Description

Kennedy Wilson (KW) is a diversified non-REIT real-estate company focusing on multi-family and commercial properties.  The vast bulk of the company’s holdings are held in the US, UK and Ireland.  The company is led by CEO Bill McMorrow who has headed the company since 1988 and has an impressive history of finding real estate value in Japan during the 1990’s, in the United States following the financial crisis, and most recently in Europe.

KW was last written up on VIC in 2011 in an excellent write-up by lvampa1070, and I encourage members to reread the write-up for some historical perspective and a detailed look at the company’s fee streams.  It should be noted that KW’s disclosure has vastly improved since this initial write-up, and the company’s supplemental quarterly disclosures will prove helpful in understanding the name.  

Over the past ~six years, KW has continued to expand its western US operations, increased the number of wholly owned investment properties and executed a European IPO (Kennedy Wilson Europe) in early 2014 following its initial 2011 acquisition of Bank of Ireland’s real estate investment management platform.  While the stock has strong returns since inception, shares have barely moved in the past 4 years, including declines of roughly 7% this year.  After examining the below operating performance, an investor might be puzzled with the stock’s recent underperformance.  

While KW has a long history of spotting value in real-estate markets across the world and has actively recycled capital across assets, it is fair to say that the company has been forced to “sell cheap to buy cheaper” as it funded acquisitions, including the previously mentioned march into Europe.  The size of the recent acquisitions required substantial new equity as seen from near doubling of KW’s outstanding shares.  And more equity is coming as a result of the pending KWE acquisition.  Following the Brexit vote in the summer of 2016, KW’s European operations (KWE) traded at a sizeable discount to net asset value as Brexit uncertainty and pound weakness spooked investors.  KW owned over 20% of KWE and this KWE discount was partially transferred to KW shares.  The discount to NAV made it difficult for KWE to raise money, and the structure made it nearly impossible for KW to recycle capital from Europe to the United States and vice versa.  Additionally, KW’s ownership in KWE was increasing through a combination of KWE share payments to KW (50% of KW’s 1% management fee was paid in KWE shares and 100% of its performance fee) as well as KWE buybacks.  If KW crossed the 30% threshold, it might have been forced to make a full offer for KWE under UK listing laws.  KW believes there is substantial asset value and reinvestment opportunities in Europe, and therefore the company ultimately concluded that it would ultimately receive a more favorable valuation owning 100% of KWE.  But this decision required KW to issue more equity at levels that were arguably below intrinsic value.  

Following an investor campaign at KWE, the offer terms were revised whereby the total offer was revised higher and included a £5.50 cash component.  The total stock component (.3854 shares of KW versus the original offer of 0.667 shares), however, declined.  Post-closing, KW investors will own approximately 75% (this was 64% under the original deal) of the combined company.   Arbitrage in the name has been a headwind, especially as KW has been restricted from repurchasing its own shares.  

In addition to the pending equity issuance, KW likely suffers from a complexity discount, smaller tradeable float (insiders own ~17% of the company while Fairfax and Wellington own approximately 11% each), and neglect from REIT investors who are reluctant to own non-REIT names.  KW predominantly owns multi-family and commercial properties, but it also owns hotels, loans, among other holdings.  KW also has sizeable minority interests, owns properties across geographies (including the previously mentioned expanded presence in Europe), and possesses a valuable (but confusing) fee franchise.  Real-estate investors often prefer more straightforward investments, and therefore the disparate nature of the holdings has been a factor in investor neglect.  

That said, KW has a strong history of creating value.  From its IPO (2009) until the end of 2016, the company claims to have achieved 30% IRRs on its total real estate investments and clearly has keen eye for spotting value across markets.    

We summarize the key investment merits below and then describe each in greater detail.  

• Attractive Multi-family properties.  While a large amount of brain drain on KW is likely spent trying to value its fee portfolio, the greatest impact on total valuation comes from its US multi-family portfolio, which has a heavy Seattle presence.  KW posted 6% same property gains in the western US in Q2 2017, following 14 quarters of at least 8% growth.  Units are primarily located in suburban markets with rates often 50% below those in more urban centers.  This should allow KW to organically increase its NOI for years to come.  

