Description

JBGS; JBG Smith Properties; stock; $30.28

I'm recommending a long position in JBGS; its closing price on this Friday is
$32.28/share. JBG Smith Properties is a REIT with a portfolio of high growth
mixed-use properties around the Washington DC area. It focus on building
vibrant, amenity-rich, walkable neighborhoods through a "placemaking" strategy.
In the company's own words; "placemaking" involves strategically mixing high
quality multi-family and commercial buildings with anchor, specialty and
neighborhood retail in a high density, thoughtfully planned and designed public
space.

Basic facts:
1. The company was formed in 2017 when Vornado Realty Trust (ticker VNO) spun
   off its Washington DC portfolio via a Reverse Morris Trust transaction.
   The "Smith" in "JBG Smith Properties" comes from VNO's contribution because
   its Washington DC segment was known as Vornado / Charles E. Smith. The "JBG"
   part is from "JBG properties" which has been merged with "Smith" immediately
   after spin-off. JBGS is managed by the "JBG Properties" management team.
   Original VNO shareholders received 73% of JBGS; "JBG Properties" received
   21%; JBGS management received 6%. All assets of JBGS are held by, and
   operated through the operating entity "JBG Smith Properties LP", which JBGS
   controls; JBGS owns 89.9% of the operating entity's common limited
   partnership units (OP Units).

2. There is good alignment of management incentive; because the majority of
   their initial equity grant is in the form of "Formation Unit"; which are
   tied to JBGS stock price appreciation from its initial trading price of $32.
   25% each will be vested on the 3rd, 4th anniversaries of the grant date;
   the other 50% will vest on the 5th anniversary. The five NEO combined own
   29.15M Formation Units. It's worth noting that this is roughly equally
   distributed among these five people instead of concentrated in the CEO.
   Management team will focus squarely on improving share price over the next
   few years because these grants are the lion's share of their compensation.
   For example, the CEO has a salary of $750K and yearly total pay (excluding
   these Formation Units) <= $5M; while at $40/share his Formation Units is
   worth $70M.

3. Current portfolio (as of 20191231): total 62 operating assets; consists of:
       44 commercial total 12.7M SF (JBGS share 10.7M)
       18 multifamily total 7111 units (JBGS share 5327 units)
   and:
       7 assets under construction:
           4 commercial total 943K SF (JBGS share 821K)
           3 multifamily total 1011 units (JBGS share 833 units)
       40 future development assets total estimate 21.9M SF (JBGS share 18.7M)
   The only tenant accounting for 10%+ revenue is the US federal government; it
   accounts for about 16.7% total revenue in 2019. So JBGS's revenue source is
   well diversified and has a robust development pipeline.

4. The company's main strategy is to focus on high growth mixed-use assets in
   metro-served submarkets in the Washington DC area. The management team came
   from the original "JBG Properties" which has very extensive experience
   operating in the DC area. There are many levers for near and medium term
   growth: (1) contractual embedded rent growth realization; (2) opportunities
   to lease up vacant assets; (3) deliver assets currently under construction;
   (4) significant pipeline for future ground up development.

5. Recent financing actions cannot be any better; they issued equity at
   $42/share (market top!) in late 2019 raising $472M; and recently launched
   a $500M share buy back program at the market bottom on March 13, 2020.
   As of March 31, JBGS repurchased 1.4M shares at average price $29.01
   totalling $41.2M. It's likely they have purchased comparable amounts during
   April to June.

6. We only have comparable data for 2018, 2019; for those two years; average
   annual FFO per diluted common JBGS share is $1.24. So the current price
   $30.28 is trading at FFO yield of 1.24 / 30.28 = 4%. Current annual dividend
   is $0.9/share with dividend rate 2.97%. The company has ample liquidity and
   is in good shape in COVID; the chance of cutting dividend is very low. This
   point will be discussed in more details below.

7. In Nov 2018, Amazon announced it had selected sites in Northern Virginia for
   its HQ2; which are owned by JBGS. So far Amazon has executed leases totaling
   857K SF at five office buildings in JBGS's National Landing portfolio. In
   March 2019, JBGS executed purchase and sales agreements with Amazon for two
   development sites, Metropolitan Park and Pen Place, which will serve as the
   initial phase of new construction for Amazon's HQ2. Amazon contracted to buy
   these two sites at $72/SF for a total of $293M. In Feb 2019, state Virginia
   passed an incentives bill providing tax benefit to Amazon if it creates up
   to 37850 full time jobs with average salaries of $150K or higher in National
   Landing. As part of the incentive pkg, we expect $1.8B in infrastructure
   and education investments led by state and local government. Let's note that
   42% of JBGS assets are within 0.5 mile of Amazon HQ2. Besides these
   direct benefits; Amazon's presence and growth will build critical mass and
   a center of gravity for the region's growing technology sector; which will
   create lots of infrastructure projects that will benefit JBGS's growth for
   a very long time.


