INDUS Realty Trust: GPT 2.0

I'm about a year late on this post, thank you to Sterling Capital (@jay_21_) -- one of the best follows on Twitter -- for pointing me back to the idea.  Also deserves a belated hat tip for collaborating on the ACR idea.  

One of my early successes was Gramercy Property Trust (GPT), originally a busted up commercial mREIT (favorite theme of mine) which following the financial crisis transformed itself into an industrial triple net lease REIT before eventually selling itself to Blackstone in 2018.  The architect of that transformation and value creation story was Gordon DuGan, one of the few CEOs I've kept a Google alert to keep tabs on where they go next.  Last March, DuGan popped back up as the new Chairman of Griffin Industrial Realty (GRIF is the old symbol), Griffin was an accidental real estate company, a 1997 spinoff from an operating company, Griffin spent the following two plus decades operating in the relative shadows slowly building out an industrial portfolio -- first in Hartford on historical land holdings and later expanding to PA, Charlotte and Orlando.  Bringing in DuGan signaled a transition for the company, late last year Griffin announced they would be rebranding as INDUS Realty Trust (INDT) and converting to a REIT.  On the investor day last fall, DuGan admitted to have never heard of the company prior to meeting the CEO at a REIT conference, but today I think the company is interesting (more of longer term value investment than event-driven) because:

• This is a jockey play, Gordon DuGan is a proven capital allocator, he did this once before, I have confidence he can do it again.  This is a somewhat similar playbook to GPT, take a small-cap industrial REIT (~$450MM) that is small enough to do one-off deals, institutionalize it, in the process the valuation re-rates up to the more liquid large-cap peers.
• Industrial REITs are richly valued, they trade for ~4-5% cap rates and have been major covid beneficiaries as ecommerce "last-mile" logistics and inventory management have become more critical.  INDT's growth is not in acquiring assets, but rather acting as a developer, industrial/logistics buildings are relatively cheap and quick to build, the arbitrage between yield on development costs and market cap rates is wide at this time.
• INDT raised a significant amount of equity this week in a secondary offering at $60, possibly weighting on the trading dynamics in the short term and creating a buying opportunity.  The equity raise is accretive to the long term value as that capital is put to work into new projects at attractive yields and it also helps improve the liquidity of the shares.

The current industrial portfolio is heavily skewed to the Hartford market where INDT had much of its undeveloped land, purchased long ago and some of that land is still held on its balance sheet at historical cost.  The company's strategy to diversify away from Hartford, instead focusing on their other markets of Lehigh Valley (PA), Charlotte and Orlando.

They point to the age and size of their assets as a differentiator, their buildings are newer and focused on the mid-sized market which provides them a lot of flexibility in the types of tenants they can attract while still being economical from a cost perspective.  I don't have a lot to add to their current portfolio, seems reasonably high quality with a diverse tenant mix.

Why INDT is unique is their ability to grow through development versus needing to rely on making sizable portfolio acquisitions to move the needle.  I'm generally a sucker for real estate development companies, my view is the market has a hard time valuing development assets correctly as they're non cash generating and thus not great for the REIT structure or investor base.  The problem with development companies is typically the long construction cycle, if for instance you're HHC, its 2018 and makes perfect sense to build a beautiful high rise office building on the Chicago River, by the time its complete in 2020, there's a pandemic and people are questioning if they'll ever go back into the office again.  A lot can happen in those two years before construction is complete and even longer to bring it to stabilization.  With industrial warehouse type properties, the construction is pretty quick and simple, 9-12 months, the product type is pretty homogeneous, you don't need a fancy architect to attract top tenants.  The timeframe from shovels in the ground to stabilization is shorter and the certainty of projected cash yield is firmer on construction costs.  This is a less risky form of development with much of the same upside.

INDT has historically been able to earn 7.7%-8.1% cash yields on their development costs, their current projects are estimated more in the 6.0%-6.5% range (guessing the difference is land cost, historical cost versus current market in their new developments), but with stabilized assets trading in the 4%-5.5% range, there's a lot of margin available to INDT's development platform to create shareholder value.

This week, the company issued equity at $60 per share giving them ample capital to pursue additional development opportunities later this year.  To illustrate what I think the company could be worth once this capital is put to work, I created the below back of envelope math.

The company still has a fair amount of non-core assets to be sold, so I assume those are sold at the price they're currently contracted at or book value which might be conservative, especially for the land holdings.  As part of their recent REIT conversion, they'll have a purging dividend that will be paid in part cash and part shares.  Then I also assume they'll sell the additional greenshoe shares, but maybe that's not a guarantee if the market's slide continues.  But then all that cash, plus incremental debt gets pushed into development projects at a 6.5% yield on cost, revalued by the market at a 5% cap rate.  The end result is roughly $82 per share, think of that as a target price a year out.  Probably a few mistakes in there, feel free to point them out.  One thing I am ignoring for now is the warrants that were issued last year as part of a private placement, those have a strike price of $60 which would raise additional capital as well.

My estimate is highly dependent on the market cap rate for industrial properties and their yield on cost for development, I ran a quick scenario analysis that shows what the math looks like at various assumptions.  Across the top is the development yield and down the left side is the market cap rate.

As you can see, the market is roughly valuing INDT at a 6% cap rate with little value being given to their development pipeline.  The math could really go in INDT's favor if they're able to issues shares closer to NAV or even above (many industrial REITs trade at a premium to NAV) creating that virtuous cycle that all REITs strive to get.  In summary, you have a proven capital allocator in a subsegment of the real estate market that should have continued tailwinds post-covid with a decently long but safe development pipeline to create significant value. 

