Description

Thesis.  Thomas Properties Group, Inc. (TPGI) currently trades at a 40% discount to conservatively stated net asset value (NAV).  In April of this year, management announced a strategic plan which entails (1) selling selected operating properties and development parcels, (2) reinvesting the proceeds in income-producing properties in selected markets, and (3) ultimately converting into a REIT.  Based on guidance provided by management, TPGI's share of the cash proceeds from property sales will, when combined with current net cash on hand, equal 80% or more of the company's current market cap.  If properly executed, this should clearly highlight the discount to NAV at which the stock currently trades. 

Company Background, Business, and Holdings.  TPGI is a real estate operating company (not a REIT) headquartered in Los Angeles.  The company owns and develops primarily Class A office buildings in Los Angeles, Houston, Austin, Philadelphia, and suburban Virginia (Reston/Fairfax).  It is one of two successors to Maguire Thomas Partners, a Los Angeles based development firm.  Maguire Thomas split in 1996, with Rob Maguire forming Maguire Properties (now MPG Office Trust; NYSE:MPG) and Jim Thomas forming Thomas Properties Group.  TPGI went public in 2004.

TPGI is a holding company.  All of its operations are conducted through an operating partnership, of which TPGI is the sole general partner and in which TPGI owns approximately 75% of the limited partnership units.  Unless otherwise specified, all references to TPGI mean both Thomas Properties Group, Inc. and the operating partnership.

TPGI owns, either in full or through one-off joint ventures, (1) two Class A office buildings, a residential/retail mixed use property, a completed but not sold out condominium project, and an entitled development parcel in Philadelphia, (2) a suburban office building and 250 acre entitled development parcel in Austin, Texas, and (3) a 24 acre entitled development parcel in El Segundo, California.  TPGI's interest in its remaining properties is held through TPGI's joint venture with the California State Teachers Retirement System (CalSTRS), which is called TPG/CalSTRS.  TPGI holds a 25% interest in TPG/CalSTRS.  TPG/CalSTRS owns directly twelve properties, located in Los Angeles, Houston, suburban Virginia, and suburban Pennsylvania.  TPGI's interest in these properties is 25%, except for the single Los Angeles property, in which TPGI holds a 7.9% interest.  TPG/CalSTRS also holds a 25% joint venture interest in the TPG-Austin Portfolio Syndication Partners JV, which owns ten properties in Austin, Texas.  TPGI's interest in these properties is 6.25%.

TPGI earns property management, asset management, leasing, and development fees from the TPG/CalSTRS joint venture properties.  In addition, TPGI manages four office properties (containing approximately 2.3 million square feet) for third parties (two of the properties are owned by CalSTRS).  TPGI also has two fee-only development projects in Los Angeles, one for Korean Air and the other for NBC Universal.  TPGI has been engaged by Korean Air to entitle and master plan a 2.7 acre site in downtown Los Angeles for 2.5 million square feet consisting of office, hotel, residential, and retail uses.  NBC Universal engaged TPGI to entitle and master plan its Universal Studios Hollywood backlot on which TPGI has a right of first offer to develop approximately 124 acres for approximately 2,937 residential units and 180,000 square feet of retail and community-serving space (the status of this project is uncertain because of Comcast's acquisition of NBC Universal). 

Debt.  There is no corporate level (or operating partnership level) debt.  All debt is at the property level and is generally non-recourse to the borrower and to TPGI.  TPGI has a contingent liability for guarantees of property loans; the guarantees total to approximately $31.6 million.

Valuation Methodology.  I included the following in calculating TPGI's NAV:  (1) unrestricted cash (including TPGI's proportionate share of the JV's unrestricted cash); (2) TPGI's proportionate share of the value of its properties, net of debt; (3) value of TPGI's 73% interest in the Philadelphia condominium project, net of debt; and (4) value of the entitled development parcels, net of debt.  Most figures used to calculate NAV were taken from the Supplemental Financial Information package posted by TPGI on its website.