• Attractive Pipeline:  KWE has multiple attractive pipeline projects, which can drive continued value in the years ahead.  Three of the larger pipeline projects are in Ireland with the country having one of the stronger economic outlooks in Europe.  Rents should increase and cap rates could actually compress from current levels.  

• Servicing Franchise Delivers Deal Flow…Valuation Subjective but not Needle Moving.  KW has long discussed how its servicing operations provide market intelligence and allow the company to source deals and avoid auctions.  The company also receives a valuable fee stream from this franchise, although its total impact is not as material as many believe to total valuation.  

• More Passive Owners Post Deal  While the motivation for the KWE deal was to allow the company to own 100% of an attractive asset with meaningful reinvestment opportunities, an interesting side effect of the deal is that the transaction will likely force a larger number of passive owners to purchase shares in a name with smaller tradeable float.  It is possible that these new buyers impact the share price post-closing.  

Attractive Multi-Family Properties

While a large amount of brain drain on KW is likely spent trying to value its fee portfolio, the greatest impact on total valuation comes from its US multi-family portfolio, which has a heavy Seattle presence.  KW posted 6% same property gains in the western US in Q2 2017, following 14 quarters of at least 8% growth.  By comparison, the commercial portfolio (with 93%-100% occupancies across regions) have generally experienced flattish LSD same-property increases in Europe and more flattish results in the US.  

The US multi-family portfolio is concentrated in the western US (California and Washington) with an emphasis on more suburban locations.  A heavy concentration in Seattle (10,430 of 25,943 total multi-family units) has likely accounted for a large portion of the outperformance.   As KW noted in its annual report, Seattle has bested the broader US market in multiple economic and demographic indicators over the past five years (KW first invested in 2008) and this outperformance is expected to continue over the next several years.  

KW has also noted that its average rents of ~$1700 unit (Seattle units would be lower) across its multi-family portfolio are far below more urban locations and therefore should allow continued price increases versus multi-family units in more urban locations.  Housing costs consume nearly 50% of take home pay in the San Francisco Bay area (where KW has been a net seller) versus 25-35% in Seattle.  While KW has said that it is more difficult to find new acquisition opportunities, the Seattle area continues to have strong visibility on rent increases.  

KW also owns multi-family properties in Japan and Ireland (the Irish properties are separate from the KWE properties) but their total NOI accounts for less than 10% of KW’s non-KWE NOI.

According to a September 2017 Morgan Stanley comp sheet, a broad set of apartment REITS traded at an average cap rate of roughly 5.1%.  Considering the heavy Seattle exposure and faster same-property NOI growth rate (Washington same property NOI was +9.3% in the second quarter), one can credibly argue that KW’s portfolio deserves to trade at a premium – a 4.5% vs. 5% total cap rate would increase total NAV per share by approximately 12% keeping all other factors constant.  As we will discuss later in the report, the lower absolute interest levels combined with normal spreads would likely imply even lower cap rates for the Irish and Japanese properties.  

Certainly, these cap rates are vulnerable to sudden increases in interest rate levels or changes in the spreads for prime properties.  KW’s multi-family portfolio, however, is not locked into multi-year leasing agreements and therefore there would appear to be an opportunity to continue rent increases in the years ahead.  Additionally, the relatively younger portfolio will likely require fewer tenant enhancements and capital spending over the coming years.  

Attractive Pipeline  

KW has a significant development pipeline that should be meaningfully accretive to NAV over the next 2-3 years.  Three of KW’s five largest property projects are based in Ireland, including Capital Dock (345,000 office square feet office, 25,000 square feet of retail, 190 multifamily units) and multi-family project Clancy Quay.  KW recently sold 130,000 of the Capital Dock Project to JP Morgan for a rumored value of $1000-$1100 per square foot.  Clancy was acquired in 2013 with 423 new units (now 97% leased) and 8 acres of land.  By the time, Quay is completed, it is anticipated to have 845 units and become one of the largest multifamily properties in all of Ireland.  KW has talked about how Clancy is just another example of the company creating value out of land that was ascribed little cost basis at acquisition.    

The rebound in the Irish economy might have been even stronger than KW’s bullish scenarios when the company first invested in 2011.  While the full impact from Brexit will likely not be known for several years, it has clearly been a positive catalyst for the Dublin office market as noted by KW and other Irish focused REITS.  One such REIT (Green REIT PLC) has noted that Irish prime office spreads are an outlier compared to other European markets, especially considering the stronger forecasted economic growth.  Green makes the case that Irish spreads are likely to compress in the years ahead.    

