Description

Select Income REIT (SIR) is a recent IPO out of CommonWealth REIT (CWH) on March 6 at $21.50. CWH has been struggling with a portfolio of poorly performing office properties as well as a large debt load. While not necessarily “distressed”, the IPO was at least partially motivated by CWH's need to raise capital and increase liquidity (they were able to raise $400mm from the IPO and debt at SIR). The offering represented 30% of the shares outstanding with CWH continuing to own the remaining 70%. CWH selected its highest quality triple-net lease properties to contribute to SIR as they were not getting credit for these within CWH.

SIR is composed of two large land portfolios in Hawaii as well as 23 single tenant triple-net lease office properties on the mainland. The company currently generates 68% of its revenues from its Hawaii portfolio where it owns 17.8mm sq. ft. of commercial land. The land is owned by SIR and leased on a long-term basis to industrial and commercial tenants who in many cases own the buildings that sit on the land. The remaining 32% of revenue comes from long-term, triple-net leased office properties in mainland United States. The mainland portfolio is composed of suburban office buildings with single tenants and minimum initial lease terms of seven years.  The mainland portfolio does not have any lease expirations until 2015.

SIR is externally managed by REIT Management & Research (RMR) which is owned by Barry and Adam Portnoy. RMR manages other publicly listed companies under the CommonWealth umbrella – CommonWealth REIT (CWH), Hospitality  Properties Trust (HPT), Senior Housing Properties Trust (SNH), Government Properties Trust (GOV), Five State Quality Care (FVE) and TravelCenters of America LLC (TA).

Given the high quality nature of SIR’s Hawaii properties, SIR is very cheap trading at 9.7% cap rate, 9.4x AFFO and 7.1% dividend yield (against an AFFO payout ratio of 67% vs. 90%+ for peers). The company is also very conservatively capitalized and underlevered for a REIT at 33% debt to equity as of Q1 ’12. At the current market value, you’re not only getting the mainland US assets for free but potentially buying the Hawaiian assets at a discount. 

I believe the discount relates to SIR’s status as a new company which isn’t well followed, the RMR and external management taint, a small float (70% of stock still owned by CWH), and the fact that the company hasn’t officially announced a dividend as it IPO’d during the first quarter.

Hawaii Properties

SIR’s Hawaiian properties consist of two large land parcels which CWH acquired in 2003 and 2005 called the Damon Estate (9.6mm sq. ft. of commercial land representing 80% of SIR’s HI NOI) and the Campbell Estate (industrial properties located on the west side of Oahu representing the remaining 20% of HI NOI). The majority of the land is in close proximity to the major sea port, airport, military installations and the Honolulu CBD. The Damon Estate was acquired in 2003 for $480mm or $50/sq. ft. and the Campbell Estate was acquired in 2005 for $115mm or $14/sq. ft. Based on management comments and conversations with Hawaiian brokers, land prices have appreciated significantly since the 2003-2005 time frame and is worth significantly more than the $595mm they paid. SIR’s Hawaiian properties have a strong growth profile due to land scarcity, periodic contractual mark-to-market rent adjustments and desirable locations in Hawaii.

The Hawaiian land portfolio has several attractive characteristics that result in private market cap rate valuations that are in the 4%-6% range. SIR's Hawaiian leases have 20-30 year terms with automatic rent resets every 5-10 years based on market rents (typically calculated by third party appraisers). The rent resets provide consistent and steady rent increases. Since the acquisition, 1/3 of the Hawaii portfolio has seen rents reset, resulting in average increases of 30%.  Since SIR owns only the land and rarely the building, there is virtually no capex investment required. Many of SIR's tenants own and occupy the buildings that sit on the land and as a result have little negotiating leverage during the rent renewal process. As an example, one of SIR's tenants is Safeway which recently re-signed its land lease. If they had been unwilling to re-sign on SIR's terms their options would have included either placing the supermarket on a tractor trailer and moving it someplace else (not likely or even possible) or knocking down the building, ripping out the parking lot, and returning the land to SIR in the same condition as when they first rented it. As you may imagine this makes their tenants very desirous of owning the land, and I’ve learned many of their tenants would be willing to pay an even lower cap rate than the 4%-6% I referenced earlier.

Over the next 2.5 years, SIR has $20mm of rental revenue scheduled for resets in HI and management has stated that current market rents are at least 50% higher than the in-place rents. This presents $10mm-$20mm of organic revenue growth which flows straight to the bottom line ($0.32-$0.64/shr).

Though there are few properties for sale within the Damon Estate (SIR owns most of it), there have been several transactions within close proximity. Included below is a sample of current offer prices for land comparable to SIR’s Damon portfolio. While these are offers and not sales, based on conversations with local real estate agents these listings seem to be a fair representation of the market:

Other Opportunities

The main concern regarding SIR is that it's externally managed by RMR. I spent some time investigating RMR and their past dealings and found no evidence of any misdeeds. Their main fault (from a shareholder perspective) is that they are primarily focused on growth through acquisitions. This is not too surprising as their management fee is driven by the historical cost of property. I suspect that they prefer to buy properties at an 8% cap rate rather than buy back the stock at a nearly 10% cap rate. In terms of the expense burden, SIR's G&A expenses as a % of revenue are actually lower than most other REITs.

RMR's intention for SIR is to grow the suburban mainland portfolio through acquisitions (including potentially buying up to $400mm of relevant remaining suburban office assets from CWH). However, SIR will only buy assets that are triple-net with a minimum 7 year lease term. In the Q1 ‘12 earnings release, SIR announced that they entered into agreements to acquire two buildings. In the near term the company will fund acquisitions through increased leverage (which will be accretive from an AFFO standpoint) and longer term they will likely sell stock, though they have been adamant that they would not issue shares anywhere near the IPO price.

Valuing the Hawaii land at a capitalization rate range of 4%-6% and mainland portfolio at 8%–10%, the upside ranges from 54% to 136%. Even if you assume some level of discount for the RMR external management, you still get a cheap stock.

Catalyst