Description
PRICE VS VALUE
The price of Kennedy-Wilson (KW) common stock is ~$11.00-12.00 (trading is light and the stock fluctuates). A reasonable upside value is $17. So it is possible that KW is trading at less than 70% of fair value. A stressed downside value is $8.50. This lower probability scenario represents 25-30% downside. The upside assumptions are that KW continues to achieve similar but slightly lower investment returns as it has in the past. The downside assumptions are that KW is forced to liquidate its property investments at roughly 10% discounts to book even though, first, there is no currently known reason why this would be required, and second, the properties were purchased generally at 50-60% of replacement cost during 2008-10. A more detailed analysis of valuation is presented below.
AN EXPLANATION OF WHY THE STOCK MAY BE MISPRICED
The stock is conceivably mispriced for numerous reasons. First, it is small, illiquid, and underfollowed (but gaining coverage). Second, the company's accounting is confusing (but getting a little more transparent). Third, and most important, book value and current earnings understate economic value.
Around 35-45% of economic earnings have been absent from reported earnings in the financial statements during the past three years. These unreported economic earnings relate to performance fees, or the company's approximately 20% share of gains on limited partner equity capital, which is sometimes known as "carried interest." Because KW records the bulk of its "investments in joint ventures" at historical cost and not fair value, gains or losses are not earned until the sale of the property, and the company's performance fees are also deferred and not recognized in earnings until real estate properties have been disposed. For the past three years, KW has been buying and rarely selling real estate properties. Most of these properties have appreciated in value.
A SHORT BUSINESS DESCRIPTION, SINCE THERE AREN'T MANY PEERS
Kennedy Wilson engages in two businesses. The primary business involves investing in commercial real estate; this requires substantial capital and the majority of earnings are deferred until asset disposal which makes them irregular and cyclical. The secondary business is property management services for real estate owned by third parties. This business supports the investment operation by gathering local market expertise, sourcing opportunities, and managing investment properties; this requires little capital and earnings are more recurring and less cyclical. (The model is quite similar to Brookfield Asset Management, which may be better known to some and has been written up on VIC before.)
The company's relationships in the real estate and banking markets provide a source of competitive differentiation. Occasionally, the owner of a property (i.e. Lennar or Bank of America or Allstate) prefers to avoid publicity surrounding an asset disposal, and values speediness to (and certainty of) closing a deal. Because Kennedy-Wilson has extensive human resources in property management services, the firm is in the flow of information regarding an extensive number of opportunities so that KW almost never buys properties in auctions. KW restricts its investments to a circle of competence defined by geographies where it has local infrastructure and market insights (US west coast, Hawaii, Tokyo). Management prefers to buy high quality properties from sellers that are distressed because of onerous capital structures rather than properties that require investment for rehabilitation. (The company recently took steps to expand its opportunity set into Europe by acquiring for next to nothing the asset management business of Bank of Ireland.)
Several of Kennedy Wilson's top managers have worked together for more than ten years, and management owns 30-35% of the equity. KW has invested in nearly 200 deals and deployed nearly $6 billion of capital. The firm has never missed a mortgage payment or returned a property to the mortgage holders.
Management's approach to valuing real estate is multi-pronged. They begin with an estimate of replacement cost, and aim to buy at 50-60% of replacement cost. Second, they get feedback from the KW property auction team about what the property (or its parts, e.g. condo units) would sell for currently in an auction. Third, they get insight from the property management team about what net operating income would be based on current rents in the local market. These insights provide a sound framework for valuing the property and for realizing the highest return on investment.