So this is all fine and dandy. Next we need to answer these two key questions:
1. Effect of COVID on JBGS.
2. Why current price represents acceptable risk with great potential.

~~~~~~ COVID impact
1. JBGS has ample liquidity going into the crisis; not only more than enough to
   cover dividends and continue operations; but provides great opportunities for
   buying back shares on the cheap or acquiring good assets if the real estate
   market crashes after covid. Including cash, undrawn capacity on credit
   facility, and potential financings on unencumbered multifamily operating and
   under construction assets; JBGS has total liquidity of about $2B. (Recall
   that the total market is about $4B.) Cash balance is about $800M. There is
   about 8% loan maturing before 2021YE. There is no liquidity risk even in the
   most severe downside scenario.

2. Relatively speaking, JBGS is in very good shape coming into this COVID
   downturn. A high percentage of revenue is from the government, government
   contractors and other well-doing tenants including Amazon, and apartment
   renters working in these industries. Some of these, such as Amazon and
   certain government agencies are actually benefiting from the COVID crisis.
   Although what's going to happen next is unclear, so far (several months into
   the crisis) there is very limited disruption to JBGS's tenants and rent
   revenue. Also, historically Washington DC region is very resilient against
   economic crisis compared with the rest of the country.
   More specifically, JBGS operates in three separate jurisdictions that
   together comprise the Metro DC area. Government policies are:
       Virginia     : 67% revenue; stay at home through June 10;
       Washington DC: 27% revenue; stay at home through May 15;
                      suspension of rent increases on new multifamily leases
                      until 30 days after emergency order is lifted
       Maryland     : 6% revenue; stay at home until order rescinded by governor
                      In Montgomery County, rent increases on multifamily leases
                      capped at 2.6% until 180 days after the emergency order is
                      lifted
   In all three jurisdictions, construction projects are deemed essential and
   remain open; also has suspension of multifamily evictions and cap on late
   fees for non-payment of rent.
   The near term financial impact is minimal; as can be seen from the April rent
   collection data:
                    % tenants paid    compared to 2019 Avg    $Paid / $Unpaid
       Office                  97%                   -2.7%   $30.5M /   $0.9M
       Residential           96.1%                   -3.8%   $10.2M /   $0.4M
       Retail                  47%                  -51.4%    $1.5M /   $1.7M
   So Retail has been decimated but that's a tiny percentage of JBGS's revenue.
   in additional to this table, commercial parking revenue was down 54% for
   April compared to the average monthly first quarter revenue of $2.6M.
   Crystal City Marriott is temporarily closed which produced NOI $1.8M in 2019.
   So far all rent accommodations are structured as deferrals; obviously if the
   crisis lasts much longer ultimate rent recovery rate will be substantially
   lower and JBGS will incur substantial cost to retenant vacant space.
   Because construction projects are deemd essential and remain open; all JBGS
   construction projects except one are active and on schedule. Also Amazon is
   accelerating its hiring efforts so it might have more space needs in HQ2
   which benefits JBGS.
   For three months ended 20200331, revenue is 120.38M compared with $119.413M
   for 2019Q4; FFO is $0.27/share for Q1.

3. Despite being relatively robust to the covid crisis in the short term; the
   long term covid impact could be dire for JBGS; income destruction; tenant
   going out of business causing rent loss; cost in retenanting; forced to lease
   vacant space at lower rates; etc. However, this is counter balanced by
   potential acquisition opportunities. As discussed above, JBGS has ample
   liquidity and a substantial portion of revenue is coming from enterprises
   likely to benefit from this covid crisis; so when the regional real estate
   market crashes after covid; JBGS will be buying good assets on the cheap.

~~~~~~~~~~~~~~~~~~~~~
~~~~~~ 2nd question ~~~~~~
~~~~~~~~~~~~~~~~~~~~~
Now we come to the second, and most important question; why is investing in JBGS
at the current price a good idea? As value investors, most of us are incurable
bargain hunters. True, JBGS has a good portfolio; but 24x FFO is not cheap;
especially after market running up 40% in front of looming virus uncertainties;
right? Here I want to argue otherwise for the following reasons:

1. Limited down side. JBGS traded down to $23 on March 23 when market bottomed
   and quickly recovered to $30+ in two days and never traded below $29 after.
   So the most we could lose here is -17% to $25/share; which is very unlikely
   to materialize given ongoing Fed action.

2. Upside. I expect JBGS to trade back to its pre-crisis price level of $40+
   and more, within several months, as the broad investing community gradually
   accept (of course grudgingly) the end of cycle reality.