Source:  Green REIT PLC Presentation

Clearly, one could argue that current European bond yields are not sustainable and that jumps in interest rates are highly likely.  Perhaps spreads will compress simply with a rise in interest rates.  But, it is also possible valuations could move higher should rates remain near current levels.  Furthermore, while there is additional supply coming to the Dublin market, there is an acute shortage of available residential housing while occupancy levels are often running above 99% in Dublin commercial properties.  For the next several years, KW would appear to have strong visibility on further increases.  

Back in the US, KW has 1,000 units under construction for its Vintage Housing program, where KW acquired a majority stake back in 2015.  At the time of the transaction (acquired during Winthrop Realty Trust’s liquidation), approximately 70% of the units were in Washington with the balance in California (756) and Nevada (344).  Since Vintage units qualify as low-income housing (renting to seniors or just low-income units), KW receives tax credits when it acquires the land.  The credits are sold prior to development and KW uses tax exempt financing on the debt side.  Adjusted for the credits, KW contributes limited/no equity for these developments.  The properties were built in 2006 on average and often sit next to regular multi-family housing units.  According to KW, several of its own Board members could not tell the difference between Vintage developments and other multi-family units.  KW has stated that it anticipates a steady pipeline of 1,500-2000 units, with a total portfolio goal of well over 10,000 units (versus 5,485 at acquisition and 1,000+ under development now).

Finally, KW controls 81 acres of land housing the Kona Village Resort property.  The project, announced in 2016, involves the refurbishment of 125 bungalows, which are scheduled to open in 2020.  The resort had been closed since 2011, following substantial damage from the 2011 tsunami.  

We provide our estimate of KW’s development pipeline in the below space.  Some of the anticipated property yields were provided in the supplemental disclosure while others were estimated.  While there is some developmental risk with the projects, KW would appear to have high visibility on several projects including the Irish and Vintage developments where KW has a history of coming in on time and within budget.  We discount both projected NOI and anticipated cash funding at 10% rates from anticipated closing.  In total, the projections suggest a development value of roughly $300mm, including anticipated cash spend.  

Fee Streams help drive franchise value…but are less of a needle mover on total valuation.  

KW has long discussed how its service arm not only generates solid fee income to the company but also allows KW to source deals outside the normal auction process.  According to KW, this use of servicing to source deals is vastly different than other investment firms using their investment reach to branch into servicing.  

As noted in lvampa1070’s write-up, KW earns multiple fees:  

• Performance fees (typically 10% above a 1% hurdle)

• Asset management fees (1-1.5% of minority equity interest)

• Property Management fees (3% of gross income (NOI/Assumed margin)

• Acquisition fees (0.5%-1% of investment purchase prices less KW debt/equity contribution)  

The exact fee charged varies depending on the fund, and KW nets out the portion of the fee charged on KW equity/debt contributions.  Furthermore, KW charges KWE both asset management and performance fees, but consolidates KWE results (despite only owning 24% of the underlying equity) and therefore eliminates fees received from KWE in consolidation.  Over time, performance fees will be the largest contributor to the total fee stream, but this will also be the fee stream that most investors will assign the lowest multiple.  Investors likely knock 5-10% off NAV simply for being forced to read this paragraph.  

KW has certainly improved disclosure and now provides annualized fees and EBITDA margins in its quarterly supplement ($46 million in total fees/~$17mm EBITDA in the first half of 2017).  Additionally, some of the confusion with the KWE fee arrangement will go away once the merger is completed.  That said, KW does not break down all fees with each bucket and one is essentially forced to assume a blanket margin across the fee categories.  

Given that KW consolidates KWE, we simply took the non-KWE equity balance ($1,543), which is grossed up for depreciation, and assume that KW achieves 15% annual returns.  We then calculate performance fees at a 40% margin and discounted the assumed value back to the end of 2017 at a 10% discount rate.  This calculation assumes only a single performance fee, but obviously KW will sell multiple assets in the years ahead.  Additionally, this calculation ignores the fact that interest income from the properties likely satisfies a large portion of the hurdle expense.  The calculation also essentially assumes that outside investors’ cost basis equals the current investment account value, which is surely false in most cases and therefore likely understates total performance fees with the above assumptions.  

