Description

Summary

Most REIT situations without significant hair do not become wildly mispriced, however I believe Peakstone Realty Trust ("PKST") is an exception.  If you track the REIT space, you know that especially “cheap stocks” usually have hair that might include external management (e.g. DHC, OPI), hideous portfolio quality and/or capex obligations (e.g. ONL, FSP) or existential use case risk (e.g. HPP, PGRE).  However, I contend that the exceedingly cheap net lease REIT PKST has none of these concerns other than some tail residual exposure to the office sector and some taint of formerly being a private REIT, both of which I will address.

Highlights of the Opportunity

• 8.5% dividend on ridiculously low 39%(!) payout ratio means little to no risk of a cut.

• Ample free cash flow, lack of near-term tenant roll (7.5% for next 2.5 years) and no near-term debt maturities take pressure off the Company and hopefully allow its high-quality management team to avoid rash decisions.

• Net lease rent roll and therefore low capex requirements – high-quality, newer properties, 43% of which are headquarters locations trading at an implied 52% cap rate for office portion (further described below).

• Management with a history of smart capital allocation over the past three years.

• Interest rate hedges on $750 million of floating rate debt through July ’25 should dovetail with Fed cutting cycle.

• Opportunity to create tremendous value through share buybacks while shares trading at 1/3 of NAV with $11/share of cash on the balance sheet.

Background

The Company began as a non-traded REIT in 2014 and went public in a direct listing in April, 2023.  These two articles from Blue Vault partners provide a good history, but I do not think the past is especially important to the current thesis.

https://bluevaultpartners.com/unraveling-the-mystery-of-peakstone-realty-trust/

https://bluevaultpartners.com/the-mystery-continues-peakstone-realty-trust/ 

Two components of its history are worth noting for specific reasons, however:

1.      The Company went public via direct listing, which I believe is one of the reasons they have almost no sell-side coverage, low levels of institutional ownership (40% vs REIT average over 70%), and little trading support from Wall Street.  Without the need to tap the capital markets, it is unclear how the Company might build bridges with the sell side.

2.      The legacy private REIT buyers (medium and high net worth buyers through RIAs) have a significantly higher basis than the current trading price.  Non-traded NAV (appraised value) in June 2022, a year prior to public listing, was $66.78/share (approximately 630% above current levels, a delta not explained by any exorbitant leverage). I believe this tired and frustrated retail shareholder base continues to “throw in the towel,” and there are no institutional investors around to pick up the slack.

Business

Peakstone is an internally managed net lease REIT that owns a nationwide portfolio of 67 office and industrial properties totaling 16.6 million square feet with a 1Q24 run rate of $190.5 million NOI.  The Company breaks down its portfolio into three buckets: Office, Industrial and Other.  Enterprise value is not particularly meaningful because the Other bucket has non-recourse debt on underwater assets, and FFO metrics are similarly misleading though still are screamingly out of line cheap at 4.1x with no troubling debt maturities.  I will take the buckets in reverse order:

“Other” Properties

I will spend no time on “Other” here other than to say, I estimate the value of all mortgaged Other properties (financings referred to as AIG Loans in filings) to be underwater and assign no value.  (*Note: properties secured by the Company’s three other first mortgages in Office and Industrial segments are easily in the money so included in net debt).  Three properties in the Other bucket totaling 2.2 million square feet in AZ, AL and CO are unlevered, and I estimate the value to be $37 million ($17/SF).  For purposes of simplifying my SOTP in Exhibit A, I have included two other assets (Corteva seller-financing receivable and value of rate swaps) in the total which leads to a value of $78.5 million.

Industrial Properties

This will be the least controversial component of valuation.  The Company has an A- portfolio in B+ submarkets - 19 properties totaling 6.0 million square feet and an average age of 14 years with an average clear height of 32’.  The portfolio is 100% leased (74% to IG tenants), and, according to management, 25% below market rents, which mitigates the somewhat short 6.5 year WALT.  While not best-in-class properties, 49% of the portfolio is proximate to major ports, and there is no exposure to over-supplied industrial markets like Southern California and Texas.  I have applied at 5.5% cap rate to the run rate NOI which yields a value $901.1 million ($101/SF) shown in Exhibit A.  The portfolio would likely trade tighter than this privately, but I want to be conservative, and this is still above the public REIT market-implied sector average of 5.1% which includes some inferior comps (BofA 7/8/24).

