Description

Price Target: $45.00 (50%)

Retail Value, Inc. has been mentioned in this forum as a spinoff of SITC (f.k.a. DDR), but not yet written up. With 50% upside, likely to be realized over the course of this year, we view it as the most attractive REIT to own now.

RVI is a liquidating strip center REIT spun out from parent strip center REIT DDR (DDR has since changed it ticker to SITC). RVI owns 25 power centers in the continental US and 12 retail centers in Puerto Rico. The continental assets are below-average quality for US shopping center REITs, but they are still “institutional quality” and of higher quality than the average US strip center.

To frame the historical context, parent DDR/SITC has long been a laggard amongst its strip center REIT peers, a result of many years of near-sighted management and lower-quality assets. In 2017, the former management team of Equity One (former because they had just sold Equity One to Regency Centers) was recruited to turn DDR around. They began by selling ~$2bn of the lowest quality assets, including two from Puerto Rico.Then, towards the end of 2017, they were hit with two major adverse events that caused their stock to fall by more than 50% and disrupted their planned liquidation of another $2bn of assets. First, the retail-armageddon narrative really started to affect the pricing of strip REITs, and, second, Hurricane Maria took most of their PR properties offline. Management responded by developing a plan to spin out those assets (into RVI), enabling them to continue an orderly liquidation, while removing the “bad asset” overhang from their own stock.

As an aside, we like the team at SITC; they have done a great job cleaning up both sides of the balance sheet, and we think they will be good capital allocators.  They (and many other strip REITs) are trading at a sizable discount to NAV, but we strongly prefer RVI due to the lower duration of the investment.

RVI is down over 10% from its spin in July (versus peers flat-to-slightly-up over that period), yet the fundamentals have improved in three material ways over the past year: (1) realized sales prices have been 5% above our underwriting; (2) they have been able to reduce leverage by 25%; and (3) the post-Maria recovery in their Puerto Rico properties has vastly surpassed our expectations (check out the videos posted on their website).

Our base case liquidation value is $40, which reflects a 10% forward cap rate for the PR properties and the continental properties sold at a 20% discount to appraised value (8.7% cap rate), with an additional 5% in frictional sales costs (for the ~25% of the portfolio sold thusfar, the actual values have been 16% & 4%).  There are three main toggles that provide upside to this $40 figure: (1) $4ps in additional value if the continental properties are sold at a 15% discount to appraisal, consistent with the sales that have already taken place; (2) another $6ps in additional value if the PR properties are sold at an 8.5% cap rate; and (3) $1.00-1.50ps per quarter in cash build-up (in-place AFFO yield is in the high-teens).  All-in, we think an orderly liquidation over the next two years would see ~$50ps in cash distributions to shareholders.

That said, we do NOT think an orderly liquidation is the most likely path from here; we think it is more likely that RVI is taken private at some point in 2019.  Our logic:

• The window for RVI to refinance its debt will open at the end of February. The combination of $400mn in asset sales and the sharp recovery in Puerto Rico means that RVI is a MUCH better credit than it was 12 months ago. We think that the refi will enable accelerated return of capital to shareholders, or (more likely) it will facilitate the sale of the remaining 37 properties as 1-3 large portfolios.
• RVI has $1bn of debt at a weighted-average cost of L+315, plus $200mn in prefs. This is supported by a 37-asset portfolio generating $160mn of NCF. $10mn of overhead and a termed-out refi at 5.0% implies $90mn in FCF to a buyer.  At $40 per RVI share, this is a 12% cash-on-cash yield for institutional quality assets. With several hundred billion dollars of dry powder in real estate private equity funds, I think one of them finds a home here.
• The entire island of Puerto Rico is an opportunity zone.
• SITC management is eager to focus on the redevelopment and growth of their own portfolio. They will be eager to accept a fair offer on RVI to remove this from their plate.

Other Notes:

• Retail CRE in Puerto Rico: The dynamic for retail CRE in PR is a bit different than on the continent: it is not as heavily-retailed, and the island provides a number of logistical barriers to competition from e-commerce. As a result, foot traffic and sales density (and rents) are higher than one might expect. A number of other REITs own property in PR; for example, strip center peer Urban Edge has two properties that they have commented on in recent earnings calls.
• History of DDR’s PR Exposure: DDR bought its PR portfolio in 2005 for $1.15bn. The REIT sold two of its PR properties several months before Maria (but well into a recession on the island) for a low 8% cap rate and 130% of gross book value. Management claims these were their lowest-quality properties on the island. The base case outlined above values the PR portfolio at a 10.5% cap rate and 70% of gross book value ($15ps discount). Note that this cap rate is being applied to in-place NOI, which is down ~15% from before the hurricane (we think a buyer may look at that lost rent as a potential source of recovery/growth).
• Recent SITC JV: Six months after the RVI spin, SITC announced a JV in which two Chinese institutional investors purchased an 80% interest in a $600mn, 10-center portfolio that was comprised of SITC’s worst remaining centers left after the RVI spin. The pricing implied a ~7.3% cap rate (compared to the 8.7% cap rate where we are valuing RVI’s continental portfolio)
• Management: We think this is a high-quality group, with much more pedigree than one would expect for a $0.5bn market cap. The team, led by CEO David Lukes, came over several years ago from Equity One, having sold that REIT to Regency Centers – a big win for shareholders.  The external management contract would normally be a big red flag, but this one was clearly crafted in a manner that is thoughtful and friendly to RVI. The fee is pro rata and shrinks alongside the asset base, while SITC has retained a large, no-coupon preferred interest that it gets back only after the debt is repaid.
• Notable Owners: Luxor is a 10%+ owner and has been buying aggressively over the last few months, including at prices around the current. The Otto family (German real estate magnate) owns 20%, which they got through the spin from SITC/DDR (they provided emergency financing to DDR during the crisis).  Cohen & Steers filed as a 10%+ owner in July, but liquidated their stake by mid-October. SITC management owns ~1%, acquired through the spin.

Why does this opportunity exist?

• Rapidly evolving spin/liquidation: while not all spinoffs are good investments, the dynamic creates a greater likelihood for mispricing, especially when combined with the complexity and relative illiquidity found in this situation
• “Bad Asset” taint: it’s no secret that RVI holds the assets that SITC didn’t want, and we think this stigma further reduces the number of investors looking at it, increasing the likelihood for mispricing.
• REIT with no dividend: since many REIT strategies require yield, a REIT with no dividend should generate less investor interest, increasing the likelihood of a mispricing. Moreover, management originally indicated that they would pay out 100% of AFFO as a dividend, but the independent Board reversed this decision as soon as they were installed, wanting to preserve maximum liquidity and optionality.
• Small & illiquid: $0.5bn market cap w/ an even smaller float and under 100k shares of daily liquidity (though very possible to accumulate several million dollars’ worth)
• Selling pressure: SEC filings would suggest Cohen & Steers liquidated ~15% of the float in the late summer/fall, which may have pressured the shares.

Catalyst

• Asset Sales
• Spring debt refi