• Each operating property was valued by (a) capitalizing estimated stabilized NOI (based on management estimates) at a blended capitalization rate of 7.6% (cap rates were arbitrarily selected as follows for different markets: Los Angeles - 7%; Houston - 8.3% (blended); Austin CDB - 7%; Austin suburban office - 8%; Philadelphia - 8%; and Virginia - 8%), (b) discounting the stabilized value to present value based on the length of time before stabilization at a 10% discount rate, (c) subtracting the amount of debt on the property, and (d) subtracting the amount of capital expenditures required to stabilize the property (again based on management estimates).
• As a separate data point, the property values used to determine NAV result in a value per square foot for the entire portfolio of $208.
• Only operating properties with a positive value after deducting debt and capital expenditures were included in calculating NAV.  Properties with a negative present value were excluded, because the debt is nonrecourse, and TPGI can walk away.  In this regard, the loans secured by TPG/CalSTRS's three suburban Pennsylvania properties are in default, and TPGI has stated publicly that neither it nor CalSTRS intends to contribute capital to cure these defaults.
• NAV was adjusted to take into account valuations implied by recent transactions. First, four properties were refinanced in July 2010 (one in Los Angeles and three in Houston). The lenders were Metropolitan Life/New York State Teachers Retirement System, Metropolitan Life, Northwestern Mutual Life Insurance Company, and Wells Fargo.  Valuing the refinanced properties based on the loan to value ratios used by the lenders in making the loans adds $37.3 million to NAV.  Second, in November 2010, TPGI entered into a joint venture with Brandywine Realty Trust for its two wholly-owned Philadelphia office towers (Commerce Square I and Commerce Square II).  In exchange for a 25% interest in the properties, Brandywine agreed to contribute $25 million to the newly formed JV. This results in an implied value for the property equity of $100 million (TPGI's share of which is $75 million), which reduces the calculated value by $3.3 million.
• The Philadelphia condominium project was valued by multiplying the square footage remaining to be sold by the average historic sales price per square foot, subtracting sales costs of 10%, and subtracting debt. The project is carried on the balance sheet at estimated fair value, and TPGI booked impairment charges on the project in 2008, 2009, and 2010.  The calculated valuation (before subtracting debt) is approximately 70% of the estimated fair value shown on the balance sheet.  In addition, the average historic sales price is approximately $500 per square foot, while the average listing price on the unsold units (nearly all of which are on the top floors) is over $800 per square foot.
• The entitled development parcels were valued at $15 per buildable square foot (El Segundo) and $10 per buildable square foot (Philadelphia and Austin); debt (El Segundo only) was then subtracted from these values.  The resulting valuation is, before subtracting debt, approximately 48% of the amount at which these assets are carried on the balance sheet.

NAV.  NAV is as follows:

Some additional notes on NAV:

• I assigned no value to TPGI's management, leasing, and development fee income stream, and made no deduction for G&A expenses.  In 2010, TPGI earned $20.7 million of fees from unconsolidated properties (primarily TPG/CalSTRS properties, including the Austin portfolio) and $6.7 million from third parties, and recognized expenses of $12.2 million, for net fee income of $15.2 million.  TPGI's 2010 G&A expenses (for all operations) were $14.2 million.  Consequently, these two items essentially cancel each other out.  I believe it would be defensible to assign significant value to the fee income, even after taking into account G&A expenses.  However, it is also worth noting that the fee income stream is highly dependent on the CalSTRS relationship.  In any event, it is not included in NAV.
• As of December 31, 2010, TPGI had approximately $22.7 million in federal net operating loss carryforwards.
• TPGI appears to be running at break even to slightly positive on a cash flow basis (it runs losses on a GAAP basis because of property depreciation).  My primary concern was to confirm that the company is not burning cash; having done that, I did not devote much effort to calculating current income and cash flow.

Alternative Valuation.  One may also analyze TPGI by determining how much one is paying for the property portfolio at the current share price.  Assigning no value to development parcels or the unsold condominiums, at the current share price, one is buying the property portfolio, plus cash, at a cap rate of approximately 8.6%, and at a cost of $183 per square foot.  In other words, at the current share price, an investor pays an 8.6% cap rate for a well-located primarily Class A office portfolio and cash on hand, and gets the development parcels, the unsold condominiums, and the fee income for free.

Major Holders.  Jim Thomas owns 3,152,046 common shares and 12,313,331 partnership units (together, a 31% economic and voting interest), and recently purchased additional shares (albeit a small amount) on the open market.  Third Avenue Management owns 7,638,579 shares (21% of the common, and a 15% economic and voting interest).  Third Avenue participated in TPGI's stock offering in December 2009 at $2.55 per share, and through that offering and other purchases increased its holdings by approximately 5 million shares in the third quarter of 2009.  Other major holders include TIAA-CREF (5,214,937 shares representing 14% of the common and a 10% economic and voting interest), Lyle Weisman filing group (3,358,078, 9%, 7%), and BlackRock (2,088,616, 6%, 4%).

Strategic Plan.  TPGI's strategic plan is focused on maximizing recurring cash flow and NOI growth, with a long-term goal to convert to REIT status and pay a meaningful dividend.  The plan provides for the disposition of selected assets and redeployment of the proceeds to acquire new assets, and includes the following specific objectives:

• Sell land and reduce development assets to approximately 10% of NAV.
• Sell non-core operating assets that are either underperforming or have achieved maximum value.
• Expansion of the office portfolio with a focus on acquiring wholly-owned or controlled income-producing assets in high barrier to entry markets, primarily in California and the western United States.
• Continue capital relationships with institutional investors (primarily CalSTRS) to acquire trophy quality office properties, with a goal of increasing ownership interests in existing joint ventures.
• Reduce leverage on the portfolio to a target of 50% LTV.

The plan can be divided into two components - a sales program and an acquisition program.

Sales Program.  In the current (second) quarter, TPGI plans to market for sale two to three operating properties, including buildings in both Austin and Houston, with the expectation that these properties will be under contract by the end of the third quarter with closings to occur by the end of the year.  In addition, TPGI is under contract to sell approximately 2 acres in its El Segundo project to a hotel developer; the sale is expected to close no later than October.  Finally, TPGI expects to go under contract to dispose of an additional land parcel in California with closing projected to occur by the end of the year.