Disclosure: I own shares of INDT

Gramercy: Switching to Plan B

REITs have been under pressure the last few months as interests rates have ticked up on the expectations of a fed funds rate hike later this year.  The triple net lease sub-sector has been particularly hard hit since their leases are typically longer term and act more like bonds.  With Gramercy's July 2016 ($36 minus any dividends paid) incentive agreement looking more out of reach, and equity raises off the table as a result of the stock's slide, management seems to be switching to plan B and unfortunately moving away from their bread and butter industrial focus.

Life Time Fitness
The first move away from the original industrial focus plan was the early June acquisition of 10 Life Time Fitness facilities as part of Life Time's private equity buyout which was in response to activist pressure to either sell the company's real estate or do a REIT conversion.

Fitness clubs, which Gramercy is classifying as "specialty retail", are notoriously difficult businesses with increased competition coming into the space from the likes of SoulCycle and CrossFit style offerings.  These are big box facilities in suburban locations that would take significant capex to repurpose into an office building.  Doesn't seem like an attractive enough deal to move off message for?  With a straight line cap rate of 7.5%, its only relatively neutral compared to where they raised significant capital earlier this year, maybe a slight positive with the operating leverage gained.

Chambers Street Properties
A former private REIT, then known as CB Richard Ellis Realty Trust, Chambers Street has been a disappointment since entering the public markets in 2013.  The incentives of the private REIT world encourage management to grow assets quickly (and collect fees) at almost any cost and sell these investments to unsophisticated retail investors looking for monthly dividends (similar to the shareholder bases of mREITs and BDCs).  The result tends to be an unfocused mess of a portfolio with many lower quality assets.

On 7/1/15, Gramercy announced a "merger of equals" with Chambers Street where Chambers Street will actually be the one acquiring Gramercy, but will change its name to Gramercy Property Trust and use the GPT ticker after the transaction.  The Gramercy management team will run the show at the new combine entity (Chambers Street was previously without permanent CEO) and waived the change of control provision in their incentive agreement.

Chambers Street and Gramercy have different shareholder bases, CSG shareholders revolted at the thought of their monthly dividend being cut without a sense of the bigger picture and as a result dragged down GPT with it due to the proposed all stock transaction.

Gramercy's asset management business has always seemed overstaffed compared to their revenue on the KBS contract, DuGan found a way to utilize this large team with CSG that has previously been working down the BofA bank branch portfolio over the past two years.  Gramercy plans to sell between $500-$700 million worth of the office properties (hopefully the multi-tenant ones) over the first year and reinvest that capital into their (previous) industrial focus.  The Chambers Street portfolio also includes some European assets that potentially moves up the timeline for listing that vehicle.

Overall, not entirely excited about this transaction, but it makes sense given the current REIT landscape and the mid-$30s share price goal a year from now.  Think of this transaction more of a backdoor capital raise in buying a scattered cheap net lease portfolio that they have staffing to work down and reinvest in properties they otherwise would have needed to access the capital markets at uneconomic levels to purchase.  My back of the envelope math shows Gramercy currently trading at 11-12x core FFO, too cheap for a management team that has until 6-8 weeks ago delivered on nearly every promise they made since the beginning in 2012.

Disclosure:  I own shares of GPT

Gramercy: European Business, AM Fees, Likely Spin

Gramercy Property Trust (GPT, f/k/a Gramercy Capital) is a well known company to many value investors, it was a busted commercial mortgage REIT that was essentially in runoff mode and traded near cash ex-non recourse debt that was obscuring the value.  In came former W.P. Carey CEO Gordon DuGan and his lieutenants in the middle of 2012 to reshape the company as an office and industrial triple net lease equity REIT.  I covered it often in 2012-2013, since then it's continued on its path of raising capital, deploying it primarily into class B net lease properties, and creating additional value by utilizing the inherent operating leverage of spreading their expenses over a larger asset base.  It's morphed into your typical equity REIT now with a $2.3B enterprise value, why am I still holding it?  First, I have great respect for management and they're 2/3rds of the way through their incentive agreement that will pay the top 3 guys $20MM if they can hit $7 in 2015 (already there) and $9 in 2016.  Second, they've made a recent move into asset management (an area of interest for me in 2015) through the creation of Gramercy Europe which should effectively create additional leverage from external management and incentive fees.

Gramercy Europe

In past investor presentations the company has teased the idea of expanding into Europe as Gordon DuGan has had previous experience with that market through W.P. Carey (started up the business in 1998 for WPC).  The question from analysts had always been why?  Gramercy is a relatively small REIT, there should be plenty of runway here in the United States for the company to grow.  In December, the company announced the formation of Gramercy Europe Property Fund, a €350MM joint venture, through the purchase of ThreadGreen Europe (renamed Gramercy Europe Asset Management) which is also run by some former W.P. Carey executives and currently manages €146MM worth of net lease industrial and office properties.

Gramercy expects to list the company within 18 months as a separately traded entity that will be externally managed by Gramercy (think North Star's recent announcement of a European spinoff).  The European market looks attractive, many corporations still hold operating real estate on their balance sheets, there's less competition, and cheap interest rates.  Other players like North Star, Blackrock, and Colony Financial have been making opportunistic pushes into Europe as well.  Gramercy is going to keep its focus on class B assets in Europe as they do in the U.S., a pretty overlooked and boring market, but one with the capability of generating predictable solid returns.

They haven't publicly disclosed what the management fees will be, but Gordon DuGan slightly slipped up on the conference call this morning mentioning a 1% base fee before retracting and stating market rates.  While unlikely to be a meaningful driver in 2015, the combination of ROI on their €50MM investment plus the added bonus of management and incentive fees should help Gramercy reach that $9 management incentive payout target by middle 2016 (25-30% return in 18 months).

