Gramercy Capital (NYSE: GKK) is a compelling short that appears massively overvalued using any reasonable valuation method and at best fairly valued using management’s suggested (and far more aggressive) methods. The company would like investors to believe that they should value cash at a premium, recently acquired properties at a premium, and limited duration cash flows as perpetuities. While that may work in the current see no evil / hear no evil market, the stock is incredibly exposed to any sort of shift in sentiment away from only seeing the sunny side and, even if things really end up as roses, there doesn’t seem to be much upside remaining. I will be using the company’s recent presentation at http://files.shareholder.com/downloads/GKK/2418013501x0x646869/AF0D7301-7585-4F00-9E72-11519F13D9A9/GKK_Update_March_2013.pdf for much of this write-up.
To start, let’s look at what I consider to be two reasonable valuation methods:
1) Valuing the company based on book value: the company today basically consists of properties acquired within the last 9 months, the associated liabilities, and cash. With those as the constituent parts, I think it’s tough to believe that they’ve created a lot of value buying properties at what appear to be reasonably market rates. The current book value of the company is approximately $139 million or $2.29 per share.
2) A second – and somewhat more generous – way to value the company would be to take a multiple of the in-place FFO and add to that the excess cash on the balance sheet. I estimate in-place FFO as follows:
As you can see from the above, I think that today's share price of $4.87 is materially overvalued in either scenario.
In contrast to what I consider the two reasonable methods of valuing the company (market value based on recent transactions and a multiple of current earnings plus excess cash), the company has a variety of ways they would prefer investors to value it. So, let’s look at three ways the company would like you to assume in order to make the stock a buy:
1) The first method suggested by the company is to take the excess cash and investments at the company and to assume that it can be invested as with their prior acquisitions. In this scenario, the valuation might look something like this:
The problem with the above valuation is that it assumes that in one fell swoop the company can turn $134.9 million of invested equity into $273 million of equity value – an instant double on their equity just for buying properties similar to those they’ve already bought.
2) In the second suggested valuation method, the company suggests that investors value their $20-million of in-place NOI at a 7% cap rate, which puts their recently acquired properties at a $280 million valuation as compared to the book value of $202 million or a $78 million revaluation gain. This would then be added to the book value of $139 million to get an net asset value of $217 million or $3.57. Obviously, this doesn’t justify the current stock price, so they are then eager to point out that triple-net REITs trade at 135.6% of NAV. Conveniently, this would get $4.85 per share in value.
Once again, this valuation method lacks credibility. First, it’s not credible to assume that a bunch of properties that were purchased in just the last few months at 8% - 9% cap rates are now worth 7% cap rates, especially when we know that the company thinks it can keep buying new properties at 8% - 9% cap rates. Second, there is no good justification for the company trading at a premium to NAV – it has no history of value creation, the young age of the assets means there is unlikely to be any hidden value on the balance sheet, and the high portion of cash on the balance sheet means that a premium to NAV is effectively valuing the cash at a premium as well. I don’t think this valuation passes the smell test, but even if it did, there wouldn’t be any upside from here.
3) Finally, the company wants investors to look at other triple-net REITs, which they say trade at an average of 2.8x book value. Using this multiple, the company would be worth $6.41 per share. However, the mean multiple is heavily skewed by Realty Income which has an outlier multiple at 4.4x. More reasonably, the median multiple is 2.0x, which would result in a value for GKK of $4.58. Isn’t it curious that this too justifies the current stock price?
While this may look mathematically reasonable, the truth is that companies trade at a premium to book value because the historic cost of their assets understates their current value. In the case of the comparable companies, many of the properties were acquired long ago when rents were lower and cap rates higher. It therefore makes sense that these companies would trade at a multiple of book. As I must again point out, GKK just acquired their properties. There’s no good reason to believe that GKK
Finally, I would like to point out that the cash flows in the asset management business are unlikely to be sustained as the Bank of America portfolio reduces in size and as KBS liquidates the properties they repossessed from GKK. These are two of the largest contracts in the asset management arm and they are both likely to decline meaningfully (or go away altogether) over the next several years.
I don’t see a credible path to upside on the current stock price, but the two most rational ways I can see to value the company suggest ~50% downside to today’s price. I suggest shorting the stock.
I do not hold a position of employment, directorship, or consultancy with the issuer. Neither I nor others I advise hold a material investment in the issuer's securities.