ANALYSIS OF UNIT ECONOMICS
Kennedy Wilson typically co-invests as a managing general partner in real estate with different limited partners, including LeFrak, Fairfax Financial, and Sigular Guff. The joint ventures utilize non-recourse property level debt with 65% loan-to-values. As such, the return on investment for KW includes: (a) fees for services provided to limited partners, (b) gains on appreciatino in the price of the property, and (c) cash flow from the property during the holding period. In short, because the JVs employ non-recourse property level debt and KW collects fees on the equity provided by limited partners, KW is able to realize returns on KW equity of 30%+ (before overhead expense). The table below illustrates the economics. During 2008-09-10, KW sold very few properties so the contribution to earnings from sales and performance fees is well below normal. The discussion that follows aims to provide a rough illustration of KW's economic model.
| ($-ooo) |
2004 |
2005 |
2006 |
2007 |
2008 |
2009 |
2010 |
| Investments in JVs* |
43,923 |
36,847
|
57,744 |
66,914 |
142,188 |
185,252 |
242,298 |
| Equity in JV income (pre-tax) |
11,520 |
35,855 |
14,689 |
27,433 |
10,097 |
8,019 |
6,883 |
| ROI pre-tax |
26% |
89% |
31% |
44% |
10% |
5% |
3% |
| *For 2004-05-06 the figures are for "Investments in JVs and real estate" because "Investments in JVs" alone was unavailable. |
Key assumptions. The table below highlights key assumptions in my illustration. These are garnered from the company's filings with the SEC (particularly the S-4 and 10-K for 2010) and discussions with industry participants. The marketing handout for the unsecured notes road show provided illustrations that subsequently confirmed many of these details.
| Assumptions |
|
| Purchase price of real estate (investment cost) |
100 |
| KW equity contribution (%) |
22.5% |
| KW acquisition fee (% of purchase price less KW equity and pro rata share of debt) |
0.50% |
| KW asset management fee (% of property rental revenue) |
1.25% |
| KW property management fee (% of property rental revenue) |
3.00% |
| KW carried interest (% of 3rd party gain) |
20.00% |
| Limited partners preferred return rate |
10.00% |
| Real estate NOI (after interest, per year) |
7.00% |
| Real estate price appreciation |
25% |
| Holding period, # of years |
3 |
| Property debt loan-to-value |
65% |
| Property debt interest rate (per year) |
7.5% |
Kennedy Wilson derives earnings from three main sources.
1. Fees paid by limited partners to Kennedy Wilson for acting as managing partner which typically amount to 35-40% of KW's investment, or an annualized ROE of 10% (before holding company expense). There are three main sources of fee income.
a. Acquisition fee - KW collects 0.50% of the real estate purchase price (less its equity contribution and its share of property debt) as commission for sourcing the investment. So in the example assumed above on a $100m property acquisition, KW would receive a commission of $0.31m (5% of KW's equity investment). This assumption is derived from several sources. in 2010, KW reported acquisition fees of $4.0m related to investments of $2,025m. Netting out KW's contribution of $150m in equity and ~$285m in debt, that leave sthe nonaffiliated partners' percentage of the total acquisition cost at $1,590m. The $4.0m is 25bps of the $1,590m. On the other hand, KW Property Fund III details that acquisition fees will be 1%, and the example in the marketing handout for the unsecured notes states 0.50% of purchase price.
b. Asset management fee - KW collects 1.00-1.50% of the JV limited partner's investment per year for managing the investments. So in the above example of the $100m deal, the mortgage would be $65m, while the JV's equity would be $35m. KW would contribute 22.50% of the equity, or $7.875m, while the limited partners contribute $27.125m. And KW would collect 1.25% of the $27.125m per year as property management fees. Over a three year holding period, these fees amount to $1.0m (-15% of KW's equity investment). In KW Property Fund III, the partnerships pay the general partner a management fee equal to 1.50% of the aggregate commitments of the nonaffiliated partners (2010 10-K). In the example in the marketing handout for the unsecured notes the asset management fee is 1.25% of the third partner equity.
c. Property management fee - KW collects around 3% of the gross income from the property for managing the operations of the real estate asset. This is derived from industry sources and from the fact that in 2010 KW earned $46,871 in "property management fees" on One Carlsbad, a JV that reported total revenues of $1,626,181. In the example above, if a property is purchased for a 7% cap rate, the gross income might be $10m, and KW would collect $0.32m per year, or $0.95m over three years (12% of KW's equity investment). In the example in the marketing handout for the unsecured notes, the property management fee is described as 3% of the revenue, assuming a property has a 6% cap rate and a 60% NOI/revenue margin.