Gramercy is a pretty simple business to value currently, management has projected a $0.45-$0.50 FFO for the year, putting a 15 multiple on that gets you a $6.75-7.50 range of reasonable value, right where its trading at currently.  Using that same math, Gramercy needs a $0.60 FFO run rate to get to $9 share price, let's say $0.05 of the needed $0.10 comes from continuing to play the private/public market arbitrage game and adding to their U.S. net lease portfolio.  If the European fund can do $9.5MM in asset management fees annually it can add another $0.05 to FFO without issuing additional shares.  Assuming some incentive fees and some expansion to the €350MM initial target, the fund probably needs to double before it lists, the $9 target shouldn't be too much a stretch. 

CDOs
My only disappointment, and its minor at that, is the CDOs.  Gramercy still holds the equity and some junior pieces in their three legacy CRE CDO transactions they sponsored as GKK from 2005-2007.  As they continue to issue additional equity, the optionality of those legacy CDO positions gets smaller and smaller to the point now they're just a drop in the bucket on a per share basis.  It would have been interesting to have seen them spinoff the CDOs or have created some kind of CVR when they switched strategies and isolated the CDO value.

Gramercy likely doesn't hold much appeal to readers anymore, but it should, watch out for the Gramercy Europe business, it might make things more interesting this time next year especially if they decide to spinoff the overall asset management business too.

[Note: There's a 1-for-4 reverse stock split coming soon, all amounts are pre-split if you're reading this after the split happens]

Disclosure: I own shares of GPT

Taking Some Profits in Gramercy

One benefit of writing down your investment thesis is it helps keep you rational, especially with your selling discipline, which I find much more difficult than buying.  Gramercy Property Trust (GPT) has been my largest and highest conviction position for almost two years and my investment thesis has mostly played out as anticipated.  I'm grateful to the Board of Directors for bringing in such a talented and transparent management team in Gordon Dugan and Benjamin Harris who breathed some much needed fresh air into a commercial mortgage REIT that was near death several times following the financial crisis.

While I believe in their business plan, the recent jump in the stock price is pricing in the future equity/asset growth over the current asset base, so today I decided to sell a little less than half my position at $5.31 to take some profits.

Running the same quick balance sheet valuation that I ran after the 2nd quarter results were announced, I actually come up with a lower per share value after the equity raise.  I think the issue is two fold, Gramercy has been purchasing assets at lower capitalization rates in the past quarter or two, and the equity raise was probably timed a little early (it would be great if they could do one at today's prices).

Going back towards a AFFO forecast valuation, I actually come up with an even lower amount than I did with the balance sheet method as MG&A is too high for the current asset base (nothing new here, management knows this).

+ $45MM in current & pipeline real estate NOI
+ $5.5MM in acquisition capacity real estate NOI
+ $3.5MM in asset management net contribution
- $12.8MM MG&A
- $12.2MM interest expense ($304 million @ 4%)
- $7.2MM preferred dividend
$21.80MM AFFO / 75.24MM shares = $0.29 AFFO/share

You can put your own multiple on AFFO, but at 15 times you get $4.35 per share.  Of course Gramercy won't look like this in 3-6 months as there will be another large equity raise and more acquisitions.  The operational leverage will start to take effect as management has previously mentioned that they could double the asset base while only increasing expenses by 10%.  That math (or buyout speculation) is the only explanation for the recent rise in the stock price that I could come up with, so I came to the conclusion that the prudent thing to do was to reduce my position from an outsized one to a more standard size core position for me (which is still concentrated).

I intend to hold my remaining position for the long-term as I'm reasonably confident in management's ability to add value through accretive asset purchases going forward and take advantage of the operational leverage by keeping the MG&A expenses relatively flat.  It's less of a Benjamin Graham stock now, more of an appealing growth story with significantly less margin of safety.

Disclosure: I own shares of GPT

Gramercy Will Pay the Preferred Dividend

Exciting day for long time Gramercy shareholders, management must have received a lot of questions regarding their equity raise press release last Friday without many other details, like what the money would be used for?  This morning, Gramercy reissued a press release announcing it had identified a large pipeline of acquisitions and that it will pay the accrued preferred dividend in full this quarter.  They also stated their intention to begin paying a dividend to the common shareholders starting next year (likely Q1?) which will mark its final step in its transformation from a commercial mortgage REIT to a net leased equity REIT.

The large investment pipeline is great news as it will be accretive to Gramercy's NAV as it takes advantage of the spread between private and public market values (although I'd assume its narrowed in recent months).  It also makes sense why management was willing to give the private placement investors the downside protection granted in the CVRs as these acquisitions should increase Gramercy's market value as it gains scale. 

I probably won't be able to listen into the conference call live this afternoon, but I'll update this post if there's anything that strikes me as interesting.  And as I've said before, I'll probably sell most, if not all, of my outsized position once the dust settles a bit and Gramercy is being valued and talked about like a normal equity REIT.

Disclosure: I own shares of GPT

Gramercy & Howard Hughes Both Raise Capital

Despite the government shutdown grabbing all the headlines, good management teams at both Gramercy and Howard Hughes are moving forward with their business plans.  In the past two weeks, both have issued press releases announcing capital raises.

Gramercy Property Trust
With Gramercy, it's a little more puzzling as the capital raise raises quite a few questions itself, below is the press released issued Friday after the close of the market.

As of the end of the second quarter (including pending asset purchases), Gramercy had $96.9 million of acquisition capacity, and during the third quarter, they announced only $20 million in asset purchases which about half appeared to be in the pipeline previously, so I'd estimate they have $85 million remaining without any undisclosed purchases.  Additionally, Gramercy announced this quarter that they closed on the long awaited credit facility, which has $63.8 million in initial borrowing capacity.  Since the acquisition capacity numbers already assumed paying the preferred dividend, plus the credit facility, and now an additional $47.4 million in equity raised, what does Gramercy have in mind for all this dry powder?  My best guess would be a rather large acquisition similar to the Bank of America JV that would give Gramercy scale, spread the MG&A expenses over a larger base, diversify their tenants and finally pay the dividend.