In the third quarter, TPGI intends to bring to market another two to three operating properties, located in the Philadelphia, Virginia, and Houston markets.  TPGI expects to close on these sales in early to mid 2012.

TPGI anticipates realizing approximately $75 million to $125 million in net proceeds from its property sales.  Combined with current cash on hand, this would result in total cash of between $120 million and $170 million, compared to a current market cap of approximately $160 million.  TPGI has no corporate level debt.  In addition, the value of TPGI's interest in its single Los Angeles property and its two Philadelphia office towers is approximately $100 million.  Thus, TPGI's sales program, if executed as described, should clearly highlight the stock's discount to NAV.

Acquisition Program.  The acquisition program is focused on acquiring income-producing assets in high barrier to entry markets, primarily in California and the western United States, and consists of three components:

• Acquiring wholly-owned assets.
• Utilizing existing capital relationships with institutional investors (primarily CalSTRS) to acquire additional properties.
• Increasing TPGI's ownership share of existing investments held in current joint ventures.

The purpose of the acquisition program is to increase recurring cash flow and NOI growth, ultimately leading to a conversion to REIT status.  The idea of converting to a REIT is plausibly attractive, given that most office REITS are trading at a premium to NAV, while TPGI is trading at a significant discount to NAV.

However, TPGI will likely pay top dollar to effectuate its plan, especially given TPGI's stated purchase parameters:  "trophy" properties located in high barrier to entry markets, primarily in California.  Class A office buildings meeting these criteria are currently far from cheap.  Management described its return objectives on acquisitions as follows:  total returns on an average five to ten year holding period between 9% and 11% with going in yields ranging between 6% and 8%.  Thus, while the acquisition program, if successfully executed, may result in a rerating of the stock upon conversion to a REIT, it is unlikely to meaningfully increase NAV, and may even impair NAV to some extent.

The acquisition strategy is not optimal for realizing shareholder value.  Using the proceeds generated by the sales program to repurchase stock would, under current market conditions, be a far better use of capital.  If TPGI is able to execute its sales program substantially as projected, it could implement a sizable buyback without impairing financial flexibility, while retaining dry powder for future opportunities.  From a capital allocation perspective, it makes more sense for TPGI to buy its own portfolio at an 8.6% cap rate rather than new properties at a 6% cap rate.

Risks.

Execution of Property Sales Program.  There is a risk that TPGI will not be able to execute its sales program as projected, either by being unable to sell the properties it has targeted for sale, or by not realizing the amount of proceeds it anticipates.  If this transpires, it may also call into question the correct amount of TPGI's NAV.  While I believe management's capital allocation skills leave something to be desired, they are competent operators, and I believe that the odds favor them executing their sales program substantially as planned.

Acquisition Program.  There are several risks associated with TPGI's proposed acquisition program.  The first is that TPGI is even considering the program.  As discussed above, based on current conditions, it would be far preferable for the company to utilize the proceeds from its sales program to repurchase its discounted stock, instead of pursing new properties in a highly competitive market.  That management is proposing an acquisition program in lieu of a stock buyback demonstrates insensitivity to shareholder value.

There is also a timing risk to the acquisition program.  The stated purpose of the acquisition program is to increase recurring cash flow and NOI growth, to enable the eventual conversion to REIT status.  Management has not laid out a timeline for achieving this goal.  I speculate that it could take two to three years to transform the portfolio sufficiently to generate enough recurring cash flow to support a dividend and justify converting to a REIT.  In the meantime, conditions could change, and REITs may no longer command premium valuations.  In other words, by the time the plan is completed, the rationale for undertaking the plan may no longer apply.

Finally, there is execution risk to the acquisition program.  As noted above, TPGI's targeted properties are not currently on the bargain rack.  Further, TPGI appears to have inherited the Maguire Thomas DNA of acquiring properties at the peak of the cycle.  For example, the TPG/CalSTRS JV acquired its Austin portfolio from Blackstone in 2007 (the Austin portfolio being part of Blackstone's overpriced Equity Office acquisition).

CalSTRS.  The majority of calculated NAV resides outside the TPG/CalSTRS JV.  However, TPGI is dependent on CalSTRS for the bulk of its fee income, both from the TPG/CalSTRS JV and from third party management contracts.  Thus, if TPGI's relationship with CalSTRS sours, it could have a significant effect on the stock price.  Based on disclosures in SEC filings, and a cursory review of the joint venture agreement, it appears that the leverage in the relationship lies with CalSTRS.  Management devotes significant attention to proclaiming CalSTRS' satisfaction with the TPGI relationship.  There is evidence to support this, as CalSTRS has, over the past two years, participated in the recapitalization of several TPG/CalSTRS properties on non-rapacious terms.  Thus, there seems to be little current likelihood that the CalSTRS relationship is in jeopardy.  Nonetheless, the dependence on CalSTRS is a risk factor.  In this regard, the joint venture agreement prohibits any transfer of shares that would reduce Jim Thomas's voting power below 30% (it is currently 31%).

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