Together, these various fees are reported in the GAAP income statement within "management and leasing fees" and as part of the "Services" segment.
| FEE INCOME TO KENNEDY WILSON (KW, $-MM) |
$2.28 |
| Annualized ROE based on fee income before holdco costs |
10% |
| Acquisition commission fee income ($-mm) |
|
| Purchase price |
$100.00 |
| KW equity + debt share |
37.13% |
| KW acquisition fee (% purchase price less KW equity + debt) |
0.50% |
| Acquisition commission fee income to KW |
$0.31 |
| |
|
| Asset management fee income ($-mm) |
|
| Join-venture partner equity investment |
$27.13 |
| KW asset management fee (% of 3rd party equity per year) |
1.25% |
| Management fee income, per annum |
$0.34 |
| Investment holding period, # of years |
3.00 |
| Cumulative asset management fee income to KW |
$1.02 |
| |
|
| Property management fee income ($-mm) |
|
| Purchase price |
$100.00 |
| Real estate NOI (after interest, per year) |
7.00% |
| Real estate rental revenue/gross income (per year) |
10.50% |
| KW property management fee (% of annual rental revenue) |
3.00% |
| Investment holding period, # of years |
3.00 |
| Cumulative property management fee income to KW |
$0.95 |
2. The gain from appreciation in the real estate price is often 120% of KW's investment. Kennedy Wilson benefits in two ways from price appreciation: from appreciation of the firm's capital and from its profit sharing in the investment return generated for its limited partners.
a. KW's equity in the property appreciates - Management aims to purchase real estate for 50-60% of recent construction costs/investment. If a $100m investment appreciates 25% during the three year holding period, and KW contributed 22.5% to the equity, then it garners $5.63m in investment gain (70% of KW equity investment). Note: this is return "on" and not return "of" capital. In other words, a 25% gain on an investment with assets/equity leverage of 3x. According to the 10-k (2010): "Since 1999, we and our equity partners have invested in 201 transactions, deploying over $6.4 billion of capital, including $2.3 billion of equity. Of the transactions, 93 have been realized and generated an internal rate of return or "IRR" of 43% and a 1.7x equity multiple."
b. Performance fees or carried interest - KW shares 20-35% of the limited partners' profits above a certain return, typically 8-12%. Quite often, the 10% hurdle rate is met from the operating cash flow on the property so that KW shares in the entire equity appreciation. That would amount to $5m, or 65% of KW's equity investment. In a more conservative illustration, the operating cash flow is not incorporated into the preferred return of the limited partners. Here, the JV partner contributes $27.125m to the investment. When the property is sold for $125m, and the debt is repaid at $60m, then the limited partner is entitled to the $27m of equity and to the first $9m of equity appreciation. The remaining $24m, less KW's equity of $7.875m, is split 80% to the LP and 20%, o4 $3.7m, to KW (50% return on KW's equity investment).