One other interesting feature of the equity raised was the corresponding CVRs the private placement investors received protecting their initial downside.  I think this is a good signal from management that a floor is in place here, hopefully they wouldn't risk additional shareholder capital and make this capital raise even more expensive.

CEO Gordon Dugan has delivered all along, it won't be long before we find out what he's been up to lately, I'm hoping for good news.

Howard Hughes
I haven't mentioned Howard Hughes on the blog since I wrote a few posts about them earlier in the spring.  The story is fully intact, this past week management gave a new investor presentation that's available on their website.  I think it's interesting how they're fully going about monetizing their master planned community assets (a difficult asset to have in a public company) and utilizing that cash to develop and redevelop long term operating assets.  It's really going to be a great case study in long term capital allocation that will probably spur additional spin-offs in the future.  But anyway, Howard Hughes recently raised $750 million through the issuance of senior bonds, they had previously announced a $500 million offering, but that must have been oversubscribed.

The redevelopment of their Ward Village development in Honolulu will be capital intensive, so I'm guessing a lot of this money will be directed there in addition to the Shops at Summerlin and their Woodlands commercial development properties.  The potential of Howard Hughes remains great, just the Ward Village alone is a $7 billion opportunity with 30% profit margins, simply just have to sit back and wait.

Misc
I apologize for the lack of posts lately, just have been standing still with my holdings (which I think is important sometimes, the best move is often no move at all) and waiting for a few situations to develop.  Hopefully I'll have a few more ideas in the coming weeks to share.  I also just finished up The Manual of Ideas by John Mihaljevic, it was a good read and a nice refresher on different value opportunities/themes as well as providing a lot of good tips for sourcing and screening ideas.

Disclosure: I own shares of GPT and HHC

Gramercy's Business Plan is Moving Along

Gramercy's quarter again looked mostly as expected, and as management stressed on the call there's a noticeable lag in what the financials look like and the future state of the business.  Gramercy made significant progress towards investing their available cash in net leased assets, completing 11 discrete transactions for $111.2 million (mostly towards the end of the quarter).  During the question and answer session of the conference call, management indicated that this level of activity would be a good base case run rate for Gramercy through the end of the year.  I found this comment particularly interesting based on their capacity analysis slide below showing $96.9 million in remaining capacity.

So this leads me to believe that most of Gramercy's available cash and borrowing capacity will be exhausted by the end of the 3rd quarter or early 4th quarter, setting up for the dividend to be caught up on the preferred by year end as that would likely need to occur before any major capital raise.

As for the what the common is worth, I'm going to take a slightly different approach than my previous quarterly recaps (here and here) and instead take a balance sheet look at the valuation based on a slide that Gramercy provided in their presentation.  The one thing I noticed initially, is the plug "Intangibles" line item on the asset side is negative, meaning the market is valuing Gramercy above its current NAV.

Given Gramercy's acquisition pace and their capacity analysis slide, I made a few adjustments below to back into a new NAV based on full cash/capacity utilization before a capital raise.  I took the $96.9 million in net equity capacity and assumed Gramercy would make new acquisitions at a 9% cap rate (average of the 2nd quarter), and then those assets would be revalued by the market at a 7% cap rate ("widest arbitrage in our experience") to come up with $124.59 million in additional real estate owned (on top of the $10.6 million in the pipeline).  Making those asset purchases zeroes out both the cash and CDO advances and asset sales line items, but keeps the KBS Promote and CDO Bonds line items.  In Gramercy's slide they leave out the value of the asset management contracts, but these clearly have value.  Given that they're generating $4 million in after tax contribution annually, and have about a 3 year lifecycle, I discounted that back a bit to a round $10 million to come up with a total asset value of $631.8 million.

On the liabilities side, I removed the preferred dividend as its paid in the capacity analysis calculation and then added the pipeline and current portfolio borrowing capacity numbers given in Gramercy's guidance, making the total debt $237.9 million, or roughly 40% of the real estate value, inline with management's comments today.

Removing the preferred par value, and the common is worth $305.8 million, or $5.14 per share, which is pretty much the same as I've come up with before, and is only ~15% above what it's trading at now.  But I think the dividend is finally on the horizon, and then Gramercy can start raising capital and further exploiting the private/public net lease arbitrage.  Gramercy remains my largest position, although I might be tempted to sell a bit if it trades above $5.20 again without paying the dividend.  

Disclosure: I own shares of GPT

"Widest arbitrage in our experience" - GPT

Gramercy Property Trust (GPT) reported its first quarter minus the CDO management business which caused all the consolidation problems with their balance sheet.  Everything looks pretty much as expected, just progressing with the already outlined plan.  I continue to be impressed by the level of disclosure Gordon DuGan and team give on a quarterly basis, if only every management team provided the level of detail on their business.

Overheated REIT Market
On the conference call today, management spent a lot of time laying out the case for how net leased REITs are trading at "very attractive valuations", and by that they mean for the sellers of equity (which they'll be after their acquisition capacity is used up) and not for the buyers.  1.2-1.3x NAV, 21x AFFO, 2.8x book, anyone buying into the sector at this point should be expecting much lower returns going forward.

At the end of my post on how REITs are overvalued, I mentioned the arbitrage opportunity that Gramercy is being presented with as a new net leased REIT flush with cash.  They could purchase commercial real estate assets in the private market and have the public REIT market almost instantly value (well probably more so after the dividend is reinstated) those same assets at a higher valuation.  I was pleased that Gramercy pointed this exact setup out on page 31 of the their updated business plan presentation.  I just hope they can balance making good asset acquisitions with the need to capitalize on the market and trade inline with peers before the cracks appear.

Updated GPT Valuation
With that macro backdrop, I want to update my valuation of Gramercy after the acquisition capacity (page 38 of the presentation) is used up.

