Tuesday, February 7, 2012


Everyday is another opportunity to be clueless about something.

Today I ran across a nice little discussion at
http://www.cornerofberkshireandfairfax.ca/forum/index.php?PHPSESSID=3d3f27e68e2810e6516ed1618112b70a&topic=5958.0 regarding a little spin-off from General Growth Properties (GGP). Rouse properties is a B-mall operator with 30 locations across the United States, an 87% occupancy rate, and ~$271 sales/sq.ft average (below industry average, though I'm completely oblivious to what that could possibly be. Like how I'm oblivious to technical analysis and witchcraft)

I don't really want to talk about intrinsic valuation (i know 80% of you will now automatically alt+back and curse my blog), only because I'm not capable of throwing out a worthwhile opinion. However, based on the discussions from Corner and Stockspinoffs, along with Brook's $15 dollar/share backstop  and the fact that the market has punished RSE down to ~$10 and change, I think Rouse just might be a worthwhile mall to consider (if you don’t shop at TJMaxx, you ought to).

Note! I realize the stock has traded up substantially. I wrote this little puppy up in early January but then sat on it. I don’t think I personally would put more money into this stock at this time, but please continue reading or I will be sad…and furious.

The most interesting part of this whole exploration really is the numbers: Operating income, core operating income, and Funds from Operations. What in Odin’s beard do they represent? From the tattered pages of the S filing, we are told:

“We define NOI as operating revenues (rental income, including lease termination fees, tenant recoveries and other income) less property and related expenses (real estate taxes, operating costs, repairs and maintenance, marketing and other property expenses). We define Core NOI as NOI excluding straight-line rent, amortization of above and below-market tenant leases and amortization of above and below market ground rent expense....we believe that NOI and Core NOI provide performance measures that, when compared year over year, reflect the revenues and expenses directly associated with owning and operating regional shopping malls and the impact on operations from trends in occupancy rates, rental rates and operating costs. “

NAREIT defines FFO as net income (loss) (computed in accordance with current GAAP), excluding gains or losses from cumulative effects of accounting changes, extraordinary items and sales of depreciable properties, plus real estate related depreciation and amortization”

Here’s a nice little write up on amortization of above/below market tenant leases:


Inherently, I don’t think it’s wildly different from the amortization of premium / discounts on a bond purchase. When Rouse “acquired” the 30 properties, they essentially evaluated the leases they had according to market value, and quite a handful of leases were “above market” (and some below, look at the pretty chart!) and thus included in the “price” of the property. Thus, over the life of the term, the extra value of the lease has to be amortized (imagine buying a 10% bond at 105, the yield is really something below that, and it’s captured by the amortization of the bond from 105 to 100 on the balance sheet- the market value for those bonds in this case may be 9% or something). The same can be said here - the value of the above market leases is reflected on the balance sheet under prepaid expenses, and must be amortized over the next ~5 years or so. Likewise, below market leases must be “accreted” (not sure if this is the correct term, but let’s coin it) like a discount bond to its face value. While I do understand the concept management presented of operating income, I’m not sure I quite understand core operating income. By adding back the amortized values, aren’t we essentially giving credit back for the “upfront” payment? That’s like adding back the amortization of a bond purchased at a premium. That doesn’t seem quite honest.

Needless to say, I thought it was necessary to clean up some of the numbers in the filing, as it was quite a cluster of mismatched “pro forma” tables with non pro-forma-ed results. (for example, the run rate $50mm FFO doesn’t include the updated interest expense and additional annual property management costs). Here are the numbers for your mental lust:

As you can see, the FFO is hardly ebullient, at nearly three quarters of the annualized $50 million FFO from the report (and from a cap ratio, it suggests 6-7%, which doesn’t seem to be a bargain among the fellow bloggers I’ve the opportunity to read). However, since this seems absurd given the amount of adjustments in non-cash expenses, I felt compelled to tweak the numbers favorably, like a good analyst at a good investment bank.