| EQUITY APPRECIATION BENEFIT TO KW ($-MM) |
$9.33 |
| IRR based on property price appreciation |
50% |
| Direct benefit from equity appreciation ($-mm) |
|
| Property asset purchase price |
$100.00 |
| Mortgage principal |
$65.00 |
| Initial JV equity investment |
$35.00 |
| KW equity contribution (%) |
22.50% |
| Property asset price appreciation |
25% |
| Property asset disposition price |
$125.00 |
| Property net asset disposition value (after $65m mortgage) |
$60.00 |
| Equity appreciation for total JV |
$25.00 |
| KW equity appreciation |
$5.63 |
| |
|
| Secondary benefit from equity appreciation -- carried interest ($-mm) |
|
| Initial JV equity investment |
$27.13 |
| Annual JV equity return hurdle rate |
10.00% |
| Investment holding period, # of years |
3.00 |
|
JV equity return before KW profit share
|
$36.10 |
| Property net asset value upon disposition (total JV equity) |
$60.00 |
| Profit sharing pool |
$18.52 |
| KW share of profit sharing pool |
20.00% |
| Carried interest income |
$3.70 |
The carried interest income is recognized in "equity in joint venture income" only upon disposition of a property. Since the earnings are dependent on the volume of properties disposed and the investment return, the reported earnings are lumpy. This is an important accounting difference compared with other investment companies. For example, Apollo Global Management (APO) reported 2010 revenue of $2,109.9 million, of which $,1,599 million was carried interest income. But, only $244 million of the carried interest was realized and the remainder was unrealized. So 65% of Apollo's 2010 revenue was unrealized carried interest income. Because real estate assets are often held at cost and not at fair value, Kennedy Wilson (and Apollo in its real estate segment) records no unrealized carried interest. Consider the history of Kennedy Wilson's equity in JV income -- see the first table presented above.
3. The operating cash flows generated by the real estate property. Kennedy Wilson may acquire a property that yields 7.0% net operating income. In 2010, the company's multifamily portfolio consisted of 78 properties and nearly 12,000 units that were 96% occupied. The net operatign income was about $103 million.
The unit economics suggest that in sum Kennedy Wilson can return 50% on equity. The table below summarizes the various sources of income, and how they compare with the initial equity outlay. The business model translates 25% real estate investment price appreciation (over three years) into 50% per year return on equity for Kennedy Wilson shareholders.
| Total income to Kenendy WIlson |
|
| Fee income ($-mm) |
2.277 |
| Acquisition fee ($-mm) |
0.314 |
| Asset management fee ($-mm) |
1.017 |
| Property management fee ($-mm) |
0.945 |
| Property ROE for KW from fee income (%) |
29% |
| Investment income ($-mm) |
9.329 |
| Investment return on equity ($-mm) |
5.625 |
| Carried interest promote ($-mm) |
3.704 |
| Property ROE for KW from real estate price appreciation (%) |
118% |
| Total KW income |
11.606 |
| KW equity |
7.875 |
| ROE |
150% |
| Annualized ROE |
50% |
MORE DISCUSSION OF VALUATION
In this analysis, I value the investments and fee businesses separately. Then I discuss the growth prospects, but there is no present value ascribed to future growth (excluding appreciation of exisiting assets).
1) Investments. Kennedy Wilson has achieved, to date, an equity multiple of 1.7x on property investments. Currently, the firm has $364m invested: a) $267m of investments in JVs ($35m is recorded at fair value not cost), b) $48m of majority owned real estate (eight properties with gross investment of $83m and mortgages totaling $35m), c) $24m of notes receivable acquired from East West Bancorp, and d) $25m of loan pool participations. (The 10-K provides lots of detail on these investments.)
If the range of value for these is between 0.9x and 1.7x, which seems quite conservative given (a) that realizations so far have been 1.7x and (b) that nearly all of the current investments were made in 2008-10, then the realization value of these investments would be $320m to $560m. Importantly, this value does not include Kennedy Wilson's performance fees (carried interest).
The investments are carried on the balance sheet at $364m, and my estimate of a reasonable value is within a range of $320m to $640m.
| |
|
0.9X |
1.7X |
| INVESTMENT ACCOUNT ($-MM) |
12/31/2010 |
LOW |
HIGH |
| Investments in JVs (cost) |
$232 |
$209 |
$395 |
| Investments in JVs (fair value) |
35 |
31 |
59 |
| Real estate |
83 |
74 |
141 |
| Mortgage debt |
(35) |
(35) |
(35) |
| Real estate, net |
48 |
39 |
106 |
| Notes receivable |
24 |
22 |
41 |
| Loan pool participations |
25 |
23 |
43 |
| TOTAL |
$364 |
$324 |
$643 |
2) Fee business. Both the "Services" and "Investments" segments include certain fee income. The Services segment includes acquisition fees, property management fees, and auction fees. The Investments segment includes rental revenues (property operating cash flows) and performance fees (carried interest), as well as sales of real estate. The rental revenues and sales of real estate form the basis for the valuation of "Investments" discussed above. But performance fees are not part of the "Investments" valuation. In my view, the performance fees are more recurring and can be capitalized. The current (and recent) reported earnings from the Investments segment include little or no performance fees. So t o estimate recurring fee income, subtract Investments earnings altogether, and then estimate a normal earnings contribution from performance fees. (EBITDA is utilized here because it captures Kennedy Wilson's pro rata share of JV earnings -- look through earnings -- in the clearest fashion, not because EBITDA is a particularly useful proxy for cash flow.)