In this slide Gramercy lays out the available cash (including the potential borrowing capacity) and subtracts out the preferred (hints that its coming this year?) and the deals already in the pipeline.  In the first quarter the cash was mostly left untouched as Gramercy used the sale proceeds from the CDO bond sales to purchase several truck terminals and industrial properties.

The current portfolio is expected to have $21.8 million net operating income (roughly the same as projected before).  If the acquisition capacity dry powder is exhausted at a 7.5% cap rate (mid-point of the arbitrage slide above) and using 55% leverage on the $150.5 million produces another $25.1 million in NOI, for a total real estate NOI of $46.9 million.  I'll keep using the $10 million net income number for the asset management group as it sounds like Gramercy is in the money on the incentive/performance fees and are planning on broadening the client base beyond the KBS portfolio and the Bank of America JV, total combined NOI is now $56.9 million.

Using a 7% cap rate, the real estate value would be $670 million and the total debt would be projected at $368 million.  So on the expense side: a 4% interest rate on $368 million equals $14.75 million annually in interest expense, core MG&A is $13.0 million, and the preferred dividend is $7.16 annually, total expenses of $34.9 million.

AFFO = $22 million or $0.37 per share, basically what I came up with last quarter, using the same 14x AFFO and I come up with a valuation of $5.19 per share.  Using Gramercy's analysis of the top comps in the net leased space at 21x(!) AFFO and you get a valuation of $7.77 per share.

I tend to think the 14x multiple is more appropriate given that Gramercy is maybe 40-50% of the way through their initial cash position since Gordon and team took over.  Management also discussed on the call how intense the competition is for net leased assets (they're trying to stay out of the fray with smaller industrial purchases), so the valuation gap between the private and public markets could narrow reducing the eventual price target.

Like many GKK investors, I bought in due to the cash balance and CDO assets, never quite imagining the company looking like it does today, but really couldn't be happier with the direction of the company.  I plan on holding until Gramercy depletes its acquisition capacity, becomes current on the dividends, and the yield hungry investors bid up the shares.

Disclosure: I own shares of GPT

GKK = Gramercy Property Trust

So the transformation continues at Gramercy Capital, this week Gramercy announced their full year results and gave another business plan update presentation.  The level of management transparency is welcomed after being essentially in the dark as a shareholder under the previous management.  They also announced that on April 15, 2013, they will change their name to Gramercy Property Trust to better reflect the new equity REIT strategy and change the ticker to GPT.

CDO Sales

Gramercy completed the sale of their CDO management business, Gramercy Finance, on Monday for $9.9 million, plus they sold their senior CDO bonds they had repurchased for $34.4 million, and will eventually recoup servicing advances of $14 over the course of the next year, freeing up a total of $58.3 million to invest in net leased assets.  Best of all, they will be able to de-consolidate the CDOs on the balance sheet, making the company much easier to understand.

They also retained the equity, which they curiously put at a value of $25 million by 2018.  Being quite familiar with CDOs, I know how difficult they are to value and what level of assumptions are necessary even if you have all the relevant information at your fingertips.  Since these are very junior/highly leveraged tranches, the $25 million number seems reasonable if real estate values continue to pick up, although I wouldn't include it in any valuation estimate of the company, more think of it as a free option with huge upside.  The 2005 CDO has the best chance, followed by the 2006 CDO, and the 2007 CDO is long gone with no value.  One concern regarding retention of the equity, is the potential for "phantom income", they disclosed the risk in their 10-K.  I'm not familiar with the tax accounting rules behind it, but this could represent a major issue if Gramercy was forced to make a dividend distribution (probably would be in stock?) to holders even if the company didn't receive any cash flow, big problem for those of us holding Gramercy in a taxable account.

Current Portfolio and Updated Valuation

Gramercy continues to be active in deploying their dry powder, put at $154 million by management on the call.  That includes $104 million of cash, $43 million of borrowing capacity on unencumbered assets (so properties without a mortgage), $15 million coming from the CDO servicing advances, and $20 million from additional non-core asset sales.  The recently announced the purchase of a property outside of Memphis that's used a distribution center for retailer Five Below.  Below is the current short term pipeline, seemingly attractive assets.

So what's the company worth now?  Well Gramercy gave a peek into what the future cash flows could look like, the current assets have a projected annual net operating income of $20 million.  If all the dry powder was deployed, Gramercy would receive an additional $26-29 million in net operating income, lets use the low number, so the total NOI would be $46 million annually.  Add in $10 million from the asset management contracts for the KBS portfolio and the Bank of America JV (for simplicity, I'm going to net out the expenses against incentive income).  Total NOI projects out to $56 million.  At that point, debt is projected to be $346 million, using a 4% interest rate (Gramercy previously put financing at 3-4.75%), that comes out to $13.88 million of interest expense.  New core MG&A run rate has been reduced down to $13 million annually, and sounds like it could move lower as Gramercy ramps up and is no longer in growth mode.  Finally, subtract the preferred dividend (the dry powder number assumed the preferred dividend was caught up) of $7.16 million, and you get total expenses of $34.04 million.  Adjusted Funds From Operations would then equal $21.96 million, or $0.36 per share.  Pretty close to the $0.40 I originally came up with in my first post.  

Put an implied capitalization rate of 7% (or an AFFO multiple of ~14x) on the AFFO, and that puts Gramercy's potential price target at $5.17 per share, leaving some more running room.  Management also stated on the call how "favorable" valuations are right now for REITs, which I agree with, so hopefully they take advantage, deploy the cash as quickly as possible, return to REIT dividend normalcy, and potentially issue equity at a high multiple.  At that point I'll probably look to sell as traditional REIT investors rush in, but it's probably another year off.

