Description

**Risk/Reward: Risk $2.5 to make $8 for an attractive skew of 1:3.

**Catalysts: (1) Nomination Window opens February 13th and runs to March 15th (2) Land & Buildings potentially nominating a slate of directors that will entertain the supposed fully financed bid (3) Madison International Realty using their 5% stake as a toe-hold before bidding themselves (4) Releasing water portfolio ahead of expectations vs. a consensus valuation that ascribes no incremental value there.

----

Brief Business Overview & Stock Narrative

·        Mack-Cali (CLI) is a mixed REIT known for its upscale multi-family properties in Westchester/CT and it’s Jersey City office assets that are running at elevated vacancies post mass tenant move-outs (e.g., Deutsche Bank and AIG) with a frustratingly slow back-fill process that is still not completed. The Company either owns, or has economic interests in 157 properties, comprised of 69 office and 70 flex, totaling ~18M square feet of leasable space. Approximately 900 commercial tenants and 18 multi-family rental properties that contain ~5,800 units make up the bulk of CLI’s revenue stream.

·        CLI trades at ~$21 today with a ~$2B Market Cap (based on fully diluted share count) and a TEV of ~$5.4B. The net leverage on the business is at the high-end of peers, running at ~11-12x vs. the peer office average of ~8.2x. The market is ascribing a ~12x/~12x AFFO multiple over the 2019/2020 periods vs. office peers trading at ~15x/~14x in the same period and residential players trading at ~19x/~18x respectively. The implied cap rate at today’s price is ~7.5% vs. office peers at ~6% and multi-family at ~5%. Lastly, the current CLI dividend yield is ~3.8%. Note that upon completion of its transformation plan, the PF REIT composition will be ~40% waterfront office, ~40% multifamily via its subsidiary Roseland Realty Trust and ~20% suburban NJ office space with room to trim this last portion down even further, creating a sole NJ-waterfront office asset combined with Roseland.

·        A core tenant of the transformative assert slimming is selling its “flex” warehouse portfolio where proceeds are estimated to be ~$550M, of which over $300M will not need to be 1031 exchanged (i.e. immediate cash proceeds will go to deleveraging). For some background, back in September 2015, CLI initiated a three-year strategic initiative to change the business into a more concentrated owner of NJ Hudson River waterfront and transit-oriented office properties alongside its goal of maintaining its regional ownership of high-end multi-family assets. However, as mentioned above, the re-leasing process has been slow at best, and arguably non-existent at worse. The stock underperformed 2018, peaking at $22 and bottoming out at ~~$17 when the forward guide came in well below 2018 consensus FFO. The delta between expectations and results was a function of a 40c swing stemming from lost Jersey City square footage that only 3 months prior was communicated to the street as being 50% better than what was reported (i.e. only a 20c impact).

·        The typical questions around a poorly communicated event began to percolate: (1) What kind of visibility does mgmt. have into this business if they overpromised by a 50% magnitude only 90 days prior to the guide? (2) AIG and Deutsche Bank rather abruptly, but the remaining portfolio is levered to similar industrial tenants, so who is to say that re-leasing is the issue to analyze vs. the very maintenance of the remaining tenants? (3) Mgmt. has done a poor job of moving CLI through this transition but from an accountability perspective, the governance here is weak, so how do we underwrite a change of pace?

·        Note that this occurred in the beginning of the year (February 2018). Research notes around the time were unsurprisingly glib. Evercore notes they are lowering their FFO/NAV estimates and PT “once again, following another soft operational quarter in office and shockingly weak FY18 guidance…The sticker shock from this outlook should be pretty meaningful: on the Q3 call management hinted at a roughly $0.10/sh to $0.15/sh decline in FFO Y/Y, and just one quarter later that number more than doubled.” Citi goes as far as saying “The report may also push investors to demand significant board refreshment, which is much needed, or strategic alternatives given the company’s own view of NAV ($38/sh) – double where stock trades today.” We saw the full range of analyst humor too in the post-guide down notes, with one analyst pondering whether or not CEO DeMarco, when he guided investors to a 2018 FFO figure of +$2, was actually thinking of the metric in terms of a Canadian Toonie.