Office Properties

PKST’s portfolio is 94% single tenant and 99% leased (66% to investment grade tenants).  The average building age is 12 years (very low by office standards), suburban in nature, and 83% are in coastal and sunbelt markets.  More crucially, however, 43% are headquarters locations which are tremendously sticky on renewals unless a tenant is going full WFH, but fully WFH is only pronounced in TAMI tenancy which comprises just 6% of PKST’s rent roll.  Additionally, 33% of rents (including HQ properties) comes from properties with “R&D, lab, or data center/command center functions” (i.e. things that can’t be done from home).  Big picture this is more akin to a healthy regional bank type office portfolio with more of an ‘owner-user’ type risk profile.  PKST’s office portfolio may actually be more attractive than any other public office REIT and only marginally less attractive than net lease REITs with non-office portfolios.

Office exposure is obviously the highly controversial component of valuation and the albatross around the Company’s neck. I do not want to debate whether office buildings will even exist in the long-term, but I want to parse the Company’s exposure to the sector in order for the reader to make an informed risk/reward decision.  Most office equity REITs own capex intensive multi-tenant properties, albeit with the large cap REITs owning what would have been considered more trophy quality properties than PKST’s.  Most net lease-equity REITs have little office exposure, even if single-tenant.  Net lease REIT comp GNL has some office exposure, but it diluted it through its merger with RTL, and WPC spun their office properties off into a liquidating vehicle, NLOP.  So, there are few comps to PKST’s office book, but also of course little investor demand for such vehicles.  While neither fish nor fowl, I do think it is noteworthy that the current public REIT net lease sector implied cap rate is 6.7%, and the office sector is 7.8% (BofA 7/8/24).  If one accepts the 5.5% cap rate for PKST’s Industrial portfolio, the market implied cap rate on PKST’s office portfolio is a tantalizing 52%. In order to value this out-of-favor pool of assets, I want to evaluate it in two pieces – contractual cash flows and potential residual value.

Contractual Cash Flow in Office Portfolio:  Tenancy is well-diversified by size and industry (no tenant contributing more than 10% of 2024 revenue).  One property, HQ for The Southern Company, accounts for approximately 22% of the remaining contractual rents due to an exceptionally long lease, but Southern Company has an $84 billion market cap and its long-term debt is rated BBB+.  I have used the NOI margin implied in the Company’s 1Q24 Presentation and cast it forward to estimate contractual NOI over the remaining 7.6 years of WALT.  For the 6 remaining office properties for which the company does not provide lease duration, I have independently estimated the remaining lease term based on various news articles, filings, and time of original lease signing.  Because 66% of rents come from investment grade tenants with little or no capex obligations, I have applied a 5.5% discount rate to this CF strip (5 year T 4.25% on 7/8/24), which equates to a total NPV of contractual office rents of $557.0 million ($103/SF) shown on Exhibit A.

Residual Value in Office Portfolio:  I will break out the numbers in the SOTP, in case the reader wants to ascribe less or no value to this residual, however, I believe PKST’s portfolio has better long-term prospects than most any other publicly traded office REIT.  The biggest challenge for office landlords in today’s environment are the decisions about renewing or extending leases when rents are falling, TI’s are rising and long-term capital flows are unclear, especially in multi-tenant buildings which require 40% occupancy to just break-even PRE-debt service.  I have gone asset-by-asset (post “Office Apocalypse”), taking into account lease term, sub-market and building quality and arrived at a full building valuation of $1,182.8 million ($219/SF) which would be a 9.3% cap rate on income in place.  The office market is moribund, so I am not claiming this could be realized in a short-term liquidation, however bear in mind that the Company has been selling far-inferior properties over the last two years and has realized a cap rate of 7.8% on non-core dispositions.  For purposes of the SOTP on Exhibit A, this excess value is segregated from the NPV of the contractual cash flow, and the excess amount totals $625.8 million.

Capitalization

The Company has a relatively simple capital structure:

• Three non-recourse mortgages with equity in the money totaling $267.2 million

• A $950 million bank facility (KeyBank as Agent and the usual suspects in the syndicate) with $160 million available on RCF and maturities from December ’25 to April ‘26

• $436.3 million of cash ($11/share)

• JV’s and preferred stock have been eliminated (As an aside, management's prescient and savvy sale of $1.1BN of suburban office to an Oak Hill JV in 2022 is the reason the Company is capitalized so well currently.)

