A Publication of Paramount Capital Corporation. Strategy and Insight for the Commercial Real Estate Industry

Transcription

1 Volume V Issue 4 A Publication of Paramount Capital Corporation April 15, 2013 Strategy and Insight for the Commercial Real Estate Industry A DISCUSSION OF THE CURRENT STATE OF THE CRE INDUSTRY, UPDATE OF NCREIF RETURNS, COMMENTARY ON THE CARRIED INTEREST DEBATE AND REIT FOCUS ON ESSEX PROPERTY TRUST, INC., AN APARTMENT REIT In this month s issue; Real Estate Focus will discuss the current state of the commercial real estate industry per RREEF and review current NCREIF investment returns, Economic Focus will discuss the proposed taxing of carried interest and REIT Focus includes an analysis of Essex Property Trust, Inc., an apartment REIT. REAL ESTATE FOCUS State of the CRE Industry The CRE industry is finally starting to show signs of life with increased activity in all sectors. As stated in prior issues of VOM, the market is bifurcated with most of the activity occurring in the core markets of New York, Boston, San Francisco, Miami and Los Angeles

2 and primarily with the large well capitalized players like the private equity firms and REITs. These firms have access to cheap capital and are able to invest that capital in CRE debt and equity at attractive spreads. This is great for the recovery of the industry; however, this capital is not, for the most part, filtering down to the rest of the industry. Smaller or entrepreneurial investment, brokerage and development firms are still having difficulty participating in transactions and obtaining capital especially in noncore markets. As the economy and industry continue to improve, hopefully the access to capital and transaction volume will trickle down to these firms. Although the industry is recovering it is still far from the last peak year of CRE industry is a transaction oriented business with the lifeblood of the industry based on the volume of sales, financings and leases. Even though the recovery is gaining steam, we here at VOM, maintain that the volume of these transactions nationally, is still down 40%-50% from One of the more robust cities for CRE activity is San Francisco, CA. There are currently seven cranes up in the city building high-rise residential towers and office buildings. According to CBRE, $6.1 billion in office properties were sold in San Francisco in 2012, the highest since 2007 and there are projected to be 2,700 new apartment units delivered in the city in 2013 The following are summarized comments and two tables from RREEF Real Estate, a member of the Deutsche Bank Group, U.S. Real Estate Strategic Outlook Paper, published in February 2013 (see for a copy of the report). Apartments are at peak rents in many market and vacancies are below their long term averages Industrial, office and retail rents are well below peak levels and vacancies higher than historical averages 2013 will see modest improvement in CRE fundamentals with increased growth in 2014 CRE remains attractive relative to other asset classes in the US Yield spreads to 10 Year US Treasuries are historically high, however, cap rates are

3 at historic lows New construction is tepid in many markets Debt markets are opening up with traditional lenders like banks and insurance companies loosening lending standards RREEF is recommending a modest underweighting to apartments due to significant price appreciation REITs continue to outperform the market with annual returns of the FTSE All Equity REIT Index from 2009 through 2012 of 21%, 23%, 4% & 15.6% CRE volume was robust in 2012 with $252 billion in transactions reported and up 25% from 2011 Below are two graphs reprinted from the RREEF report on Real Estate Transaction Volume and Current Value Capitalization Rate Trends.

4 NCREIF Returns The National Council of Real Estate Investment Fiduciaries (NCREIF) is a non-partisan collector, processor, validator and disseminator of real estate performance information and below are two tables showing property returns for 2012 and the last 1, 5, 10 & 20 year periods. Annual Returns for 2012 Property Type Total Return Income Return Appreciation Return Apartment 11.2% 5.4% 5.6% Industrial 10.7% 6.3% 4.3%