Disclosure: I own shares of GKK/GPT

Gramercy Sells CDO Management Business

Gramercy Capital has been on quite a run lately (22% YTD) as it continues its transformation into a net-lease equity REIT.  After the close today, Gramercy announced they sold the CDO management business to CWCapital for $9.9 million plus freeing capital that was tied up in the CDOs:

Gramercy will continue to hold the equity tranche of each CDO, which are probably worthless but potentially have some optionality value if the commercial real estate continues to improve.  While retaining the equity tranches is likely the right thing to do long term (free option), it means the CDOs will still be consolidated on the balance sheet creating negative shareholder's equity.  I'd probably trade the CDO equity for a clean balance sheet that more investors are able to understand.

Even with an additional $56 million in liquidity, Gramercy will still need to raise additional equity to fully becoming a performing REIT again and reinstate the dividend, but at least with the recent runup, they won't be issuing equity quite as cheap.

Disclosure: I own shares of GKK and GKK-A

UPDATE (2/6/13): I heard back from Investor Relations that "at settlement, we expect to deconsolidate."  Great news, Gramercy will have a clean balance sheet making the company easier to understand for investors and get to retain the potential upside of the CDO equity, however small that might be.

Quick Gramercy Update

Gramercy recently announced the closing of their two previously discussed transactions, one the Indianapolis industrial properties last week and the much larger Bank of America portfolio transaction today.

Gramercy Capital Corp. Announces the Acquisition of a $27.125 Million Industrial Portfolio

Gramercy Capital Corp. Closes the Previously Announced Acquisition of a $485 Million Portfolio in a Joint Venture with Garrison Investment Group

Both transactions closed at nearly the same terms as previously described, which speaks well for management transparency and their ability to meet expectations.  The industrial properties were purchased for cash, but management has discussed the advantage of being able to close with cash quickly and then refinancing once the dust settles, so expect to see a mortgage put on the properties shortly.

However, the closing of these properties doesn't change my valuation of the common shares as Gramercy still needs to increase assets, and thus the equity, to spread their overhead costs across a larger base.  One news item I'm looking forward to is the sale of the CDO equity and management business (hopefully before year end), if the sale brings in a material amount it would improve the outlook by freeing up additional cash for investment without issuing shares and clear most of the complexity in the balance sheet.

Gramercy 2.0

Summary/Background Information:

Gramercy Capital (www.gkk.com) is a commercial mortgage REIT that is undergoing a transformation to become a net lease equity REIT focused on office and industrial properties.  Formed in 2004, Gramercy previously originated and acquired commercial real estate whole loans, mezzanine loans, and commercial mortgage backed securities by utilizing financing through collateralized debt obligations (CDO).  Gramercy issued three CDOs, one each in 2005, 2006, and 2007. Gramercy managed and retained the equity interest in the CDO, thus exposing themselves to the first loss in the collateral pool.  CDOs have an overcollateralization ratio test which measures the assets owned divided by the liabilities issued by the CDO, if the test is breached, excess interest cash flows are diverted from the equity and junior notes to pay down the most senior notes in the structure until the test is cured.  As of 9/30/12, all three of Gramercy’s CDOs are failing their overcollateralization tests and the cash flows are now limited to the senior management fee.

Outside of the CDO management business, Gramercy also has a property management division, named Gramercy Realty, which oversees its small and low-quality owned portfolio of 21 bank branches and 13 office buildings with an occupancy rate of 40.9% as of 9/30/12.  Additionally, Gramercy Realty manages $1.9 billion in real estate assets for KBS Real Estate Investment, Inc. (KBS), as part of a collateral transfer and settlement agreement executed in September 2011 where Gramercy Realty’s prior assets were transferred to KBS for the forgiveness of debt.  The portfolio includes 514 bank branches, 273 office buildings and one land parcel, totaling approximately 20.1 million rentable square feet.  After the settlement agreement, Gramercy Realty was retained to manage the portfolio for a fee of $12 million annually with some additional incentive bonuses.  Going forward, Gramercy is going to use the Realty platform as a launching pad for the net lease business model.

The company's past as a commercial mortgage REIT has been well documented, so I’d like to focus on what the company could be worth going forward with the new net lease equity REIT business model.

Balance Sheet

Gramercy has a strong liquidity position, which is being masked by the GAAP accounting treatment of the equity ownership in the CDOs.  Accounting rules require Gramercy to consolidate the CDOs assets and liabilities on its balance sheet, creating a negative book value due to the assets in the CDOs being marked at less than the CDO debt outstanding.   It also creates the illusion of a highly leveraged company; however all the CDO liabilities are non-recourse to Gramercy, meaning any losses beyond Gramercy’s initial equity investment in the CDOs will be borne by CDO debt holders.  If you remove the CDO consolidation the balance sheet would breakout as below:

Gramercy’s capital structure also includes 3,525,822 Class A preferred shares with a redemption value of $25.00 per share, which earn $0.50781 in dividends quarterly (8.125% annually).  Beginning in the 4th quarter of 2008, Gramercy elected to suspend the preferred dividend payment to maintain liquidity in order to survive the financial crisis, as of the end of Q3 12, the amount due to preferred holders totaled $28.65 million.  Due to the non-payment of preferred dividends for six consecutive quarters, the preferred stockholders exercised their right to elect a board member, William Lenehan, and will continue to have representation on the board until the accrued dividends are current.

New Management & Strategy:

After considering strategic alternatives, including an outright sale of the company, Gramercy decided to stay an independent company and in July 2012, the Board of Directors hired a new management team to transform the existing public entity into a net lease equity REIT. In a triple-net lease, the tenant is typically responsible for all improvements and is contractually obligated to pay all property operating expenses, such as real estate taxes, insurance premiums and repair and maintenance costs.  Gordon DuGan was brought in as CEO, he spent over 20 years at real estate firm W.P. Carey & Co (NYSE: WPC) where as CEO he oversaw the growth of the company’s assets from $2.5 to $10 billion.  One concern is how he abruptly resigned from W.P. Carey in 2010 because of a disagreement with the founder and chairman (http://www.footnoted.com/buried-treasure/the-family-business/running-afoul-of-the-founder-at-w-p-carey/).  But on the plus side, under his leadership Gramercy is resuming quarterly conference calls which were absent the last couple of years.