First off, the debt rate adjustment is a funky number added to interest expense that doesn’t really belie the amount of interest truly due (which we calculated above!), so that should probably be excused from the “adjusted FFO,” bringing Adj. FFO to $51 million. While I am a bit conflicted over the amortization of leases (taking out the amortization would “normalize” earnings per-se), the inclusion of this cash flow would add another ~$17 million to adjusted FFO. The number now seems to be more akin to CFO with exclusion of working capital changes, which might be a better proxy for the mall’s operational purposes. I’m not trying to inflate how sexy Rouse is (she’s a feisty B-class), but unlike NOI, I do believe funds should serve to address the cash flow condition of the mall. 

I know I stated earlier I didn’t really want to talk about valuation, but that’s just silly. Here are some comps I grabbed from Wells Fargo’s report on malls from a week ago– do be warned that these comps are wildly different, with exception of Penn REIT and CBL Associates

Tussling my hair, I happened to notice that the AFFO multiples might be mislabeled. The main problem is our inherent lack of intelligence regarding what these FFO/AFFO numbers consist of, and whether they are quite uniform across the board. Grabbing some numbers from the latest 10Q’s (and these are sloppy! Imagine a 2 year-old’s handwriting on a toilet stool) and making some half-hearted adjustments (FFO taken and annualized, CFO takes out NWC changes to match our RSE CFO and then annualized), it’s actually hard to conclude that Rouse (especially after the run-up from $11) is cheap from a comparative perspective. In fact, it’s more expensive when looking at cash flow yield, and not so much better when including capex.

So now you’re twiddling your thumbs and a bit disconcerted over this write up. I know I know – I feel a bit awful for posting this after the fact, but it’s also a nice exercise to refresh the thesis after such a rapid run. Granted I’m not releasing my bowels in excitement about RSE any longer, I think the stock is still a bit below fair value, and would be mindful of a pullback opportunity. Penn REIT might look omg so much cheaper on a cash flow basis, but with a net debt/EBITDA ratio (from capIQ) that is 3.5 turns higher, and with only $50 million of cash on hand, the leeway for error is a bit cramped. I think CBL is definitely worth a look if mall REITS look inexpensive to you (http://www.google.com/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=6&ved=0CGEQtwIwBQ&url=http%3A%2F%2Fwww.reit.com%2FVideos%2FClass-B-Mall-Operators-Make-Good-Real-Estate-Investments.aspx&ei=IssxT-m2NYqRiQLq3_SKCg&usg=AFQjCNG42YUj8HqGQPXsSzSUaUmCEccAdw&sig2=g0MmhUmfle9oxuzjW9ExgA), but Rouse offers a nice ~10% cash flow yield, and will have substantially far less net debt then either of the two due to its secondary rights offering (which will provide enough cash to fund the totality of its capital expenditures in the next few years), and currently doesn’t have to pay a dividend due to high operating losses.

To further our valuation, we also use a cap rate eval.  From the NOI, we get a RSE current implied cap rate of 9.66%, and a potential IRR of 15-25% over the next 4 years if management is indeed able to raise NOI back to $200 million  by the end of 2015 (9.27% is Penn’s current cap rate):

I think it will be quite difficult to try to value the company from a comparables perspective, simply because the assets of all these REITs are so diverse that an apples to apples is quite improbable. Most mall REITS trade at cap rates around ~5.0-6.0%, but they also include estates that are brightly lit and incredibly beautiful and where you can probably never find a good sale, versus the more mundane properties that Rouse operates (though you never know what you might find at TJ Maxx…). Offsetting this is the fact that tenant occupancy rates at Rouse are significantly lower and hence have further room for improvement (like idle capacity at a DRAM producing fab), and quite a few of these properties are actually the only shopping center within a large traveling radius (refer to the Rouse presentation for some individual facts/pictures). So what rate should Rouse be trading at? The current implied rate of ~9-10% is a huge premium to GGP and its comparables. And if management does indeed achieve a $200 million CNOI in the next 4 years, the cap rate will be ~12-13% at the current stock price and capital structure. Current FFO (excluding amortization) of ~$68 million implies cash flow of ~$1.39 per share on a share price of $13.80. For comparative purposes, here are Penn and CBL:

Granted our Rouse numbers are conjectures – the matter of significant above market lease amortization points to a number of leases at the date of spinoff which may fall upon renewal or request – we should pull ourselves out of the current poopoo state and venture to wonder: will lease rates begin to strengthen this year? And the next? and the year after? Are squirrels indigenous to North America? Did you know water only makes up .07% of earth’s mass?
If you conjecture that lease rates may strengthen this year or perhaps stay flat and then increase in 2013, you are cute. I personally don’t want to venture a guess about Europe’s ECB, about Greek’s little debt shuffle, about Japan’s growing social security sending (at 52%!!), about housing prices and the ~10 million shadow inventory, about what flavors DQ might introduce into their blizzard lineup (hopefully something with yogurt pretzels), or about whether I can run a 6 minute mile. These are secrets for retrospection, and the time you spend speculating is probably more useful spent elsewhere.

Here are the facts (and quite a few are subjective from Rouse’s management, so take it with a salt block)
·         60% of RSE’s properties are located in one-mall markets
·         Occupancy has historically been 93%, and is currently at 87.6%
·         Leasing activity for 2011 roughly in line with expirations in terms of GLA (flat)
·         11.5% of leases expire in 2012 at relatively strong rates, followed by 14.9% in 2013 at relatively weak rates. Potentially CNOI may decline this year before strengthening
·         Core NOI was over $200 million in 2007, and has fallen 25% to $150 million
·         CBL, often known as the largest B-mall operator, trades at a cap rate of 8.0%. Penn trades slightly better than RSE, and still has a significantly worse balance sheet
Looking at some other REITS, it seems that the quick deceleration of leases isn’t completely idiosyncratic to Rouse (and this would make sense, as we probably assume that larger tenants and anchors sign contracts that are far longer in duration, and hence they become more predominant in lease makeup as we extend outwards in time). If one were to observe Equity One’s tenant expiration schedule (page 45 of the 10K), one would see an absolute trend of average minimum rent per square foot for small tenants rise linearly from 2011-2019 and even thereafter, while all tenants actually declines after 2012/2013 (with exception of a weird 2016), impacted by timing differences / cost of anchor tenants. The same goes for a majority of the REITS that you’re quite welcome to look into.
Last, to conclude the piece, I was curious about the districts where these malls are located and so pulled up some facts from the U.S. census (all 2010 data, except sales/capita, which is from 2007), along with the trade area population if Rouse mentioned it in the IR.

Sadly, I can’t seem to extrapolate anything of much consistency regarding occupancy rate on the independent variables (for example, Lansing and St. Vicent have above national average lease rates, but flunk in terms of population growth, bachelors, and median income), but suffice to say that half of these malls are in general districts where the median income is below average, half where population growth is below average, and roughly 2/3 where education is below average. The argument here, of course, is that class B malls exaggerate the business cycle – any downturn will hurt occupancy and sales far more severely than the more inelastic demand at class A malls (I read recently that non-college educated unemployment rate is ~3x that of college educated), as the unemployment rate around these areas are probably much higher than the national rate. Thus, during the recession, it wasn’t too much a question of “spending less” rather than “having nothing to spend.” If you do believe that we’re finally coming out of a recession, and nice old Mr. Bernanke can shield us from the dangers of Europe like he promises to, then it’s also quite likely that class B malls will rebound much faster in terms of sales per square feet and close the capitalization gap to its class A peers (Well’s Fargo’s primer states that historical capitalization ratios for class B malls has been ~8%, exactly what we target in our bullish recovery scenario).

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