Description
Newkirk Realty Trust, Inc.
NYSE: NKT
Date: 3/2/06
Price per share: $17.50
f/d shares outstanding: 64.4 mm
f/d market cap: $1,127 mm
Pro forma cash: $227 mm
Pro forma debt: $716 mm
***Thesis***
Newkirk Realty Trust (NKT) is a net lease REIT run by Michael Ashner, an extremely smart and successful real estate investor with an excellent track record of long term value creation. Due to some interesting circumstances surrounding the IPO of NKT four months ago, we are presented with the opportunity to invest with Michael Ashner at a 13% discount to liquidation value of $20.00/share and receive for free the valuable call option that Michael Ashner creates value going forward for NKT shareholders.
While valuing the optionality of a smart investor is more art than science, our base case scenario assumes NKT can generate and distribute $1.60 of FFO/share going forward. Placing a cap rate of 7.5% on this FFO implies a value of $21.30 per NKT share today, with $1.60/share of cash accreting each year of the investment.
In other words, we think that NKT is easily worth $21.30/share and you get a 9% yield in actual dividend payments while you wait. We expect our base case thesis to play out in 12 months, resulting in a 31% IRR.
We think the probability that Michael Ashner does something smart that results in FFO/share of greater than $1.60 is very high. Indeed, Ashner and his team at Winthrop are very incented to grow FFO/share and will be well-compensated if they are successful. Our high-case outcome results in NKT delivering $2.00 of FFO/share within 36 months, resulting in a value per NKT including the dividends of roughly $32/share or 83% total return.
Our worst-case outcome is liquidation value, where we still do not lose money.
In other words, Newkirk is both safe and cheap, and you get paid 9% a year to wait!
Michael Ashner and his lieutenant Peter Braverman also agree that NKT is a great idea; they have been buying NKT shares in the open market adding to their already substantial investment in the company.
***Why is Newkirk so Cheap?***
The Newkirk story is a very, very complicated story. NKT will be facing declining rents from their existing properties each year as more and more leases renew and roll down from an above-market rate to a lower contractual renewal rate or current market rate.
Newkirk’s $1.60 dividend rate is dependant on management making acquisitions of new net lease properties. If management were to sit on the excess cash at Newkirk and not make any acquisitions, the $1.60 dividend could not be supported. Thus the Newkirk investment story is dependant on management making acquisitions, something most investors do not like to bank on.
There is a potentially large overhang depending on how Apollo distributes or sells their shares once they are free from lock-up in November of 2006.
The market for income-related securities has been weak due to overwhelming supply of new issuances.
***Introduction***
Newkirk is a REIT that invests in net lease real estate. Net lease real estate, also referred to as triple net leases, is a lease arrangement where the landlord will lease the building to the tenant where the tenant is responsible for all expenses and maintenance. The landlord accepts a lower rent rate in return. It can be a preferred lease arrangement in some situations since the tenant can control the maintenance of the property and the landlord does nothing except receive a check every month.
Newkirk’s history is unusual. The properties Newkirk owns are from 90 different limited partnerships sponsored by a syndicate called Integrated Resources from 1978 to 1984. Each partnership owns commercial properties. Apollo Real Estate acquired these partnerships in 1997. In 1998 Vornado acquired a portion of Apollo’s position. In 2002 these partnerships were rolled up into one master limited partnership called Newkirk MLP (NMLP). Newkirk Realty Trust’s IPO is the first step towards a liquidity event for Apollo’s investment which is in a fund with a finite life.
Newkirk Major Owners on a f/d basis:
Apollo Real Estate: 36.3%
Vornado Realty Trust: 15.8%
Other LP’s: 14.7%
Management: 3.1%
Winthrop REIT (FUR): 6.8%
Newkirk has no actual employees; it is externally managed by NKT Advisors (Winthrop). Michael Ashner and his team at Winthrop are paid a base management fee and 20% of any FFO above a certain hurdle rate. The hurdle is set so that Winthrop will not make any incentive fee on the existing portfolio’s above-market rents, but rather on new investments and superior execution of the lease renewals in the upcoming years.
***The Existing Portfolio and Strategy Going Forward***
For the existing portfolio of properties, 84% of Newkirk’s tenants are investment-grade corporate credits. Office represents 60% of rental revenues, Retail represents 20% of rental revenues, Industrial represents 9% of rental revenues, and the rest of the rents are classified as “other.”
The existing portfolio of pure vanilla properties and investment-grade tenants is an anachronism of the company’s history. Going forward, Newkirk will focus on special situations single-tenant net lease deals. Examples include non investment-grade tenants, properties with renewal risk, other securities within the capital structure such as mezzanine debt, and other situations where there is “hair” on the deal and a correspondingly higher yield. Newkirk is very similar to a publicly-trade real estate opportunity fund. Importantly, you have an exceedingly smart and successful real estate investor allocating your capital, as any LP would look for when investing in a closed pool of capital.
***The Busted IPO***
NKT originally tried to price in the fall of 2005, selling 20 million shares at $20.00 per share. We believe the initial pricing was determined by placing an 8% cap rate on the $1.60/share dividend set by management. The underwriters could not price NKT at $20.00 for several reasons (as described above in section “why is Newkirk so cheap?”).
The result was that management had to reduce the number of shares offered from 20 million to 15 million, and more importantly reduce the offering price from $19-$21 to $15-17 per share. The shares priced at $16, a 20% discount from the $20 midpoint!
***Valuation***
We approached the valuation of NKT from 2 different angles. First, we looked at what the fair value would be if we sold the existing portfolio at current market prices and liquidated the business. Second, we looked at NKT as an ongoing operation that would grow its portfolio and incur operating expenses and fees to Winthrop.