Gramercy’s new stated strategy is to focus on industrial and office properties in top 50 markets with an average lease term of more than 10 years.  Gramercy plans to use leverage of approximately 50%, utilizing primarily fixed-rate non-recourse debt with an expected borrowing rate between 3.0% and 4.75%.  By targeting cap rates of 7.5% to 9.0% and 1:1 leverage, Gramercy expects to earn an ROE in the 12%-15% range.

Insider Purchases

As a show of commitment to the new business strategy, Mr. DuGan purchased 1,000,000 shares of common stock at $2.52 per share directly from the company (not in the secondary market) before taking his post as CEO.  He’s not the only insider showing confidence with their wallet, new president Benjamin Harris also made an open market purchase of 40,000 shares at $2.64 a share on 8/27 and preferred share director William Lenehan purchased 20,000 common shares at $2.62 a share on 8/24.  With his interests aligned with the preferred shareholders it’s interesting to see Mr. Lenehan purchasing the common shares, it makes the investment case even stronger that the accrued preferred dividend will be paid before too long.

MG&A Costs

One of the new management’s goals is to reduce the cost structure of Gramercy; the net-leased business by nature should be a low overhead operating model.  A lot of the cost baked into Gramercy lies in the CDO management business, Gramercy Finance, which employs 25 people and experiences a lot of the professional fees associated with managing distressed assets.  Gramercy communicated in their September investor call that the goal SG&A run rate is below $20 million, which still seems high in comparison to their size.  Hopefully as the asset base grows, the expenses come more in line with peers.

Bank of America Portfolio Transaction

Management has gotten off to a quick start in deploying Gramercy’s free cash into the new investment strategy.  They started off on 8/21 by entering into a joint venture with Garrison Investment Group to purchase a portfolio of office buildings and bank branches which had previously been apart of Gramercy Realty and are currently in the KBS Portfolio that Gramercy already manages.  The portfolio consists of 5.6 million square feet of which approximately 81% is leased to Bank of America, N.A. for a term ending in June 2023.  The projected 2012 net operating income for the portfolio is approximately $41.5 million.  Gramercy will also manage the portfolio and earn a management fee of about $1 million from the joint venture, although that’s less than the agreed decrease in the management fee of the KBS portfolio from $12 million annually to $9 million on the remaining KBS portfolio.

At the deal closing, the joint venture will sell two large office buildings in Chicago and Charlotte for $135 million, bringing down the total purchase price to $350 million.  Additionally, management has a plan to sell 45 non-core and primarily multi-tenant properties to “more active investors” in the next twelve months for an estimated $350 million, leaving the joint venture with a portfolio of core properties primarily leased to Bank of America, N.A.

To fund the purchase, Gramercy will use $60 million of its cash position and issue $15 million worth of common stock to KBS (6 million shares at $2.50 per share, no transaction fees).  The common stock issuance is a little puzzling as management is issuing cheap shares (expensive funding) when it has plenty of available cash on the balance sheet.  Potentially KBS knows the Bank of America Portfolio is an attractive asset and negotiated receiving equity in exchange for slightly more favorable terms.  Garrison will also kick in $75 million in equity, and then the joint venture has secured a $200 million loan from a major bank.

Industrial Property Acquisitions

Gramercy also recently announced it has entered into a contract to purchase two Class A industrial buildings in Indianapolis leased to three tenants for an average weighted lease term of 10+ years.  Details provided so far have been light but management provided the below in a recent investor presentation:

Another transaction that appears more preliminary was announced in the third quarter results press release.  Gramercy entered into a letter of intent to buy an industrial building portfolio totaling 1 million square feet with a cap rate in excess of 8.5%.

After the closing of the three transactions, Gramercy provided the below data for what the asset composition will look like at year end:

After the closing of the three transactions, based on the approve purchase price and leverage, Gramercy will be left with available free cash of $73.95MM.  The company also has additional assets that are up for sale or can be sold and used to buy additional net lease portfolios.

CDO Management Sale

Gramercy has hired Wells Fargo as an advisor to sell the CDO management business and the CDO equity.  All three CDOs are failing their overcollateralization tests and it is likely that they will for the foreseeable future.  However, that doesn’t mean the equity pieces are worthless, with a long-term horizon and an active management approach a manager could eventually end up extracting value from the CDOs.  On the 3rd quarter conference call, Gordon DeGan commented, “Our hope is the transaction will be completed this year and I think that the investors will be pleased with the results of that transaction.”  While the CDO/CLO market is making a surprising comeback, it's still advisable to temper expectations and assume the sale will bring in a non-material amount.

The non-accounting reporting benefits to selling the CDO business includes reducing overhead costs and freeing up cash advances made to the CDOs.  The current servicing advances to the CDOs total $10.2 million as of the end of the 3rd quarter, which should be freed as a result of the CDO business sale and become available for investment in the new strategy.

KBS Mezzanine Loan

As part of the KBS/Bank of America Portfolio transaction, Gramercy invested $19 million in the origination of a mezzanine loan to KBS which KBS will pay off with the proceeds of the Bank of America Portfolio closing.  The loan included a 1% origination fee and accrues interest at 10% annually, creating a quick but compelling IRR profit if the Bank of America Portfolio closes as expected in the 4th quarter.  The repayment of the loan will also increase the available cash proceeds for investment.

