|Shares Out. (in M):||130||P/E||12.0x||0|
|Market Cap (in $M):||3,350||P/FCF||0||0|
|Net Debt (in $M):||2,235||EBIT||0||0|
We think Equity Commonwealth is an orphaned REIT equity undergoing a significant transformation under new management. We think the stock has base case +35-40% upside over the next 12-18 months. Right now the stock is underowned by REIT investors because it isn't paying a dividend and it hasn't fully articulated its strategy. Both of these overhangs will be eliminated in 2015 and the stock has significant room to re-rate given: 1) it has the highest cap rate of the group (8.8% vs. 6-7% for other suburban office REITs and 4% for the office REITs in Tier 1 markets like NYC); 2) it has an underleveraged balance sheet (4.5x vs. ~7x for the average office REIT) which gives new management significant flexibility in accretive capital allocation. We are conservatively using a 7.5% cap rate to derive our $35 target (+35%) plus whatever dividend they pay will (maybe 3-4% yield) once the dividend is reinitiated this year. We also believe there is incremental upside over the next several years from cost reductions as management simplies the portfolio. The company has gone from being run by the worst capital allocators in real estate to some of the best, yet still garners the lowest multiple in the group. This leaves significant room for the stock to re-rate as new management cleans up the portfolio, initiates a dividend, and articulates a clear strategy.
Background on EQC: An office REIT that has 155 properties (43mm square feet) focus on CBD (60% of NOI) and suburban (40% of NOI) markets. Key markets are Chicago, Philadelphia, Indianapolis, with lesser exposures in other markets like Denver, Milwaukee, New Jersey, Baltimore.
History (for those not familiar): EQC (f.k.a. Commonwealth REIT) has spent most of its long existence as an externally-managed REIT that was systematically plundered by a privately-held entity called RMR (Reit Management Research) due to an incentive system that paid RMR to grow assets regardless of value creation. An activist fund (Corvex) joined Related (a real estate developer/investment manager) to fight a long campaign to dislodge RMR which they ultimately won. In conjunction with the victory, Sam Zell joined as Chairman and brought his former head of M&A at Equity Office Properties, David Helfand, to be the CEO. Zell/Helfand took over in the 2H of 2013 and have spent the last 2 quarters internalizing the REIT (firing RMR from both property management and G&A responsibility and unwinding their onerous contracts, hiring CBRE to manage the properties, hiring 50+ people at the corporate level to handle administrative functions). They also initiated a portfolio review which will be completed this quarter to get their arms around EQC's assets and decide which they will keep vs. sell. Lastly, they suspended the dividend in order to put in place their own dividend policy (vs. inheriting the dividend policy of RMR).
The upside opportunity:
- The perception of EQC in the dedicated REIT investor world based on our conversations is that the assets are low quality/sub-scale (the key bear case). And it's true that if you look at their 155 properties, ~50% of them are <150,000 square feet (sub-scale assets). However what's interesting is that those ~75 properties in total contribute only 15% of total EBITDA/NOI. Our view is that Zell/Helfand are going to sell these assets off (into a good real estate market) over the next 12-24 months, leaving a core of much higher quality buildings in more significant markets that should drive a re-rating. The fact that this long tail of lower quality assets only represents 15% of NOI significant de-risks the execution of this because the upside scenario we are underwriting for the stock isn't sensitive to what cap rate they ultimately realize on these sales.
- With the portfolio simplification will come a meaningful opportunity to reduce costs (lower G&A/administrative costs). Helfand has guided to $50-55mm in G&A in 2015 (the numbers are messy in 2014 b/c of all the separation costs with RMR). We think this (and the property management costs) can come down through time. Corvex/Related in their initial bottom-up work pegged this uplift from better cost management at ~10-15% of NOI.
- Zell/Helfand took 4mm in equity options with strike prices ~$24/share. They wouldn't be putting their time into this if they didn't see upside here. Asset quality would be very easy for these guys to due diligence given their relationships in the industry. Given this is the core of the bear case, we think their posture here is significant.
|Current Capitalization||Portfolio Summary (9/30/14)||Square||Leasing|
|Current Stock Price||$26.00||Note: Excludes Discont. Ops||Properties||Feet (mm)||Status|
|Unsecured Notes||1,328||Cost Basis ($mm)||5,886|
|Secured Mortgage Notes||608||$/sf Cost Basis||$137|
|Perpetual Preferreds||398||Net Book Value ($mm)||4,898|
|Net Debt and Preferred||2,236||$/sf Cost Basis||$114|
|Less: Other Non-Real Estate||(96)|
|Implied Real Estate Value||5,491|
|Net Debt and Preferred / EBITDA||5.2x|
|Net Debt / EBITDA||4.2x|
|EV / EBITDA||12.7x|
|P / FFO||12.1x|
|P / AFFO||20.6x|
Dividend reinitiation (1H 2015)
Articulation of portfolio strategy (1H 2015)
Use of underleveraged balance sheet to accretively acquire assets