Terra Catalyst Fund

Ticker: TCF LN (London Stock Exchange)

Price: 59p (pence, or cents of pounds sterling)

Shares out: 17,605,067

Market cap: $16m

Summary

With the ongoing real estate recovery in the US, investors are beginning to look at Europe, where the cycle is a few years behind us. Within Europe there is an array of real estate assets in different geographies and asset types. Warehouses in Italy is probably in one corner, being very economically sensitive and in the periphery.

Terra Catalyst Fund (TCF) is a liquidating real estate holding company trading at a stated discount to net asset value of ~40%, although I believe the real discount is closer to 60% and perhaps greater, as will be explained below. As such, there is substantial potential upside as TCF liquidates its remaining holdings.

Assets

TCF holds three assets:

1)     6,128,610 shares of Spazio Investment NV, which at €2.47 per share equals 71.9p per TCF share

2)     9,454,545 shares of Tamar European Industrial Fund, which trades publicly, and at the most recent price of 36p equals 19.3p per TCF share

3)     Cash equal to 4.7p per share

Put it all together and stated NAV is 96p per share.

Both Spazio and Tamar are themselves at significant discounts to NAV, and have an explicit mandate to liquidate their assets and return cash to shareholders. Tamar is publicly traded, and it is likely that by now, TCF has liquidated its holdings in Tamar and converted them to cash. If that is the case, we should expect to see TCF conduct a mandatory redemption of shares for around 20% of shares outstanding in the coming month. At that point the only remaining assets inside TCF would be Spazio and a small amount of cash.

Spazio was privatized in 2009 through a tender offer conducted by UK activist hedge fund Laxey Partners, and is therefore delisted. Laxey is majority owner of Spazio with around 71% of the shares outstanding (which includes its 8.4% ownership of TCF), and has board seats on both TCF and Spazio.

Spazio

Spazio Investment NV, aka Spazio Industriale, has 22,945,874 shares outstanding. TCF therefore owns owns around 27% of Spazio, with the other big shareholder being Prelios (previously Pirelli Real Estate), with 22%.

Spazio primarily owns warehouses in Italy on long-term leases to Telecom Italia, Prada, Enel, and other credit tenants. It also owns a development called Eastgate Park in the town of Portogruaro, in the northeast of Italy, and some smaller assets.

In aggregate these assets span 5.4m square feet (not including undeveloped land), and were appraised at 12/31/2012 at around $95 psf. This is not a very meaningful number because it encompasses assets across many uses, locations, etc., so it must be taken in that context.

Underlying each of these assets are low cost loans which have recently been extended, detailed below.

Spazio has a website with yearly financials and its IPO prospectus:

http://www.spazioinvestment.com/eng/Investor_Relations/Annual_Reports.asp

Development portfolio

Eastgate Park

http://www.eastgatepark.it/eng_index.html

Eastgate Park has an estimated market value of €80m, currently producing minimal rental income. Of this amount, about €54m is undeveloped land. In addition there are another set of €4m of development properties not at Portogruaro. Underlying the development portfolio is the Portogruaro loan in the amount of €43.8m, costing 3M Euribor + 250 bps, maturing 12/31/2015.

The net LTV of the Portogruaro loan including cash collateral is 42.9%.

Eastgate Park has a net book value per Spazio share of €1.7.

Warehouses

http://www.celticitaly.it/english/pageRicerca.aspx (choose Owner: "Spazio Industriale" on the right)

The balance of Spazio’s assets consists of €282m of buildings, of which €147m are leased to Telecom Italia, another €63 are income producing and leased to other tenants, and €72m which are either vacant, or will be vacant soon and must be redeveloped or sold.

This portfolio has a jumbo loan in the amount of €183m, costing Euribor + 250 bps, maturing 10/31/2016.

The net LTV of the jumbo loan portfolio including cash collateral is 56.6%.

The jumbo loan portfolio has a net book value per Spazio share of €4.3.

