Description

Kennedy Wilson

Introduction

• Kennedy Wilson is a diversified real estate c-corp. It has several unique qualities that differentiate it from traditional REITs (all %’s by NOI):

  • 1) Asset diversification: It owns traditional multifamily (47%), affordable multifamily (8%), office (29%), retail (6%), industrial (3%) and hotels (4%)

  •  2) Geographic diversification: United States (61%), UK (17%), Ireland (19%), Italy/Spain (3%)

  • 3) Large Development Pipeline: Through its development pipeline and assets in lease-up, KW expects to add ~20% of NOI over the next 2-3 years.

  • 4) Ownership Interests: A mix of consolidated interests (63%), 50/50 owned joint ventures with other investors (27%), and minority owned interests in fund investments and single asset joint ventures (10%)

• Typically, having just one of the above constructs creates a complexity discount in REITs. On top of the above points, KW is significantly levered – at ~19x my estimate of run-rate EBITDA, or 78% loan to value on a consolidated basis through TEV. In spite of this, KW actually trades very expensively

  • 10% premium to NAV, or an implied 5.6% cap rate

  • Inclusive of run-rate G&A (but generously excluding stock-based comp), KW’s cap rate is 4.1%. Inclusive of taxes and maintenance capex, I believe KW to trade at a 2.7% unlevered FCF yield

  • KW doesn’t report AFFO – a REIT metric that is quasi-equivalent to free cash flow excluding growth capex – but I believe if reported it would be negative.

• Because of the general market’s admiration for its unique platform and management team, I believe this is an unusual case where complexity may actually be helping the Company’s valuation. It’s shareholder base is pretty stagnant, and the sell-side is not incentivized to get into the granularity that exposes KW’s weaknesses – both of which support its share price.

• In my opinion, this valuation discrepancy will likely normalize over time, particularly as the market realizes the management team’s capital allocation has been particularly weaker than advertised. Given all of the above, a 5.6% implied cap rate / 2.7% unlevered FCF yield is certainly not the right valuation.

• Fundamentals of KW’s assets should deteriorate over the next several quarters. Its “Mountain West” (Idaho, Utah, Nevada) multifamily portfolio saw explosive growth during Covid and is likely currently seeing negative market rent growth. It’s US office portfolio has significant challenges which will likely become more clear in the near-term.

• In addition, I believe the market today is missing several concepts which should lead to a de-rating over time.

  • 1) True run-rate earnings due to complexity and lack of reporting metrics. The Company reports EBITDA inclusive of gain of sale from assets. It does not however report AFFO, but I believe this is negative. The Company is only able to cover its dividend because of its sale of non-core assets – I believe this fact will become clear over time.

  • 2) Debt has significant near-term mark-to-market, so while development assets + organic growth should deliver ~$115mm of additional NOI through 2025, interest expense should grow ~$90mm over the same period.

  • 3) Appropriate valuation framework – if one were to compare each segment of KW’s asset pool to its relevant public comp (i.e. its multifamily portfolio to ESS/MAA, its west coast office portfolio to HPP, etc.), KW should trade at a ~6.5% cap rate. Given its significant leverage, this would imply KW’s equity to be worth ~$8/sh, or a 50% discount to the current share price. Even rolling forward to 2025 when its development pipeline stabilizes (giving full credit to KW’s underwritten estimates), applying the same valuation framework would imply the stock to be worth ~$10, or ~40% downside.

Fundamental deterioration

• Multifamily Portfolio - “Crown jewel” seeing significant negative rental pressures

  • US Multifamily (~42% of NOI)

    • The mountain west region, which KW has made the core part of its portfolio, is among the most decelerating market in the US for rent growth. This is because of 1) over-earning during Covid, 2) over-earning induced significant supply in the market

    • However, in Q1 the biggest weakness was from its Northern and Southern California assets – which saw -10.7% and 3.3% SSNOI growth YoY, respectively. This was partially due to Covid-induced eviction moratoriums being lifted, which is a general positive, but creates an operating challenge to lease up vacant units in a softer leasing market. This headwind should persist for the next couple of quarters, on top of generally weak rental rate growth, which should drive higher concessions. ESS, which has the most analogous portfolio by geography, is among the worst performing multi REITs, and reported a very weak June mid-quarter operating update (decelerating effective rent growth QTD, whereas most REITs saw acceleration into the very important spring/summer leasing season).

    • In Q1, KW’s US total SSNOI was 5.4% which is ~50% lower than average multifamily group of ~11%. The lowest performer in the group excluding KW was 8.1%.