The key to both valuations is to normalize the existing portfolio and place an appropriate cap rate on the rental stream. Currently the existing portfolio is throwing off “excess” cash flows because the rents are on average higher than what the current market rents are or what the tenant’s contractual renewal right rents would be. The decrease in rents when “marking” the portfolio to “market” is significant, as seen below. For our analysis, our worst case scenario is that the leases are renewed at the lower of current market rents or the contractual renewal rates. Our best case scenario is that the leases are renewed at market rents. To understand what the current market rents were for each property, we used appraisal data that CB Richard Ellis prepared in conjunction with Newkirk’s IPO.
Actual 2006E rental revenues (in thous): $235,350
Normalized 2006E (in thous):
Worst case -- lower of market or contractual: $109,233
Midpoint between worst and best case $123,513
Best case -- mark to current market rents $137,793
To calculate liquidation value to the equity, we placed a cap rate on the normalized rental stream, accreted the present-valued excess cash flow from the abnormally-high current rents, and adjusted for the capital structure. Our liquidation value per share is below:
Sensitivity Analysis:
Cap Rates
8.0% 7.5% 7.0%
-------- -------- --------
Worst case $109,233 || $17.99 $19.40 $21.02
25% higher than worst case $116,373 || $18.88 $20.39 $22.11
Midpoint between worst/best $123,513 || $19.78 $21.38 $23.21
25% lower than best case $130,653 || $20.68 $22.37 $24.30
Best case $137,793 || $21.57 $23.35 $25.39
We chose to use $116,373 of rental income and a 7.5% cap rate to get to our liquidation value estimate of $20.00/share.
One can see the potential for value creation from aggressively managing the lease renewal process. Conversations with management emphasize the importance they place on extracting value from the lease renewal negotiations with each tenant. Winthrop has employees in asset management that do nothing except talk to their tenants all day to understand their tenants needs and expectations, as well as the surrounding dynamics, to most effectively negotiate for Newkirk on every renewal. Lease renewals are an opportunity for Winthrop to add value and increase their incentive fee payments.
(Footnote: as an interesting thought-experiment, if you were to mark the existing properties to the higher of contractual or market, the normalized rents would be $162,586. Thus, there could be upside even to our best case scenario if tenants exercised renewal rights at rents higher than market. Indeed, there are examples of this happening already within Newkirk’s portfolio of properties.)
For our valuation of Newkirk as an ongoing business, we normalized the rents of the existing portfolio in the same manner, but now included the operating expenses that NKT would incur. We then added a value for what we thought Winthrop could create by growing the portfolio in the current environment.
Sticking with the normalized $116,373 rental stream, we derived a “core” FFO from the existing portfolio of $.95/share. This ignores the current above-market rents, and instead assumes that the excess cash flow and cash on hand is used to acquire new net leases properties. Management has guided towards $1.0-$1.2 billion of acquisitions in the next 3 years. However, because each potential investment is unique (these are not plain-vanilla investment-grade long lease-life deals that trade at a sub 6% cap rate) it is impossible to say what the spread between the cap rate and the borrowing rate will be and what the appropriate amount of leverage will be.
For our base case analysis, we assumed $1.2 billion of acquisitions at a 200 basis point spread using 70% debt/equity. This leads to an additional $.63/share of FFO. Adding the growth portfolio FFO to the existing portfolio FFO results in a total normalized FFO of $1.58/share.
Again, valuing the growth portfolio is a lot of guess work. Playing around with the sensitivities of the drivers of the growth portfolio (spread, leverage, and total amount of acquisitions) will yield very different results. For example, in our upside scenario, we assumed $1.7 billion of acquisitions at a 250 basis point spread using 70% debt to equity. Note that this requires an additional $2.33/share of cash but NKT will have more than this amount of cash on hand to deploy. This scenario results in the growth portfolio contributing $1.02/share of FFO or a total of $1.97/share of FFO to NKT shareholders.
At the end of the day the upside to Newkirk is completely dependant on management’s skill in investing. We are comforted by the fact that if Michael Ashner ran an opportunity fund and charged 2 and 20, we would have invested, if he would have taken our money in the first place. Instead we get to invest with Ashner at a material discount to intrinsic value.
***Management’s Track Record***
Michael Ashner and his team at Winthrop have a strong track record investing in real estate special situations. Their most recent venture is First Union Realty, now known as Winthrop Realty Trust traded under the ticker FUR. FUR also resembles a publicly-traded opportunity fund although it only focuses on capital appreciation while Newkirk is geared towards total return (income plus appreciation). Since Ashner took control of FUR at the end of 2003, the stock has appreciated 145% from $2.20 to $5.40/share and appears fairly valued to us.
At FUR, Ashner has demonstrated success investing in special situations at attractive cap rates as well as using FUR’s capital to become a shareholder activist in situations such as Sizeler Properties (SIZ). SIZ currently trades for $14.50/share, up materially from $9-10/share when Ashner first got involved in 2005.
Before FUR, Ashner succeeded in outmaneuvering Carl Icahn to gain control of three publicly-trade REIT’s (Shelbourne I, II, and II) and realized 50% IRR’s for investors by liquidating the trusts.
Ashner and his team at Winthrop have been together for over 10 years when Apollo first recruited Ashner to run Winthrop.
***Risks***
Newkirk is not able to make attractive acquisitions and can not sustain the $1.60/share dividend.
Lease renewals fair poorly. Vacancy rates increase and Newkirk can not support the mortgage on the property and loses their equity.
Real estate values decrease significantly.
Interest rates increase sharply.
Catalyst
Newkirk begins to make acquisitions. Once the market gains confidence that the $1.60/share dividend is sustainable, NKT should quickly trade to a 7.5% cap rate or $21.30/share.