5 Retail 11.6% 6.2% 5.2% Office 9.5% 5.7% 3.7% Total Return 10.5% 5.8% 4.5% Source: RREEF and NCREIF (amounts may not total due to rounding) Annual Total Returns Property Type 1 Year 5 Year 10 Year 20 Year Apartment 11.2% 3.0% 8.3% 9.8% Industrial 10.7% 1.4% 7.7% 9.1% Retail 11.6% 4.1% 10.5% 9.2% Office 9.5%.9% 7.8% 8.5% Total Index 10.5% 2.1% 8.4% 8.9% Source: RREEF and NCREIF (amounts may not total due to rounding) Please note the drop in returns for the five year period, 2008 through 2012, due to the financial depression. The NCREIF returns are based on a portfolio consisting of 7,276 properties with a market value of over $315 billion. Each property s return is weighted by its market value on an unlevered basis. ECONOMIC FOCUS Carried Interest There has been a lot of commentary and political posturing lately on taxation of carried

6 interest for hedge funds, venture capital firms, private equity firms and private real estate investment firms. Carried interest is the percentage ownership that accrues to the sponsor of the deal or fund for structuring the deal/fund, raising the capital, acquiring the property or company, making the investment, managing and monitoring the deal or fund, communicating with the investor group, preparing various accounting/tax reports, selling the fund assets and distributing the proceeds. This carried interest is taxed at the capital gain rate, currently 20% and not at higher ordinary income rates currently at a maximum of 39%. Many politicians and pundits have been calling for an increase in the taxation of carried interest to the ordinary income rate of 39% for fairness, redistribution and to punish those rich and greedy investment firms. President Obama included raising the rate in his 2014 budget which was released last week. They argue that many of these firms are not bearing any risk and therefore should pay a higher rate. Capital gains have been taxed at a lower rate than ordinary income since the early 1900 s to encourage private sector investment. This helps foster job growth, new company formation and economic growth. It s also an incentive for people to take financial risk to generate profits and keep the US a robust and prosperous country. We here at VOM vehemently disagree with changing the taxation to ordinary income rates because it alters the historical characteristic of capital investment as discussed above and will not generate any significant revenues for the Treasury. If an investor buys 100 shares of McDonalds (currently at $102 per share) in a brokerage account, holds those shares for over one year and sells them, then the investor would pay tax at the capital gain rate of 20%. If this same investor buys all the shares outstanding of McDonalds and takes it private, holds those shares in a brokerage account or a fund with capital from outside investors for more than one year and sells them, then that investor should get the same capital gain treatment. Therefore we here at VOM do not understand the argument of why this second transaction is any different? There is a risk of loss in both situations and capital is at risk. The second investor may not use his own funds due to the large size of the investment however, he still bears all the risks associated with the deal from putting the fund together to selling the investment. In the first example, it costs the investor $10,200 plus a commission, which can be paid for in cash or on margin. In the second example, buying out all the shares of

7 McDonalds would take tens of billions of dollars and therefore must be structured with outside capital in a fund or pass-through entity format. This is why all investment funds are structured as partnerships or limited liability companies. In both scenarios, the investor buys an asset, holds it for longer than one year and then sells that asset. In either case, this is a capital gain transaction and should be taxed as such. REIT FOCUS This month s REIT Focus is on Essex Property Trust, Inc. ( ESS ), a publicly traded, selfmanaged real estate investment trust that acquires, develops, redevelops, and manages multifamily residential properties in selected West Coast communities, primarily in the states of CA and WA. ESS owns a 94.5% general partner interest in Essex Portfolio, L.P., its UpReit general partnership. As of 12/31/12, ESS owned a controlling interest in 163 apartment communities with 33,468 units, five commercial buildings totaling 315,900 sq. ft. and nine active development projects with 2,495 apartment units. As of 12/31/12, the average occupancy and monthly rental rate for the apartment properties was 96% and $1,324, respectively. ESS was founded in 1971, was incorporated as a REIT in the State of Maryland in 1994, is traded on the NYSE and is based in Palo Alto, CA. ESS has 37.9 million common shares outstanding and a market capitalization of approximately $5.9 billion. In April 2013, ESS sold $300 million of senior unsecured notes at a yield of 3.35% and with a BBB+ rating by Fitch. ESS has an experienced and well regarded management team that includes George M. Marcus, Founder and Chairman, Michael J. Schall, President and Chief Executive Officer and Michael T. Dance, Executive Vice President and Chief Financial Officer.