   One basic fact about market is that asset valuation is very dependent on the
   interest rate level; for the same level of $EPS (assuming interest rate
   change does not affect $EPS); higher interest rate leads to lower stock price
   and lower interest rate leads to higher stock price. This fact is totally
   obvious when stated abstractly; but is often overlooked in practice because
   interest rate usually doesn't change much within a few months (which is
   already longer than most investors' attention span). This deficiency (not
   paying enough attention to interest rate) is especially pronounced among our
   value investors: We spent too much time studying people like Buffett or
   Joel Greenblatt. Let's face it: we cannot make large money doing what Buffett
   described in his annual letters pre-1987, because nowadays high quality
   companies won't have stock selling for 10x or 7x earnings. Greenblatt said
   (in one of his MBA classes) that we should benchmark pre-tax earnings yield
   against 10Y rate; but should use 6% if 10Y rate is lower than 6% to have
   enough margin of safety; but nowadays truely high ROIC business won't sell
   for P/E = 17 unless something terrible is happening to the company. Looking
   back, a large part of the 1982-2008 bull market return is due to interest
   rate dropping 17% -> 0% and this is not repeatable because we won't see rate
   dropping from 0% to -17%. As a mirror symmetry of the 1982-2008 bull market,
   1964-1981 is a terrible time for average stock investors: on Dec 31, 1964,
   DJIA = 874.12; on Dec 31, 1981, DJIA = 875; and we have 17 years of rampant
   inflation; all this happenned when US interest rate went from 4% to 17%.

   All this is just saying that taking into account Fed policy is very important
   for (even value) investors. Now we are at 0%; Fed have ran QE for 10 years;
   and just printed several $T for the government to spend because of COVID.
   This very likely will change the investment landscape permenantly going
   forward. We have already seen this partially from the recent market run-up;
   this rally to a large extent is probably driven by Fed money flow instead of
   improving company fundamentals. I have a hypothesis that post-covid high
   quality business (extremely robust cash flow; slow growth) will permenantly
   trade at 30x, 40x or higher P/E; because many of these stocks will be used as
   "bond substitute" when regular bonds have no yield.

   So why do I pose this hypothesis? Because I think going forward the Fed will
   not preemptively tighten in front of potential inflation; but will keep the
   printing press running until inflation really picks up; then it might slow
   down a little bit... and continue printing... As a result, most bonds will
   have no yield; and investors must find a new "reservoir" for their endless
   money; and companies with robust (and hopefully growing) cash flow are good
   candidates. Let's flesh out this logical sequence a bit more. This covid
   crisis is a sudden income shock; to avoid really catastrophic results Fed has
   no choice but print lots of money and let government give it out to fill the
   income hole. There are two cases (of course it could be in between):
       a. Fed keeps printing enough money as the economy slowly recovers;
       b. Fed stops before employment/income is recovered sufficiently;
   (a) is bad because besides income loss, we also have supply destruction since
   people are staying at home instead of working; so when people finally go out
   after re-open they will be spending stimulus money to purchase things from a
   reduced supply; causing inflation; (more bluntly, people won't work hard
   enough to service existing debt and don't want belt-tightening; so there is
   no choice but to "inflate" away outstanding obligations) (b) is obviously
   also bad because it leads to self-reinforcing depression. In terms of market
   action, (a) will lead to something similar to what I described above while
   (b) will lead to crash. So we are basically choosing the lesser one among
   two evils.  Of course what happens in the end is Mr Powell's call; but if
   history is of any guide, (a) is way more likely than (b). As Keynes famously
   said, "inflation is unjust and deflation is inexpedient"; in the end people
   likely will take the road of least resistence and just inflate away their
   obligations.

   Looking from this perspective, I suggest thinking of JBGS common stock as a
   solid 4% yield bond with growth potential. I know you might call me
   preposterous; or maybe you will google what tychus is and realize that I'm
   full of muscle with no brain. But yes, you read it right: this is a solid
   4% bond with growth potential!

   I think JBGS will trade back to $40 within several months. After the March
   2020 crash and the recent rally the market somewhat divided itself into two
   families. While the SP500 average is about the same now vs Feb 2020; price
   actions on individual stocks are very different: mediocre companies see their
   stock price languish while many other stocks are reaching new highs. I think
   part of this is due to investors subconsciously thinking of stocks of these
   high quality companies as "bond substitutes" to park their newly printed
   money. JBGS fits this bill; it's not widely followed and is a REIT; so it's
   not in the first group to rightfully reaching back to pre-covid prices.
   But it will. Even if this doesn't play out; JBGS still has a solid growth
   strategy and we can collect its 3% dividend while waiting for growth to
   materialize.


SUMMARY
1. Limited downside of 17%.
2. 4% bond with growth; "bond substitute" psychology will bring
   price back to pre-covid level within a few months.
3. Solid growth playbook; potential acquisition opportunities is the backup plan.

Catalyst

market realize that JBGS is not affected much by COVID, and could benefit from acquisition opportunities if there is a real estate market crash