    • The trajectory of data post Q1 is even more concerning. The real time data of market rent growth as of June shows that essentially all of KW’s markets are seeing negative market rent growth. See how the graphic below of KW’s exposure compares with the report from Realpage (tweet highlighted below). Boise, Las Vegas, Reno, Salt Lake City are all in the top 15 most decelerating markets nationally. NoCal / SoCal also called out as flat to negative rent growth.

      • https://twitter.com/jayparsons/status/1679500542756757505?s=12&t=0-WmxHOuG6_eqMcWw6deEw

      • 

  • US Affordable Housing (~8% of NOI)

    • This is a pretty steady business. SSNOI should consistently be 3-5%, but this is dependent on local legislative rules that allow landlords to pass through rent increases that keep up with operating expense growth. In NYC for example, this is a big issue – as the Rent Guideline Board has historically restricted rent increases to below CPI growth, while operating expenses increase more rapidly, which pressures NOI growth.

  • Ireland Multifamily (~6% of NOI)

    • The other significant portion of its multifamily portfolio is a concentration around Dublin, Ireland. In 2021, Ireland adopted rent control policies, so at maximum, KW will only be able to grow rents 2.0% a year in perpetuity. Operating expenses will likely be in excess of 2.0%, thus putting negative pressure on SSNOI. Look at the ticker IRES ID to understand the impact of this policy (and higher interest rates) on Irish residential values…

• Office Portfolio

  • KW’s US office (~9% of total NOI) has performed okay based on same-store data (likely because limited lease maturities), but suggests upcoming concerns

    • KW’s 3rd largest asset across its portfolio (~3% of NOI) is an office building in suburban Bellevue, WA. Based on CoStar data, Microsoft is its largest tenant (400k out of 567k SF), and is likely to vacate when its lease matures in November. This is not private information, but I haven’t seen the news mentioned in a sell-side report or by the company. Given the asset’s location on the I-90 corridor, I think this asset will struggle significantly to attract any tenant other than Costco, who is the neighboring tenant. Generally put, this is a non-desirable suburban office.

    • KW’s other large US office asset is called Hamilton Landing in Novato, CA, which is a suburb in Marin County north of SF. SF has seen significant office challenges, and while the suburban markets have different fundamentals than downtown SF, in this particular submarket, according to a CBRE market report, office vacancy is 30%+ for Class A office (in comparison I believe Manhattan is 12% today, and downtown SF is ~32%).

  • Ireland office portfolio (~7% of NOI)

    • The other significant portion of its office portfolio is around Dublin, Ireland. Dublin’s office market has slowed dramatically given its leverage to tech employers. Green Street forecasts Dublin to have the worst market rent growth of any major city in Europe over the next 3 years. KW has at least one large development assets under-construction here that I imagine will struggle to be leased at completion.

  • UK office portfolio (~12% of total NOI)

    • Comprised of two high quality assets in Central London (111 BPR / Embassy Gardens, together roughly 6% of NOI), and a mix of smaller assets in regional locations (the other 6%). The story of UK office is a bit similar to the US, albeit central London is a much stronger market than any in the US (much lower vacancy, real net effective rent growth). The regional markets though are similar to the US – higher vacancy, higher TI packages – which implies ~half of the UK office portfolio will struggle.

• Other Remaining Components

  • UK / Ireland Retail (~6% of NOI) – don’t have much of a view, but these are typically malls / high street retail, which are both challenged asset classes

  • Industrial (3% of NOI) – many will point to KW’s industrial exposure as a positive, but because this is in a fund structure and KW is co-invested in a traditional minority GP stake, it’s a much less relevant to their total pro-rata NOI and bottom line. These assets should likely do okay here because of secular tailwinds to industrial, but I question the **stellar** capital allocation of management, who have really missed most of the move in industrial and plowed into the sector at the top of the capital cycle.

  • Hotels (4% of NOI) – the only contributor today is the Shelbourne hotel in Dublin. This is a high quality trophy asset that is likely performing well, and liquid if marketed to be sold. This is probably the asset I’m the least worried about in the whole portfolio. Under-construction (not a contributor yet) is KW’s Rosewood hotel in Kona Hawaii. This will again look nice and pretty on an investor presentation. I believe KW’s cost basis here to be almost $5mm / key, which is astronomic. So, while KW will talk about beating underwritten ADR’s and other metrics, they probably aren’t mentioning that even at a stabilized value of ~$5.5mm / key by taking KW’s estimated NOI, adding 13%, and applying a 6% cap rate (consistent with Jackson Hole Four Seasons / Montage trades in 2022), this isn’t a “home run” from a return perspective.