In 2010, Kennedy Wilson reported adjusted EBITDA of $58m. I make the following adjustments to derive a figure that makes sense to capitalize.
- Subtract the Investment segment, which contributed $56m in 2010. This included approximately $3m from the sale of real estate.
- Normalize performance fees, which contributed perhaps $3m in 2010. My estimate of normal performance fees is ~$40m. KW reports Investments in JVs of $267m. Historically, carried interest earned upon sale typically equaled between 30% and 130% of KW's initial equity investment in the JV. In the economic model detailed above, KW's performance fees amount to 45-50% of its initial equity investment in the JV. This suggests carried interest of $80-350m, with a likely value of around $120m. Since investments are typically held for three years, the annual performance fees equal ~$40m.
- Two other adjustments are proposed but are not adopted for the sake of conservatism. First, the auction fees in the Services segment will be higher in 2011 that in recent years. KW's auction pipeline for 2011 is about $600m. The company earns 3% in fees. This suggests fees of $18m in 2011, compared with $6m in 2010, and $4m in 2009 and 2008. Second, holding company expenses were elevated in 2010, KW's first full year as a public company. Ongoing expenses are more likely $5m (2009) than $7m (2010).
The fee businesses are worth $170m based on 4x recurring EBITDA from 2010, or nearly $340m based on 8x.
| Recurring earnings |
2008 |
2009 |
2010 |
| Investments EBITDA |
$20 |
$38 |
$56 |
| Services EBITDA |
8 |
4 |
9 |
| Other EBITDA |
(1) |
(5) |
(7) |
| Total Adj EBITDA* |
$27 |
$37 |
$58 |
| Less Investments EBITDA |
20 |
38 |
56 |
| Normal EBITDA from performance fees |
40 |
40 |
40 |
| Adj EBITDA from recurring sources |
$47 |
$39 |
$42 |
| Avg assets |
105 |
164 |
214 |
| ROA |
45% |
24% |
20% |
| Value @ 4x |
$188 |
$155 |
$169 |
| Value @ 6x |
$281 |
$233 |
$253 |
| Value @ 8x |
$375 |
$310 |
$337 |
| *"Adjusted" is defined and reported by the company |
|
|
|
3) Growth. Kennedy Wilson acquired about $2 billion in assets for the partnerships in 2010, boosting its investment account from $212m to $364m. The company ended the year with $47m in cash, or nearly 10% of total assets. After a $200m debt issuance, and $60m or so of cash from asset disposals, KW will have in excess of $200m for investment. The partnership equity has already been arranged with Fairfax, LeFrak, and Deutsche Bank. There are 9.8m warrants outstanding with an exercies price of $12.50 to fund continued growth, but some of the larger owners of those warrants reportedly don't have the liquidity to exercise the warrants.
Management reports that the pipeline is higher than 12 months ago (stemming from commercial real estate maturities in 2011-14) with almost $2.8 billion of deal flow at various stages of underwriting. Accordingly, the investment account is expected to increase from $364m to $500m or more at the end of 2011. Year-to-date, the company has closed $216m of investments, and has another $1.6 billion under contract.