As can be seen from the link above, these assets are not pretty, but they are likely worth more at an arm’s length transaction (perhaps in a residential or retail redevelopment) than leased. Several of the assets are located near their respective town centers, and would have substantial upside in a redevelopment scenario. (See extensive comments regarding this in Spazio’s annual reports and TCF’s latest half year report dated Dec 19: http://www.londonstockexchange.com/exchange/news/market-news/market-news-detail.html?announcementId=11811049)

Other assets

In addition, Spazio owns Edificio 16 (an office building), another small real estate asset, and cash, bringing the total NAV per Spazio share to €6.97 as of 6/30/2013.

Cash flow & debt

It is difficult to have a clear idea of the run-rate cash flow generation of the Spazio portfolio, since full financials are only reported yearly. Yet for the year ended 2012, Spazio had rental income of €20.9m and operating costs of €11.7. Interest expense should be running at around €6.2m, so Spazio should be generating a small profit of €2.9m or €0.13 per Spazio share.

The recent debt renegotiations were a very positive event for Spazio; it now has time to conduct measured sales of its assets. Yet the debt renegotiations require a cash trap until debt is substantially paid down, meaning that any cash distributions from Spazio won’t happen until this is accomplished.

Valuation and why this is cheap

Spazio’s net asset value of €6.97 per share compares favorably with how TCF has decided to mark it on its balance sheet, at only €2.47. Given the leverage in Spazio, TCF’s mark of €2.47 implies a discount of around 30% across all of Spazio’s buildings.

In contrast, Spazio has sold properties at discounts to valuation ranging from 6.5% to 11.3% over the past three years.

Therefore, I believe €2.47 to be a conservative number. If Spazio were to sell all of its holdings at a 14% discount to valuation, I estimate NAV would be close to €5.00.

The euro zone recession, debt crisis, and troubled banks in Italy have all cast a cloud over real estate transactions in Italy. There is, however, reason to believe the situation is improving.

As has been widely reported, the euro zone is exiting its protracted recession. Furthermore, not only have there been many media reports of investment funds taking an interest in European real estate, but the Italian government has taken steps to make foreign investment in real estate easier (see: http://destinazioneitalia.gov.it/english/)

Given that around 20% of TCF’s current portfolio is either in Tamar shares or cash (if Tamar has been liquidated), at the current price of 59p an investor in TCF is effectively buying Spazio for only €1.20 per Spazio share.

This is an 83% discount to Spazio’s NAV of €6.97 per share, or a 52% discount to the €2.47 at which Spazio is marked on TCF’s balance sheet.

In any case, I believe buying TCF at current levels affords an investor a very wide margin of safety and the potential for attractive returns. Assuming it takes three full years to liquidate Spazio, if we only get €2.47 per Spazio share, the IRR is ~22% (assuming a Feb 2014 distribution of the excess cash at TCF). Assuming a recovery of €5 per Spazio share raises the IRR to 53%.

Risks

-          A massive euro devaluation relative to the pound would lower the value of Spazio to TCF, since TCF is quoted in pounds but Spazio owns assets valued in euro.

-          The usual euro zone risks – more recession, banking crises, political instability in Italy, a return to the lira, etc.

-          Portogruaro and the jumbo loan have cross collateralization provisions, so a default in either would presumably drag down the entire portfolio; however given the low LTV I believe the manager would be able to sell properties, even if at significant discounts, before this ever happened.

-          Spazio has pending issues with Italian tax authorities; these are explained in the Spazio and TCF financials and in many ways are already priced in. Management seems to think that it is unlikely that the Italian government will prevail, however.

Opportunities & Catalysts

-          As Spazio’s leases mature, there is an opportunity to convert low yielding warehouses into higher and better use real estate. It would not be unreasonable to imagine an institution with a long-term horizon being in a position to make such an investment, particularly since Spazio’s size would allow a good chunk of capital to be put to work. If this happens, there could potentially be upside to the reported NAV of €6.97.

-          Italy improves its attractiveness to foreign investment and/or elects a government capable of making needed reforms.

-          Sentiment towards Italian real estate improves.

-          Euro / Italian banks recapitalize and start lending again.