• The public REIT owns 91.8% of the OP

• Net Debt of $780.9 million at 3/31/24 shown on Exhibit A (excluding AIG loans intentionally)

SOTP Valuation

Please refer to Exhibit A for breakdown of value by component, but here are the main takeaways:

• NAV with ZERO value attribution to the Office Portfolio estimated at $5.22/share (i.e. the Company’s Industrial portfolio covers the debt and then some)

• NAV with only NPV of contractual office cash flow of $19.31/share ($26.38/share undiscounted)

• NAV with estimated office value at 9.3% cap rate on in-place NOI of $35.12

Since the Company has not entered a liquidation program, we need some sort of approach on G&A drag.  G&A current annual run rate is $38.7 million ($0.98/share).  This G&A level is clearly outsized for a $400 million market cap company so PKST will either have to reduce it over time or grow into it, and the management team recognizes that.  However, there are no real estate transactions that could justify growth at this share price, and it would be lunacy to issue equity at any price below mid-$20’s as a starting point.  I have applied a 8.0x G&A drag to NAV as it seems improbable that the market and the Board will stand idly by while management takes $300 million out of a $400 million market cap company over the next 8 years without some transformational change, but we will model it undiscounted nonetheless.  At that $300 million level, net NAV would be $27.29, but you can see how valuation would be incredibly sensitive to how this line items changes over time.  While this G&A is probably double what similar sized REITs run at, the management team, especially the CEO, are talented and more qualified than most, if not all CEOs in this market cap range. i.e. you are overpaying for management, but at least you’re getting quality in exchange.

Activist campaigns are difficult in REIT-land but not impossible.  According to a Vison & Elkins study from 2022, of the 99 activist campaigns tracked in REITs in the three years prior, 41% were successful or partially successful, and this was before the roll-out of universal proxy in 2023.  The Company’s 5-person Board members are also all elected annually for 1-year terms (i.e. non-classified Board), which is shareholder friendly.  Given the bite-sized nature of the Company, its large cash hoard and benign debt profile, some mid-sized hedge or PE funds might be drawn to this situation, even with its office exposure.  Hopefully, the Board and Management will choose to be proactive with shares this depressed (they have not ruled out a share buyback plan), but if not, it is heartening to know the shareholders have some governance levers to pull if necessary.

https://media.velaw.com/wp-content/uploads/2022/10/14155710/REIT-Series-Shareholder-Activism-10-24-2022.pdf

Possible Risks

• The main risk would be that Management feels compelled to do something, anything, and there would be no justification to buy anything other than the Company’s own shares with the $11/share cash they are holding.  Any traditional real estate transaction at almost any cap rate would be dilutive short and long-term.

• Management might elect to do dilutive lease-extensions with office tenants rather than just letting the properties go vacant if renewal terms are non-economic (i.e. negative net-effective rents or close to it), but they seem too savvy to make this mistake.

• Management is not super well-aligned; high G&A run-rate and generous comp to C-suite with relatively low ownership %.  May be tempting to just sit on their hands given little to no bankruptcy risk.

• At this small market cap, the odds of finding interest among the institutional REIT mafia are low which could leave the Company’s shares orphaned.

Conclusion

As I stated at the beginning, REITs simply do not get this mispriced with internal high-quality management, attractive portfolios and relatively healthy overall WALTs.  While I feel confident the valuation assumptions can withstand scrutiny, and the discount to NAV remains attractive even if more conservative assumptions are made, what management will decide to do is another matter.  The lack of balance sheet pressure and generous compensation packages could lead to prolonged stasis or conversely ill-advised transaction activity to justify their existence.

Nonetheless, the extremely low valuation and lack of balance sheet risk compensate for business plan risk.  Just as a point of reference, I have reviewed NLOP’s portfolio and estimate its stock trades approximately 71% of liquidation NAV whereas PKST trades at 29%.  Granted NLOP has formally committed to liquidation, but they still pay WPC $15 million/year for third-party management and have some pressing debt issues, including a $108 million,14.5% coupon mezzanine loan at the corporate level.  If PKST were to trade at 71% of liquidation NAV, its share price would be $24.94, more than double the current level.

Catalyst

Share Repurchases

Increased Coverage