·        Following this event, the stock bottomed out at $17, with the remainder of the 2018 fiscal year being summarized by consensus numbers looking to find a floor. At this point, I would argue that consensus had yet to fully capitulate. Most believed that the updated numbers’ assumptions underpinning the $1.80-$1.90 embedded minimal lease-up activity for the remainder of the year and in turn re-set the deck. As we worked through the year, CLI’s stock remained range-bound at $17 into the Q1 print where the multi-family business continued its strong performance and FFO came in slightly ahead of consensus. The core bear points for the stock though remained: (1) With the high-leverage, CLI has a cost of capital issue that has fewer tools to address as refinancings and asset sales were largely lapped and (2) Back-filling the waterfront office assets continues to be a losing game. Nonetheless, the print was enough for consensus to hold, and the stock responded positively, running to ~$18.25 before fading back to $17 along with market gyrations, and eventually trading up to ~$20-21 through the summer and into the Q2 print.  

·        It wasn’t until the Q2’18 print where investors and consensus threw their arms up in their air with this management team. Again, Citi says it well in their recap note on August 1st: “Reaction to Mack-Cali’s earnings release is likely to be negative as trends remain soft and investor patience remains thin.” Once again, the 2018 FFO guide was tightened to the bottom-end of the range, now $1.80-$1.86 due to MSD declines in SSNOI with no backfill and high incentives being given out causing lease economics to soften. However, the cash SSNOI expectations were less negative than expected (note numbers were trending below mgmt. guide at this point) and management noted traffic and interest continues to be strong in both their waterfront and suburban office space. I would argue that it was here a margin of safety was finally built in, with consensus numbers now officially discounting management guide, sitting today at 2018 FFO of $1.77 (3% below mgmt. midpoint), however – investors now looked to 2019 with bated breath.

·        Finally, we are in Q3 in the fall of 2018 and the 2018 FFO guide was maintained with consensus numbers remaining below. The same trends continued and the same questions remained around leverage and velocity of waterfront releasing. Recently, the Company has been on the road with analysts and even conducted a Waterfront Tour / Investor Presentation at the end of January 2019. SunTrust notes that the newly-introduced 2019 guide assumes only 79%-83% YE office leased percentage and 10%-14% decline in cash SSNOI. The range is $1.60-$1.70, again lower than consensus estimates of ~$1.78.

·        While the history here is clearly poor in terms of numbers directional movement, we are at an interesting air pocket of de-risked EPS events combined with governance openings that may trigger the right time for a formal campaign. The investor presentation provided the 2019 look while the Q4 2018 print is relatively straight forward as the company tightened the outlook last time. Additionally, the Waterfront Tour day included management noting an incremental 190K sq. ft. of space in final negotiations that may add ~390bps to the 2018 occupancy figure.

Why Set-Up Today is Compelling (Potential Activism + Potential M&A + Clear Catalyst Path with Nomination Window Opening)

·        Overview: Jonathan Litt’s Land & Buildings, a real estate activist firm with a strong track record has taken a significant stake in CLI. While at first their intentions were not clear, the campaign has turned uglier. The fund has come out and claimed that they are aware of a fully financed bidder willing to pay a steep premium to CLI’s share price when it was around $19-20. Additionally, the nomination window opens up February 13th and closes March 15th. The board is annually elected, and while they still maintain the right to unilaterally staffer it as they have not opted out of MUTA (Maryland Unsolicited Takeovers Act), it is Chairman Bill Mack’s final year on the board before he ages out. I am willing to be that Bill will be more inclined to not have his lasting memory be a poor-form governance maneuver against a former board member and well respected member of the real estate investing community. While CEO Demarco has apparently told some research analyst’s he is not aware of the fully financed bid that Land & Buildings has referenced, actions speak louder than words. On February 7th, we found out that Madison International Realty has taken a 5% stake in CLI, citing a severe dislocation of public market ascribed value and their view of private value. Note that Madison owns large-scale retail properties around the area of CLI’s NJ office assets. Additionally, their most recent public market stake was in MORE (Monogram Residential Trust) which was eventually sold to Greystar.

