Franklin Street is a REIT that owns 32 office buildings located across the country, generally in suburban markets. In addition, Franklin Street features a real estate investment banking group that syndicates the ownership of individual real estate properties primarily to high net worth investors. In our view, Franklin Street's investment banking business is structurally impaired, and its portfolio of owned real estate is also facing many challenges. Moreover, the market is pricing Franklin Street at a material premium to its intrinsic value, and we believe that the company will soon have trouble funding its dividend. In our view, the combination of a fundamentally impaired business, overvaluation, and catalyst of a potential dividend cut makes Franklin Street a compelling short candidate.
Franklin Street's business model used to work as follows. The company would source an office building to acquire and would purchase it using its corporate line of credit. Sometimes the asset would end up simply being owned by Franklin Street, but the company's preference was for its investment bankers to create a private REIT for the property (off of Franklin Street's balance sheet) and syndicate the ownership of this private REIT to individual investors. Franklin Street would receive transaction fees from the individual investors for doing the syndication, as well as ongoing management fees for managing the asset on their behalf. While owning the asset in the private REIT, the individual investors would receive regular dividends of the property's taxable income. Eventually the private REIT would dispose of the asset, returning principal (and hopefully a gain) to the individual investors, net of additional transactional fees due to Franklin Street for handling the disposition. Sometimes Franklin Street itself would be the purchaser of the asset from the private REIT.
Over the years, Franklin Street built up its two businesses by amassing a portfolio of owned properties either by directly purchasing them in the private market or by purchasing them from one of its managed private REITs, and it grew its investment banking division by syndicating an increasing number of properties. Franklin Street would also occasionally sell its owned real estate properties, usually generating gains since the real estate market surged over much of the past decade. Franklin Street's investment banking division was unusual for a publicly traded REIT; in addition, FSP differentiated itself from peers by refusing to leverage its owned assets with property-level mortgages. As such, the company marketed itself as a different breed of REIT, one that had a safer dividend since it had three sources to draw on: investment banking fees, asset sale gains, and operating income from the ownership of unencumbered properties.
Today, Franklin Street's business looks quite different. The investment banking business has fallen off a cliff; after achieving EBITDA of $18-21mm in each of the years 2002-2004, and $12-16mm in each of the years 2005-2007, investment banking achieved EBITDA of $4mm in 2008, $1mm in 2009, and breakeven in the trailing twelve months ended 3/31/10. The decline in the business from the 2002-2004 period to the 2005-2007 period, which occurred during a bull market, suggests that the decline in this business is not purely a cyclical issue. We believe that as it has become far easier for individual investors to access commercial real estate investments, primarily through the institutionalization of publicly-traded REITs and ETFs with very low management fees, individual investors have little need to pay high fees to invest in single asset private REITs like the ones Franklin Street offers. This is a structural change that poses an existential threat to Franklin Street's investment banking business.
We believe that the existing private REITs are in poor shape due to the high prices paid for assets by Franklin Street and the company's failure to create value in the assets over time. For each of the past six quarters, Franklin Street has been lending an increasing amount of money to some of its existing private REITs so that those private REITs can make capital improvements to their properties and pay dividends to their investors (the property cash flows of those private REITs are evidently insufficient to cover these needs). Given that Franklin Street purchased many of the assets for its private REITs during the last decade's bubble, we believe that many properties are not worth their cost bases, and therefore individual investors are in danger of receiving less than their principal upon disposition.
Therefore, we believe that Franklin Street is facing a "Sophie's choice" with respect to its existing private REITs: it can either cease supporting the troubled private REITs and eventually sell the assets at their market values, or it can continue to lend to the troubled private REITs and eventually buy the assets itself to make the investors whole. The former would cause current investors in private REITs to have their dividends reduced or eliminated and to not be made whole on their principal upon disposition of the asset - this would likely be the final nail in the coffin of Franklin Street's investment banking division. The latter would dilute the value of equity investors in Franklin Street since the company would be making loans to troubled creditors and paying well above market value for assets. It is not clear to us which result would be worse for Franklin Street's shareholders, but either outcome would be good for us as short sellers.
