blackstone studio JV and is responsible for day-to-day operations, leasing, and development.  This JV also owns five office buildings in Hollywood located adjacent to the studio properties.  (The New York and London studio projects, which also include Blackstone as a partner, are owned by separate JVs.)

The pandemic and its aftermath negatively impacted HPP's office portfolio, pressuring occupancies, leasing activity, and rental rates.  Meanwhile the 2023 strikes by the Writers Guild of America and the Screen Actors Guild brought production activities to a virtual halt, and activity has yet to return to pre-strike levels.  As a result, while 2022 AFFO declined slightly compared to 2021, 2023 AFFO was cut in half compared to 2022.

In Q2 2023 HPP cut its common stock dividend in half (from $0.25 per quarter to $0.125 per quarter) and HPP then suspended it entirely in Q3 2023.  HPP reinstated the common dividend in Q1 2024, albeit at a significantly reduced rate of $0.05 per quarter.  In addition, HPP sold five properties during 2023, yielding gross proceeds of $900 million and net proceeds of nearly $600 million after paying off approximately $300 million in associated debt.

Enterprise Value.  HPP's enterprise value is as follows:

Trailing AFFO/per share:  5.9

Debt.  HPP's consolidated financial statements do not present a complete picture of HPP's debt burden.  HPP's March 31, 2024 balance sheet shows consolidated debt of over $4 billion.  However, $1.5 billion of that amount is secured debt owed by joint ventures, nonrecourse to HPP, and another $168 million is secured debt encumbering a wholly-owned HPP property, again nonrecourse to HPP.  A schedule showing HPP's consolidated debt follows:

HPP's corporate level debt is $2.4 billion.  Maturities are manageable, with the first maturity of $259 million due in December 2025 and another $430 million due in the second half of 2026.  The debt trades at stressed, but not distressed, levels, with YTMs ranging from 9.6% for debt maturing in 2027 to 10.7% for later maturities.

Series C Preferred.  The terms of the Series C preferred stock are as follows:

Only Class of Preferred.  The Series C preferred is HPP's only preferred issue outstanding.  While HPP may issue other series of preferred stock at parity to the Series C preferred, the approval of the holders of at least two-thirds of the outstanding shares of Series C preferred is required for HPP to issue any series of stock ranking senior to the Series C preferred.

Liquidation Preference.  $25.00.

Dividends.  The Series C preferred pays a 4.75% dividend.  Dividends are paid quarterly and are cumulative.

Company Redemption Rights.  On and after November 16, 2026 (or earlier upon a change of control) the Series C preferred stock is redeemable at HPP's option, in whole or in part, for cash at a redemption price of $25.00 per share, plus accrued and unpaid dividends.

Holder Conversion Rights on Change of Control.  Upon the occurrence of a change of control (which is defined in fairly typical fashion), and subject to HPP's optional redemption rights in such event, each holder of Series C preferred stock has the right to convert some or all of the holder's Series C preferred into a number of shares of HPP common stock per share of Series C preferred equal to the lesser of (1) 1.9121 shares or (2) the quotient obtained by dividing (a) the sum of the $25.00 liquidation preference plus the amount of any accrued and unpaid dividends by (b) the common stock price (generally determined by the consideration received on the change of control).  The share cap of 1.9121 common shares is equivalent to a common share price of $13.07; thus, the conversion right is currently out of the money.

Thesis.

As mentioned in the introduction, the success of this investment depends on a recovery in West Coast office and studio fundamentals.  I will not attempt to convince anyone that office fundamentals will improve; there is a plethora of easily obtainable commentary, analysis, and opinion on that topic for anyone who cares to investigate.  Regardless, if you are an office bear, then the Series C preferred is not for you.

However, if West Coast office and studio fundamentals do in fact improve over time, I am confident that in such case HPP will survive and potentially thrive.  HPP's office properties are well located in its various submarkets, and management is competent and (by all available evidence) ethical.  Further, my impression is that Victor Coleman, HPP's CEO and Chairman, is protective of his reputation and will work diligently to ensure HPP's ultimate success.

With manageable maturities, HPP's capital structure gives management flexibility to buy time for an ultimate recovery.  Importantly, HPP owns 34 unencumbered office properties comprising nearly 10 million square feet.  Although exact figures are difficult to ascertain, I estimate that the NOI of HPP's unencumbered properties covers HPP's corporate level interest obligations by well over 2x, and the large number of unencumbered properties gives management additional flexibility to sell or refinance properties if necessary to enhance liquidity.

Furthermore, a recovery in studio fundamentals seems more imminent than an office recovery.  The studio joint ventures should again contribute positive NOI to HPP and the pending studio developments should result in additional NOI increases over time.

Returns.  Assuming a five year hold, below is a range of returns:

Assuming a tepid, but real, recovery in office and studio fundamentals, and a slight drop in interest rates, the Series C preferred should trade up to $17.50 per share (current yield of 6.8%), yielding an IRR of 17%.

Assuming more optimistically a significant (but not necessarily to pre-Covid, pre-strike level) recovery in office and studio fundamentals, and a more significant decline in interest rates (but not to ZIRP-era levels), the Series C preferred may trade up to $20.00 per share (current yield of 5.9%), yielding an IRR of over 20%.

Finally, it is conceivable that, assuming fundamentals sufficiently recover, management will choose to ultimately sell the company.  Victor Coleman is 62 years old.  He sold his previous company, Arden Realty, to GE Capital in 2006.  It would not be surprising if Coleman eventually did the same with HPP.  Assuming the sales price exceeds $13.07 per common share (a 6.4% cap rate on currently depressed NOI and a 16x multiple on currently depressed AFFO), the Series C preferred would, through exercise of conversion rights, receive the equivalent of $25 per Series C share, yielding an IRR of over 26%.

Risks.

• Interest rates increase further or do not decline.
• Office fundamentals in HPP's markets (1) do not improve or (2) deteriorate further.
• Studio fundamentals in HPP's markets (1) do not improve or (2) deteriorate further.
• HPP is acquired at a common stock valuation under $13.07 per share, leaving the Series C preferred as an orphan security in the acquirer's capital structure.  Mitigating this risk is the likelihood that the acquirer is stronger financially than HPP, resulting in the Series C preferred trading more on a yield basis and less on a credit basis, leading to improved pricing.

Catalyst

Improvement in office and studio fundamentals

Decline in interest rates

Acquisition of HPP above the conversion option breakeven price