Moreover, the company anticipates net operating income from the multifamily properties currently in JVs to increase from $103m in 2010 to as much as $150m over the next couple of years owing to strong demand and limited supply of new multifamily units.
| KENNEDY WILSON VALUATION, figures in 000s |
|
|
| figures in 000s, except per share |
|
|
|
| |
BOOK |
LOW |
HIGH |
| A. INVESTMENTS |
|
|
|
| Investments in JVs, historical cost |
232,213 |
208,992 |
394,762 |
| Investments in JVs, fair value |
34,687 |
31,218 |
34,687 |
| Real estate, net |
47,500 |
39,430 |
105,590 |
| Notes receivable |
24,100 |
21,690 |
40,970 |
| Investment in loan pool participation |
25,200 |
22,680 |
42,840 |
| TOTAL INVESTMENTS |
363,700 |
327,330 |
594,009 |
| |
|
|
|
| B. FEE INCOME |
|
|
|
| Recurring EBITDA @ 4x and 8x |
42,614 |
170,455 |
340,909 |
| TOTAL PROPERTY MANAGEMENT SERVICES |
|
170,455 |
340,909 |
| |
|
|
|
| C. OTHER |
|
|
|
| Cash |
46,968 |
42,271 |
79,846 |
| Cash from warrants |
|
0 |
122,593 |
| Receivables, goodwill, other |
41,974 |
37,777 |
41,974 |
| Total liabilities less mortgage debt |
(139,693) |
(139,693) |
(139,693) |
| TOTAL NET OTHER |
(50,751) |
(59,645) |
104,720 |
| |
|
|
|
| D. TOTAL NET VALUE |
|
|
|
| Net asset value |
312,949 |
438,139 |
1,039,638 |
| Shares outstanding |
40,180 |
51,280 |
61,087 |
| NAV PER SHARE |
7.79 |
8.54 |
17.02 |
| PRICE/VALUE |
150% |
140% |
68% |
KEY RISKS
1) Low earnings yield. This is rarely preferable, and is highly out of favor today.
2) Major deflation. Kennedy Wilson primarily owns commercial real estate. Major deflation will reduce the value of the company's properties, and earnings will likely suffer in the near term owing to fewer real estate transactions. Two factors mitigate the negative impact of deflation. First, the company purchased the bulk of its properties in 2008-09-10, just following a major property deflation (albeit a brief one). Second, the company aims to purchase assts at around 50% of construction cost and uses non-recourse mortgage debt but with a 35% equity cushion. Finally, Kennedy Wilson has in excess of $200m in cash on hand and access to capital (this obviously could change) that would permit the company to capitalize on deflation by investing in more distressed assets.
3) Liquidity. At all times, management intends to hold $50-75m of cash at the holding company, and to have a similar amount of availability on its line of credit with US Bancorp. At year end, KW held $128m of debt, including $35m of mortgages with recourse only to the properties. Only $10m matures within one year, and the company has $50m of availability under its $75m credit line with US Bancorp and East West Bancorp. Also, KW guaranteed $28m of JV debt, but the guarantees expire during 2011. Note that at 12/31/2011, the partnerships had debt of $1.8 billion and assets of $3.04 billion (60% LTV).
4) Higher interest rates. Higher rates would increase the company's cost of capital and reduce cash flow to equity holders. Management just issued $200m of fixed rate notes at the holding company and has little variable rate debt currently. The partnerships have $1.8 billion in mortgage debt, of which less than half is variable rate, and all the variable rate mortgages have interest rate caps.
5). Big seller. A top holder selling the stock can hurt in the near term. For example, Frontpoint sold nearly 1.5m shares during the fourth quarter of 2010. I believe that sale had little to do specifically with KW, and rather was part of a firmwide decision to exit illiquid positions.
OTHER
1) High insider ownership. Management owns 30-35% of the equity. The company's capital discipline, so far, illustrates a sharerholder minded orientation.
2) Value oriented shareholders. There are some well known value oriented shareholders today, including Fairfax (20%), Royce (12%), Wally Weitz (30,000 shares), and Stanley Zax (CEO of Zenith Insurance, 25,000 shares).
Catalyst
Disposal of commercial properties and realization of performance fees -- probably a few years in the future still