·        Event Chronology:

o   August 14, 2018: Land & Buildings increased their existing and smaller position in CLI, moving its stake from ~50bps of the company to 1.85%. At this point Jon Litt’s firm didn’t comment on their intentions, but the path seemed relatively clear as CLI had struggled with its amalgamation of Office, Apartment and Multi-family assets along with a board that is Chaired by Bill Mack, set to age out term in the following year.

o   September 27, 2018: Land & Buildings says Mack-Cali may have turned away an unidentified suitor. Jonathan Litt wrote a letter to the CLI board saying that their fund learned a potential buyer was interested in making a fully financed bid for CLI at “a significant premium to the current [CLI] share price”. Note that throughout September CLI traded ~$20-$21 and that Jon Litt said on CLI’s board for over two years from 2012 to 2014.

o   October 20th, 2018: Bloomberg reports that Litt may put forth a slate of directors because “he continues to believe the company is refusing to engage with a potential buyer”. It goes on to say that Land & Buildings plans to nominate a slate, but will back off should CLI entertain offers (plural).

o   February 7th, 2019: Madison International Realty takes a 5% stake in CLI.  Ronald Dickerman, President of the Real Estate Private Equity firm said “We acquired the shares at what we believe to be a discount to net asset value (NAV), and we believe Mack-Cali holds material upside potential.  We see a significant discrepancy between how the public market is pricing the company’s shares and our private valuation…The company has articulated and is executing a transition to become a focused play on prime office and multi-family residential properties on the New Jersey waterfront and is committed to closing the NAV discount in its shares. The company has divested, and has stated that it will continue to divest, legacy suburban and flex assets to focus on office and multi-family directly across the Hudson River from Manhattan, Brookfield Place and Hudson Yards, and offers its prime space at a significantly discounted rent.

·        Corporate Governance:

o   CLI has an annually elected 10-member board where 7 of 10 are considered independent.

o   The Company is Maryland domiciled though, and it does not appear they have opted out of MUTA. It actually specifically says that they still retain this right in the proxy where they declassified the board.

o   Bylaws allow for a SH to call a Special Meeting. A shareholder would request a Record Date whereby the Board has to respond within 10 business days. From there, the Board must set a date within 90 days of the Record Request Date.

o   Nomination window is set to be more 90-120 days before next year’s AGM which isn’t until June 13th 2019, so the opening is February 13th – March 15th of 2019.

o   The Board is Chaired by founder Bill Mack who also created the Apollo Real Estate investment arm and owns a fair amount of shares (~2.4% if total shares out).

o   Board tenure is very long with an average of 13 years, and if you take out the two, most recent additions, it is closer to ~17 years. Note that one of the board members is David Mack, Bill’s brother.

·        Land & Buildings History with CLI

o   Land & Buildings was founded by Jonathan Litt.

o   Jonathan was on the board from March 2014 to August 2016 where he oversaw the Company declassify the board.

o   Jonathan was instrumental in putting current CEO Mike Demarco in place.

·        History of Madison International Realty

o   In January 5th of 2015, Madison International Realty acquired a 5.3% stake in Monogram Residential Trust (“MORE”). At the time, president Rickerman said “We believe the company’s shares have been trading at a discount…we think Monogram offers robust growth potential and is a good fit with our differentiated investment strategy.” A few years later, Greystar acquired MORE for $12 a share.

o   Other public market investments include Songbird Estates, a publicly listed company traded on the AIM which is an LSE submarket. Songbird owns a 69.4% interest in Canary Wharf Group, which owns 20 Class A office and retail properties comprising ~7M sq. ft. in the Canary Wharf submarket in London.

o   More recently in September of 2017, the PE firm agreed to buy FCE’s NY Retail Portfolio for $1B. Note this was a controlling buyout as they already were the 49% JV Partner.

Upside Valuation

Low-Hanging Fruit: (~$24)

·        CLI trades at a 30% discount to consensus NAV of $30 and at a 41% discount to Company NAV of $36. A weighted average of typical P/NAV discounts in the Office and Multi-Family space would suggest that the proper blended trading discount should be ~19%, which would imply a $24 stock vs. today’s $21.

·        Running this out further, the implicit delta of ~$3 (appropriate trading level – current price) can be disaggregated between CLI’s high-leverage levels (~11x vs. peers ~8x) and management/board entrenchment. For argument’s sake, let’s assume that the leverage-related dollars within that $3 is ~$1. I don’t think this is a stretch as there is clear line of sight into deleveraging, but since the market doesn’t price in end-game events until we get closer, there is still going to be some relatively-worst cost of capital discount.

·        If you believe that, then the implied management discount is ~$2, or ~1.25x turns worth. Isolating this out is important because even with the most recent $2 YTD move, there is still $2, or ~10% worth of low-hanging fruit to be picked off as the market prices in (1) The nomination window opening (2) Reality that Bill Mack ages out regardless by end of the year and (3) Activist presence generally yielding a more dialed-in management group.