CDO Senior Bonds

Gramercy holds some senior bonds that were previously issued by their CDOs but were repurchased by the company, these bonds are consolidated and cancelled on the balance sheet, but they have a face value of $45.4 million with a fair market value of $36.2 million.  Gramercy previously had purchased junior notes at a discount in order to cancel them to prevent the overcollateralization tests from failing and to keep the equity payment turned on.  However the CDO bonds currently held are high in the capital structure of each CDO (Class A-1, A-2, and B) and wouldn’t have a material impact on the overcollateralization tests if cancelled as you get more bang for your buck lower in the capital structure. 

Due to GAAP accounting rules, these holdings are consolidated on the balance sheet and are essentially cancelled out.  Once management has invested the available cash, they have indicated they would look to sell the CDO bonds in order to continue investing in net leased properties until fully ramped.

Available Liquidity

If you conservatively assume that Gramercy will get the $10.2 million in servicing advances out of the CDOs, receives full payment of the $19 million KBS loan, and is able to sell the CDO bonds for $36.2 million, that frees up an additional $65.2 million in cash for a total of $139.35 million in available funds to purchase more net-leased assets, with upside pending the CDO business sale.

Valuation

At current prices the market is valuing the common shares at about investable cash (including the additional liquidity items mentioned above) subtracting out the preferred shares, almost like a blank check IPO.  Equity REITs typically are valued on a multiple of funds from operations (FFO), which is calculated by adding depreciation and amortization expenses to earnings, instead of earnings.  Management has declined to provide any FFO guidance, so in order to attempt to put a value on the new Gramercy model; I’ve attempted to project what the normalized FFO could be given the money available for investment.

Using the numbers provided by management of what the portfolio will look like on 12/31/12, and then assuming the remaining $139.35 million (including the CDO servicing advances, CDO bonds, and KBS loan) is invested in similar fashion I come up with the below via a back of the envelope income statement:

This doesn’t include the value of any of the legacy owned properties or any cash that comes out of the sale of the company’s CDOs and CDO management business.

Comparable NNN REITS

Realty Income (O) and National Retail Properties (NNN) are not great comparables since they are primarily focused on the retail market and trade at high valuations due to their long track record of dividends, dividend increases, perceived quality, and the rush into yield in the zero rate investment environment.  In terms of assets and quality, CapLease (LSE) and Lexington Realty Trust (LXP) are better comparables for Gramercy, averaging the two Price/FFO ratios equals an 8 multiple, leading to a value of ~$3.20 for Gramercy’s common shares, with the potential upside in time to trade closer to a 13.2 multiple of the average net lease REIT.  It should be noted that each of these comparables is much larger than the projected Gramercy and can spread their costs over a much larger asset base, so as Gramercy adds assets using equity issuances the increased scale should be accretive to future FFO.

Risks

Most net lease REITs are highly diversified across tenants and industries, Gramercy will start out with its largest pool of properties highly primarily leased to Bank of America, N.A.  Bank of America is still in the midst of their own turnaround and reorganization strategy to sell non-core assets, shrink the business, and cut costs in the aftermath of the financial crisis.  While Gramercy management stresses that these properties are critical to Bank of America’s operations, it’s still worth noting and monitoring.  As management deploys more cash into net lease assets, it will be important to increase the number of tenants in order to reduce credit risk to any one entity.

Management’s decision to issue shares as part of the Bank of America Portfolio purchase when it has plenty of available cash is concerning, one of the new goals is also to “expand the equity base” of the company which foreshadows additional equity raises in the near future.  Gramercy should wait until its shares are trading more in line with net-leased peers to avoid issuing additional undervalued shares.  However, even fully invested, Gramercy would be one of the smallest publicly traded net leased REIT and it will be necessary to issue additional equity in order to gain scale and spread the management costs over a wider asset basis.

Conclusion

Old Gramercy didn’t have a natural long-term buyer; it’s a non-dividend paying mortgage REIT with a negative book value.  So yield investors aren’t interested, and with a shareholder deficit it doesn’t show up on many screens utilized by value investors.  By reshaping the company as a net-leased REIT, Gramercy will have two main catalysts to unlock value: (1) the sale of the CDO business to allow for the balance sheet to be easier to understand and (2) the payment of a dividend after the investment of the free cash in income producing net leased assets.

Management has hinted that the CDO business could be sold as early as the end of the year.  Mr. DuGan said on the recent conference call that the fourth quarter would be a “watershed quarter in terms of transition” for Gramercy, presumably he means shedding this legacy business in order to fully focus efforts on the net-lease space.   If the CDOs and CDO management business bring in a material amount in the sale, that could provide more upside to the share price.

The timing of the dividend is a little more uncertain, while management has expressed that they intend to pay a dividend and remain a REIT, its difficult to project exactly when that will happen.   Management has stated their philosophy is to pay dividends out of “recurring cash flows”, so only once the available cash is invested in the new strategy and those investments start to cash flow the dividend payments will be turned back on to investors.  The preferred shares have accrued $28.6 million up to this point (still accruing $1.8 million per quarter), and based on my projections of FFO, it could still be another 18 months until the preferred dividend is paid in full.

The preferred shares still offer a compelling investment opportunity; currently trading at $30.00 the preferred shares offer a 10.8% discount to the fully accrued dividend and $25 redemption value ($33.63 as of the most recent missed dividend date).   The preferred shares are well covered by the assets and cash on the balance sheet, and management has signaled repeatedly that they intend to pay the dividend once the new strategy is up and running, it continues to accrue 6.8% in yield off of the current market price, creating an attractive risk/reward opportunity in a low return environment.

At current prices, the common shares sell for near cash, creating a margin of safety.  Once the business is simplified and the dividends are turned back on, the shares should trade up more inline with the net lease peers in time, but it will test the patience of current shareholders who have already been waiting quite some time for the turnaround to materialize.

Disclosure: I own both GKK and GKK-A.