Franklin Street's portfolio of owned properties also has its share of problems. Currently, occupancy in the portfolio is at 85%, down from the low 90%s it operated at for much of the last decade. Many of the properties are located in challenged markets with difficult supply/demand characteristics, such as Houston, Denver, and St. Louis - all markets that saw substantial construction during the last cycle and currently have significant vacant space. Furthermore, many of Franklin Street's properties are buildings either entirely occupied by a single tenant or in which one tenant leases a substantial majority of the space. These types of assets are very challenging to re-tenant upon lease expirations, since the tenant often possesses the negotiating leverage and can demand some combination of reduced rent, term, or increased capital spending by the landlord, particularly in markets where there is a substantial amount of vacant space. The first quarter of 2010 evidenced these issues, as occupancy and rental rates for the portfolio remained flat, but Franklin Street paid $6.9mm in tenant improvements and leasing commissions during the quarter, nearly the same amount it paid in the entire year of 2009. Almost 18% of Franklin Street's leased space expires during 2010, and another 9% expires in 2011, presenting the company with a very large amount of space to release in the currently challenging economic times.
What this all leads to is the question of whether or not Franklin Street will be able to pay its current $0.76/sh annual dividend. Whether the challenges in Franklin Street's portfolio manifest themselves in reduced rental rates, reduced occupancy, or elevated capital spending (or some combination thereof), all of these results end up reducing the cash flow Franklin Street will have available to pay dividends. Our conservative base case calls for Franklin Street to generate distributable cash flow of only about $0.60/sh over the next twelve months, roughly 80% of its current stated dividend. Without any contribution expected from the investment banking division, we believe that Franklin Street will have three choices: 1) reduce the current stated dividend, 2) sell or mortgage existing owned properties and use the proceeds to fund the shortfall in the dividend, or 3) acquire new assets that generate cash flow to cover the dividend shortfall, which will have to be funded through mortgage debt and/or new equity issuances. Choice #1 would clearly benefit our short; choice #2 amounts to burning your furniture to heat your home - it is not a sustainable long-term solution; and choice #3 would either merely prolong the inevitable, change the risk profile of an investment in Franklin Street (by introducing debt to the company), or serve as a positive catalyst for the short by means of an equity offering.
If we take the $0.60/sh dividend we expect Franklin Street to be able to pay and apply a 7% warranted yield, we arrive at a target stock price of about $8.50. Supporting this target price is our Net Asset Value (NAV)-based approach. By applying a 8.5% market cap rate to the in-place net operating income of Franklin Street's properties and adjusting for other balance sheet assets and liabilities, we arrive at an estimated NAV/sh of $8.60. This analysis implies that Franklin Street's properties are worth roughly $120 per square foot, in-line with how many third party valuation services value similar assets in Franklin Street's markets.
We believe the risks to this investment to be limited. The primary risk is that the investment banking business rebounds and begins once again to contribute meaningful cash flow. However, even if this business were to suddenly return to its peak EBITDA of $20mm from 2003, the resulting cash flow would not be sufficient to bridge the gap between the $0.60 of estimated cash flow we model and the $0.76 current dividend obligation. Due to the reasons laid out in this write-up, though, we strongly believe that this business is indeed impaired and will never return to its prior peak. Other risks relate mainly to timing, in our view. If Franklin Street does choose to sell or mortgage existing assets or acquire new assets in order to fund the current dividend, this serves to prolong the inevitable rather than remedy it. Still, as short sellers, we could be left having to pay the dividend while this occurred. However, even if Franklin Street is to be able to maintain the $0.76 rate, that would amount to only a 6.3% carrying cost. We believe this risk to be vastly outweighed by the chances of a catalyst in our favor and the magnitude of overvaluation.
Potential dividend cut or equity offering
Continued deterioration of property fundamentals