Reporting Complexity

• Things that KW doesn’t show (that a typical REIT would)

  • Cash NOI

    • KW obfuscates reporting items to inflate its own NOI figure. For example, they include $3mm of NOI for it’s owned and occupied corporate headquarters, which assumes $100/sf rent in Beverly Hills whereas market rents are probably more like $75/sf. They also exclude management fees for multifamily and add back a significant amount of straight lined rents (which I incorporate into my Cash NOI figure)

  • Same-Store Metrics Across Whole Portfolio

    • KW only shows 75% of its office portfolio in SSNOI, 80% of Multi portfolio in its SSNOI, and nothing on Retail/Industrial/Hotels which make up 13% of total NOI. It feels a bit like cherry picking their assets

  • “Clean” EBITDA

    • KW’s EBITDA metric includes “gains on sale” which hides the true run-rate factor of EBITDA. Since KW has been a net seller over the past several years, between 2018-2021, roughly half of its EBITDA came from gains on sale. This is unlikely going forward given capital markets in commercial real estate.

  • Most importantly though, KW does not report AFFO or FCF like metrics - when breaking down correctly, on run-rate, I believe KW actually produces negative AFFO

    • KW runs an enormous G&A budget – it would be in the top 5 of the 110+ REITs covered by GSA even when adding back its fee revenue from its investment management business (calculated as G&A incl. stock based comp less investment management fees divided by total gross assets). The only REIT >$5b of asset value with a larger G&A budget is EQIX, which has abnormally large sales component to its cost structure given its sales-heavy business model.

    • Bulls will point to ~$115mm of NOI growth from active developments + assets in lease-up + organic growth, but interest expense should grow significantly as well

    • Gains on sale are what are funding the dividend, steady state business is not. In the long-run, this will become more clear

Leverage

• KW promotes that 97% of its debt is “fixed” – but that doesn’t tell the whole story because of 1) hedges, 2) implied mark-to-market at maturity will be significantly higher

  • 1) Interest rate hedges have WALT of 1.9 years, and are 26% of total debt. As these roll off, interest expense will be much higher given where rates are today vs where they were when these hedges were struck

  • 2) As an example, KW Europe has bonds outstanding due in 2025 that trade at 9% YTW. The in-place interest rate 3.3%.

    • They also have unsecured bonds that mature in 2029/30/31 that trade at ~10% YTW vs. an in-place coupon of ~5%. Obviously we won’t see this in the near-term but it gives some indication where the credit markets would mark-to-market KW’s debt today.

• Most sell side aren’t covering this properly. Typically, because of complexity, most will anchor to a spot NAV analysis, so forward interest expense is not accounted for

• When rolling forward, and adjusting for hedges rolling off, interest expense should increase by $90mm between now and 2025

Valuation

• My view of NAV is $15.50/sh when doing a SOTP analysis on each segment of its portfolio. On a number of valuation methodologies, KW is insanely expensive:

• 1) NAV Premium: KW current trades at a ~10% NAV premium. For reference, according to Green St Advisors, the US multi sector trades at a ~12% discount, office at a ~35% discount.

• 2) Implied Cap Rate: The proper way to value is on GAV – because of different leverage profiles across REITs. If you apply the same implied cap rates of public companies that have similar portfolios (i.e. ESS to multi portfolio, HPP to office portfolio, British Land to UK office portfolio), and a sector-wide GAV discount to portfolios that don’t have a direct comp (i.e. the US REIT multifamily sector GAV discount as a proxy for KW’s affordable multifamily portfolio), it implies a blended 6.5% cap rate. This would imply a share price of ~$8/sh, or a 50% discount.

  

  • Even when rolling forward to 2025, applying the same cap rate, I get to ~$10.00/sh, or 40% downside from today’s share price.

  • Layer in: diversification, heavy development pipeline + cash drag, significant leverage, complexity, it would suggest KW should trade worse than its comps, so the above is likely a conservative estimate

• 3) Unlevered Free Cash Flow Yield: KW trades at 2.7% today and 3.0% in 2025. Again, this is generously not including KW’s SBC – if included its unlevered FCF yield would be ~40 bps lower. For reference, ESS/MAA (US multifamily names) trade at ~4.4% ULFCF yield. Even REXR, which is a very low cap rate industrial name because its rents have an embedded mark to market of 50% (something that KW clearly does not have), trades at a 3.2% unlevered FCF yield. If you apply ESS/MAA’s unlevered FCF yield, KW is worth negative equity value. To be clear, I don’t think KW’s equity is worthless, I just think this exercise highlights the absurdity of the valuation.