8 Select financial data for ESS as of the 12/31/12 10K and for the period 1/1-12/31/12 is as follows (in millions where applicable): Real Estate Assets, Gross (including co-investments) $5,672 Total Assets $4,847 Mortgages, Unsecured Debt and Line of Credit $2,819 Stockholders Equity $1,765 Revenue $543 Net Income $120 Net Income Per Share $3.42 Cash Flow from Operations $267 Unsecured Line of Credit ($600 with $141 used) $459 Market Capitalization $5,900 Debt to: Gross Real Estate Assets 50% Market Capitalization 48% Real Estate Assets Per Sq. Ft. $191 Dividend and Yield ($4.84/sh.) 3.1% Valuation Methodology: 2012 Revenue Per Above $543 Less: Operating Expenses (excluding depreciation, amortization 148 & interest expense, plus G&A expenses and co-investment and other income) Projected Net Operating Income 2012 $395 Projected Inflation Rate at 3.5% x103.5% Projected Forward NOI for Next Year $409 Projected Cap Rate 6% Projected Value of Real Estate Assets $6,817 Add: Net Operating Working Capital 113 Total Projected Asset Value $6,930 Less: Total Debt Per Above (2,819) Less: Series H Redeemable Preferred Stock (74) Less: Series G Redeemable Convertible Preferred Stock (4) Projected Net Asset Value $4,033 Shares Outstanding, 40M (common stock, 37.9M shares plus operating partnership units, 2.1M shares) Projected NAV Per Share $101 Closing Market Price Per Share on 4/15/13 $155

9 The gross real estate assets, net income and funds from operations for 2010 to 2012 are shown in the table below: (millions) Gross Real Estate Assets $4,181 $4,357 $5,672 % Change NA 4% 30% Net Income $34 $40 $120 % Change NA 17% 200% Funds from Operations $171 $200 $251 % Change NA 17% 26% As shown above, our net asset value per share for ESS is $101 versus a market price of $155 per share. Current average cap rates for apartment properties on the West Coast per CBRE are in the 3.5% to 7% range, depending on the location and quality of the property. We have used a cap rate of 6% due to ESS s portfolio being primarily Class A properties located in West Coast cities with barriers to entry for new development and lack of developable land. The cap rate based on the current market price of the stock is 4.5%. ESS s strengths include; solid and experienced management team, acceptable dividend yield of 3.1%, high occupancy of 96% and strong growth in assets and funds from operations. Weaknesses include; high stock valuation, FFO multiple at 24 times and portfolio concentration in CA. We do not recommend the purchase of this stock at the current price. ESS is a well managed REIT with a top notch portfolio, however, it is very expensive and we would not be a buyer at this level.

10 A five year price chart of ESS is shown below: REIT Focus reviews in prior issues of VOM are as follows: 1. BRE Properties, Inc., June 15, Boston Properties, Inc., July 15, Simon Properties Group, Inc., August 15, First Industrial Realty Trust, September 15, Public Storage, October 15, 2011

11 6. Ashford Hospitality Trust, Inc., November 15, AvalonBay Communities, Inc., December 15, Alexandria Real Estate Equities, Inc., January 15, Federal Realty Investment Trust, Inc., February 15, Digital Realty Trust, Inc., March 15, Lasalle Hotel Properties, April 15, Apartment Investment and Management Company, May 15, Equity Residential Apartment Company, June 15, The Macerich Company, July 15, SL Green Realty Corp., August 15, Kimco Realty Corp., September 15, Cole Credit Property Trust II, Inc., October 15, Realty Income Corporation, November 15, Piedmont Office Realty Trust, Inc., December 15, Camden Property Trust, January 15, Hudson Pacific Properties, Inc. 22. CBL & Associates Properties, Inc.

12 THE VIEW OF THE MARKET NEWSLETTER ARCHIVES For a Subscription to this letter see Copyright Paramount Capital Corporation 2013 Disclaimer: The information, strategies and material presented in the newsletter are for information purposes only and not to be considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments. This newsletter is available only by paid subscription and should not be reproduced, copied, ed or disseminated in whole or in part without the express written consent of Paramount Capital Corporation. CopyRight 2013 ParamountCapitalCorp.com.