We assume a 1.25% asset management fee across the non-KWE equity balance.  We then assume total non-KW owned NOI (including KWE) of roughly $317mm.  At a 60% NOI margin and 3% revenue fee, this would imply roughly $18 million of total fees.  We then estimated an additional $15-$20 million in other non-KW affiliated/non-property service fees based on total disclosed property services and research fees. While KW will surely buy additional assets over the coming years, we assume the portfolio stays constant and therefore ignore acquisition fees.  This number is capitalized at 10x and when added to the performance fees results in a total fee value of around $250 million.  

The sell-side analysts who cover the name have essentially annualized the YTD figures fee numbers and capitalized the value at anywhere from 8-10x and ignored other adjustments.  In some ways, this might be the smarter approach given the problems of trying to be falsely precise given the number of unknown variables.  An investor can easily spend 90% of his/her time trying to value a part that accounts for less than 10% of total NAV value.   As shown in the valuation, even if we assume no performance fees are achieved or if KW has no hurdle rate (which is met with interest income) and 20% annual returns, the total impact on NAV is not significant.   Of course, if our recurring fee estimate is too low, this could have a more meaningful impact on total valuation.  Additionally, KW’s servicing business has significant value above the stated NAV contribution as this investor network has allowed KW to source more attractive deals outside the auction process.    

More Passive Owners Post Deal

While the motivation for KW’s acquisition of KWE was to allow the company to own 100% of an attractive asset with meaningful reinvestment opportunities, an interesting side effect of the deal is that the transaction will likely force a larger number of passive owners to purchase shares.  KW highlighted the effect in one of its merger slides.  

It has also been noted that Vanguard (the largest owner of REITs at around 15% and a roughly 6% owner of KW) will be making a change to the underlying benchmarks for its largest mutual funds and ETFs whereby a larger number of names (including Diversified Real Estate in which KW is labeled) will be included.  According to a July 2017 Citigroup Research report, the moves coincide with a 2016 change where real estate became the 11th GICS sector inclusive of all REITs and real estate companies.  This category differed from Vanguard’s system which focused on REITs owning commercial real estate.  Apparently, Vanguard has discussed size constraints with its real estate index and noted that owning a larger universe of names would be helpful.  The change is expected to go into effect in early 2018.

The above chart combined with the proposed 12% hike in the dividend (30% dividend CAGR since 2012) post-closing suggests that KW is marketing the combined company to the real estate focused crowd.  It is highly likely that there will be several new buyers of KW post close and this likely could provide a short-term share rally – perhaps significant.  It is possible, however, that KW will also feel pressure to conform to more rigid real estate capital allocation standards – i.e., pay dividends versus repurchasing stock, own 100% of properties and avoid minority interests, become a more focused company, avoid non-income producing assets, etc.  Some investors might actually agree with many of these principles and embrace KW’s move in this direction.  But for others (ourselves included), this would appear to be a risk factor.  

Total Valuation:  Reasonable Upside/Downside Protection

We combine our assumptions above discussed above and use the following cap rate sensitivities for the major US properties:

For our KWE/pipeline estimates, we assume values 20% above and below our base case value.  For the fee franchise, we assume returns of 20% and 0% in the high and low case.  On a post-deal basis, we assume that all shareholders accept the higher mixed cash/stock offer and use the current dollar/pound exchange rate.  While the hotel properties will not significantly move the needle on total valuation, we would note that KW owns a couple of trophy properties, including the 100% owned Shelbourne Dublin as well as The Ritz-Carlton Lake Tahoe.  Per key valuations might suggest material upside to the below numbers.  