• 

• 4) AFFO Yield: KW produces negative AFFO so this metric isn’t even comparable to other REITs.

Conclusion

• So, in conclusion, you have a real estate c-corp with:

  • 1) Among the highest leverage across the REIT sector – 80% LTV / 19x EBITDA (which is still 15x EBITDA pro-forma for all the development completion)

  • 2) 30% office exposure, with significant near term challenges

  • 3) Majorly decelerating fundamentals in its multifamily business

  • 4) Negative AFFO

  • 5) Significant other complexity

  • 6) Trading at a 5.6% implied cap rate, of 2.7% unlevered free cash flow yield

Risks

• Take private or management led buyout? Unlikely, management team gets paid so well (CEO made $19mm per year over last 8 years despite stock being down 40%). KW issued equity in Q1, so the company/management must think we are still close to fair value.

• The market just doesn’t care. Many of the points above have been true for some time (negative AFFO), leverage, etc. The Company seems to be getting the benefit of the doubt on its cash flow profile because it has been a net seller of assets for several years.

• Management can keep selling non-core assets to cover the dividend and hide true run-rate free cash flow, particularly since it doesn’t report AFFO. Fairfax, who as investors are generally held in high regard, support KW via providing capital in its investment manager business. This is highlighted by the recent PacWest deal, whereby Fairfax also injected $200mm via new preferred equity (plus free penny warrants) to support KW’s pro-rata share of the PacWest deal. Anecdotally, I think this deal was just okay – 50% LTV (hopefully this meant loan-to-cost and not loan to stabilized value) on a portfolio of construction loans for ~10% annualized yield is pretty much market terms today for construction debt financing. The positive spin on this deal is the returns work because of management fees, albeit the loans I believe only have a WALT of <2 years, so this isn’t a big needle mover.

Valuation Methodology Comments - Appendix

• Implied Cap Rate – mentioned above at 5.6%

  • I mentioned above that the implied cap rate for KW is 5.6%. I calculate this in the following manner:

  • Denominator: Calculate KW’s TEV, reduced by KW’s disclosed valuation for construction in progress, non-income producing assets in lease-up, its land portfolio, its loan portfolio and an implied value on KW’s investment management business

    • The investment management business I calculate as: fee related revenue at a 50% margin, to produce fee related earnings, and ascribe a 15x multiple on it, and add additional value for NPV of expected carried interest.

  • Numerator: Taking KW’s provided annual NOI (from supplemental) and include property management expenses to the multifamily assets, and reduce the commercial assets NOI by straight-lined rents

• Share Price Target

  • 1) Taking in-place NOI, applying a low single digit growth rate, but applied individually depending on the segment (i.e. US multi, US office, Dublin office, etc.)

  • 2) Taking KW’s forecasted stabilized NOI on development and assets under lease-up

  • 3) Applying the 6.5% cap rate mentioned above

  • 4) Adding value for KW’s land / for-sale residential business

  • 5) Adding valuation to KW’s investment management business, by taking in-place fee related revenue and growing at 10% annually, applying the same 50% FRE margin, and a 15x multiple, as well as adding additional carried interest

  • 6) Backing out current gross debt, and adding cash net of expected costs to complete development in-place

• I also reference Green St from most metrics here (pretty much all comp cap rates, etc. come from Green St). In the AFFO analysis, I am using Green St’s normalized capital expenditure load as maintenance capex. In real life, REITs show something lower, but I think this understates the true amount of capital intensity of the business in the long term, and agree with Green St’s framework.

Catalyst

•  Fundamental performance decelerating. SSNOI across office portfolio should be negative, SSNOI in the multifamily portfolio will continue to exhibit negative rate of change, and likely will be see negative market rent growth.

• Office asset in Bellevue (mentioned above) with tenant vacating in November

• Headline EBITDA to be meaningfully lower with lower "gain on sale" of assets

• Interest expense growing should be a credit negative for the in-place bonds over time. FCF should inflect negatively as caps roll off and debt matures.

• More spotlight on the company from sell-side and others should highlight the absurd valuation of the company. Over the long-run, the company's poor capital allocation and quality of assets should be reflected in ROIC and de-rate the multiple.