SOTP: (~$28)

·        Consensus NAV is a bit all over the place (JPM/Evercore/STRH estimate $26.50/$30/$30) and are below company calculated NAV of ~$36. Note though that CLI’s multi-family unit Roseland is JV funded with Rockpoint Group, and as part of the agreement, it is appraised by PWC annually. The most recent valuation was ~$15.46. If you apply a typical multi-family average discount for a trading comparison of 11%, than the discounted Roseland Stub is worth ~13.75. This would imply that the Office portfolio is trading on 2019E AFFO at ~4.3x vs. the Office average of ~14x.

·        The lowest peer in the group trades ~10x 2019E AFFO which is Brandywine Realty. BDN’s leverage is much lower at ~6.2x but is geographically exposed to Washington D.C., an unfavorable market that deserves a group-discount. To continue conservatism, even if you think the RemainCo assets deserve a deeper discount than BDN would due to their arguably equivalent geographic positioning without assuming any recovery in the area, than at 8x 2019E AFFO, the OfficeCo piece would be worth ~$13.80.

·        This together yields a SOTP value of ~$28.

M&A (~$28-$30)

·        As a precedent, FCE/A was acquired by Brookfield at a ~10% discount to Consensus NAV. Assuming Consensus NAV is ~$30, still well-below company NAV, a similar discount suggests $28 as M&A value. The puts and takes around this though need more explaining, as FCE/A had office properties across the country vs. a troughed Jersey market and also structured a deal prior with Madison International (Sponsor now in CLI) to sell them their NYC Specialty Retail portfolio for ~$1B.

·        FCE/A also did not provide a company NAV calculation, so a comparison of the discount to Consensus NAV vs. Company NAV is difficult. Taking a step back further, FCE/A was an owner of assets concentrated in urban markets such as NYC< Boston, Washington D.C., LA and San Francisco. It had a historical dual class structure that was ultimately eliminated in the beginning of 2016 and removed a governance overhang such that the market began to look at the stock as a more normalized REIT.

·        The company was undergoing a similar transformation whereby they were selling their retail portfolio, announced in August 2016 that it would explore strategic alternatives, culminating in Madison International Realty, an existing JV partner at the time, buying out the controlling stake. A previous VIC write-up in September of 2017 called out that following the sale, “FCE’s assets will be limited to multi-family and office properties…This will make FCE easier to analyze as a public company and also make it more attractive to potential acquirers.”

·        The issue with applying a 10% premium to consensus NAV at these levels is that it does not encapsulate the upside from any releasing activity that the potential owners would have an option on. You can either factor this in by applying a more aggressive NAV calculation, or by assuming that the precedent 10% discount is more of a floor than ceiling. At an in-line consensus NAV, but still maintain a healthy discount to Company NAV (~17%), you can see $30 as an upside case.

Downside Math ($18-19)

·        I see downside math at ~$18-$19.

·        Even if you believe that 2019 numbers still embed risk despite the reset and lack of onerous releasing assumptions implicitly in the consensus $1.73 2019 AFFO, with the nomination window being open for the next ~45 days and the new presence of Private Equity in the shareholder structure, it is likely the multiple holds.

·        Add in the fact that Bill Mack is aging out, and so too should the isolated mgmt. multiple discount in the stock move away over time too.

·        Currently, 2019 is underwriting that the most recent Q occupancy level of 84.2% is going to stay roughly flat by year-end 2019 with some estimating a further ~100bp decline. If you assume that there are zero renewals from now until end of ’19 than 2019 AFFO is shaved by 10c. In other words, every ~20bp change in releasing is ~1c of AFFO.

·        At a worst-case zero-lease activity scenario, the 2019E AFFO would shift down 5c to $1.68 or 3% down from consensus.

·        Prior to the activism noise, CLI was trading at a ~11x multiple.

·        To be incredibly conservative, at a multiple compression back to that level with an incremental half turn hit to ~10.5x, downside is $18.

Catalyst

(1) Nomination Window opens February 13th and runs to March 15th (2) Land & Buildings potentially nominating a slate of directors that will entertain the supposed fully financed bid (3) Madison International Realty using their 5% stake as a toe-hold before bidding themselves (4) Releasing water portfolio ahead of expectations vs. a consensus valuation that ascribes no incremental value t