IFRS accounting requires KWE to use a third party NAV estimate, which we include after the valuation.  The valuation essentially assumes an adjusted (for rent discounts and other adjustments) cap rate of 5.4%.  As previously noted, roughly 87% of KWE’s total portfolio comes from the UK (54%) and Ireland (33%).  While the Brexit decision has provided a near-term bump to Irish property demand, there has yet to be any noticeable impact on UK properties where occupancy levels (93%) remain high and KW has generally reported favorable rent trends on renewals.   As of now, most of the increased Brexit activity in Dublin appears to be incremental – the mass exodus from London has yet to occur.  KW has further noted that increased London deal activity and certain high-profile London transactions (Leadenhall/Walkie Talkie at over $2000 per square foot) led by Asian buyers suggest a healthy market.  According to Cushman and Wakefield, Central London is on track to record £17.6 billion in commercial property trades in 2017, up 30% from 2016.  KWE has sold over 100 properties since its initial European purchases and continues to believe it will not struggle to find buyers going forward.  KWE has been actively selling its retail exposure, and the vast bulk of this portfolio is a collection of sub £5 million exposures where there is strong demand from high-net worth individuals.  

Pound/Dollar fluctuations will certainly impact KWE asset values, as will changes in Euro/Pound exchange rates given the Irish holdings.  It is possible that declines will negatively impact KW and/or that investors will punish the combined KW for the increased FX exposure.  The full impact of Brexit will not be known for years and it is certainly possible it will ultimately negatively impact both the UK and Irish economies.  That said, there very well could be more attractive investment opportunities in Europe versus the US and any further European dislocations could allow favorable capital deployment by KW.  

Additionally, as seen in the post-market NAV analysis, the consolidated ownership of KWE will accentuate any upside/downside estimates to European property estimates.  A 100 basis point drop in Irish Office property yields would equate to a roughly 6% gain in total pro-forma NAV per share.  It is also worth noting that KWE has lower funding costs (3% vs. 4.2%) than KW and KWE has an investment grade rating (KW:  BB- with positive outlook).  The deal will lower KW funding costs, and the combined company has a reasonable chance of becoming investment grade.      

While one can certainly argue with any of these assumptions, KW appears to trade at a meaningful discount to NAV, especially if one believes Seattle/Ireland rents can continue rising and/or there might be interesting capital deployment opportunities (especially in Europe).  KW’s team has a long-history of spotting value and while another European shock might pressure shares, it could also potentially allow the team to attractively deploy capital.  It would also seem the downside is protected in most reasonable scenarios.  

On the risk front, we’ve discussed the possibility of higher rates and spreads which could negatively affect KW’s valuation.  Foreign exchange fluctuations will be more meaningful going forward and KW would suffer if a major terrorist strike hit Seattle, Dublin or a handful of other concentrated markets.  Additionally, as previously discussed, we also see some risk to the company’s model of recycling current assets to fund new purchases.  While the company has a history of effectively selling assets, it also has a history of selling shares as seen by the near doubling of its share count over the past four years.  The next great value opportunity might not coincide with a period where it is difficult for KW to unload fully valued properties.  Interestingly, the proxy projections do not show any major share issuances in the years ahead – KW’s history suggests investors should take this with a grain of salt.  And as we previously discussed, KW (for better or worse) will be a growing dividend payer.  While real estate focused investors may prefer this capital allocation and the decision could prove to bolster the underlying valuation, it might not always be the highest returning capital allocation decision.  Arguably, at current prices the best decision would simply be to repurchase shares and pay no dividend.  Obviously, such a decision would be difficult with certain shareholders (presumably not including Prem Watsa) and would certainly not be consistent with attracting new real estate focused holders.  

Finally, there is a question as to when KW’s size will prevent the company from continuing to source below the radar deals.  As noted, KW claims to have achieved a 30% IRR on realized investments since becoming a public company (2009).  While the company is larger and future IRRs will almost certainly be lower, it should still be nimble enough to find opportunities unavailable to the largest real estate investors.  It is possible, however, that pressure to fully own properties, to avoid non-income producing assets and to avoid areas outside multi-family and commercial might cause certain self-imposed handcuffs on future transactions.  

One final note.  It is not inconceivable to think that Fairfax might have an interest in owning all of KW at some point.  A deal would allow Fairfax to deploy excess capital at attractive returns and perhaps provide KW a better way to finance opportunities as they emerge.  Such a transaction would likely be years away (if it were to happen), and would only be done on friendly terms.  Shorter-term, simply closing the KWE deal might provide a meaningful bump.    

Catalyst

-KWE deal close

-Passive buying of KW shares

-Continued strength in Seattle multi-family

-Completion of pipeline projects

-Compression Irish cap rates