October 23, 2016 - 6:03pm EST by
2016 2017
Price: 18.19 EPS 0 0
Shares Out. (in M): 50 P/E 0 0
Market Cap (in $M): 914 P/FCF 0 0
Net Debt (in $M): 615 EBIT 0 0
TEV ($): 1,530 TEV/EBIT 0 0
Borrow Cost: General Collateral

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2016.10.23 Short PKY ($18.19) Thesis

I recommend shorting Parkway, Inc. (“PKY”) common stock.  PKY was recently formed by combining the Houston assets of legacy Cousins Properties (ticker CUZ) and the Houston assets of legacy Parkway Properties (old ticker PKY) into new Parkway, Inc.  The new PKY was spun off and began trading regular way on October 7, 2016.

The portfolio consists of 5 assets – 3 from legacy Parkway (Phoenix Tower, CityWestPlace, and San Felipe Plaza) and 2 from legacy Cousins (Greenway Plaza and Post Oak Central) – and totals 8.7 mm SF of office space entirely in the Houston market.

There are several elements to the short thesis.  I think that there has been somewhat of an informational vacuum and that many of the metrics emphasized most have been rather misleading, or at least not fully contextualized.  I believe that the fundamentals for Houston office are weak and as is common with many cyclicals, I think that folks have tried to call the turn prematurely.  Taken together, while PKY appears to be “cheap” on current numbers, especially on implied cap rates of GAAP NOI , I believe that when we project forward or utilize other valuation methodologies that PKY is actually quite expensive.

Here is a quick summary of the properties:

Here are some helpful slides put out over the course of this transaction coming together.

Late April 2016 slides:

Early June 2016 slides:

These June 2016 slides in particular have a lot of excellent long term data on the Houston Class A office market --especially slides 6, 9, 14, 15, and 22.

While legacy PKY and legacy CUZ did not report all their metrics consistently and it required a fair bit of digging across multiple sources, here is a summary of the occupancy progression across the portfolio I put together:

You can easily see that the assets were all acquired near peak occupancy, which has deteriorated substantially since then.

Next, you’ll note that annualized GAAP NOI figures were given in the slide decks.  The first deck gave the Q4’15 annualized figures and the next deck gave the Q1’16 annualized figures.  I then derived the Q2’16 annualized figures from the H1’16 figures given in the updated information statement, link here:

What jumps out at me is that at the time of the deal being announced and at the time of the conference call discussing the merger, the annualized NOI being shown for HoustonCo (i.e. New PKY) was $177mm on a Q4’15 LQA basis.  Meanwhile, look what has happened since then:

I’m not sure if there was any intent to obscure (I assume not).  But there is usually a delta between GAAP NOI and cash NOI.  In my experience, cash NOI is all anyone cares about, (aside from limited exceptions such as unusually high free rent periods that rae about to burn off shortly, etc.).  Yet the emphasized number in the slides and elsewhere is the GAAP NOI number.

In this particular case, I believe that the delta between GAAP NOI and cash NOI is unusually large and that the delta happened to peak in Q4’15, making the Q4’15 annualized basis a particularly troublesome “base” from which to begin.  While there are always lots of moving parts in going from GAAP NOI to cash NOI, the main two components are straight-lining of rents and GAAP amortization of above (below) market leases at the time of acquisitons.  In this case, because of the large BMC contraction of over 300k SF in Q1’16 (notification given to legacy PKY in 2015), I believe this was a source of positive non-cash adjustments to GAAP NOI on a recurring basis from the time of the acquisition of CityWestPlace in 2013.  Moreover, I believe there was an additional non-cash “true-up” of sorts to GAAP NOI in H2’15 (and partially in Q1’16) after legacy PKY received notification of BMC’s upcoming contraction but prior to BMC actual vacating during Q1’16.  Essentially, I believe the noncash positive adjustments to GAAP NOI that would have been spread through 2021 had BMC not contracted their space instead had to be “front-loaded” into the period ending with the time of BMC vacating.  So I think this unduly inflated GAAP NOI for the “base” period of 2015 (and partially Q1’16).  I think this likely also got exacerbated by using the LQA convention for showing GAAP NOI in the slides.  Thus, LQA GAAP NOI went from $177mm in Q4’15 to $152.6mm in Q2’16!  So Q2’16 should be the most realistic number to be used as a base for GAAP NOI as the “noise” from such adjustments should have been gone from Q2’16 numbers.  Thus, an implied GAAP cap rate today of 11.6% using Q4’15A is 10.0% using Q2’16A.

But I believe there remains a substantial delta between GAAP NOI and cash NOI even in Q2’16.  The latest version of the information statement that utilized Q1’16 figures was this one from July 28:

The final information statement from Sept 28 ( utilizes H1’16 figures, so we can back into Q2’16 figures.  To go from GAAP NOI to cash NOI with pro forma adjustments, I simply removed the PF Parkway Houston straight-line adjustments, the PF Parkway Houston below market rent adjustments, and the legacy Cousins Houston non-cash adjustments:

As seen, this lowers the implied cap rate today to 8.4% on PF cash NOI using Q2’16 LQA.  Needless to say, there is a huge difference between an implied cap rate of 8.4% using the most reasonable historical “base” versus the 11.6% implied cap rate derived from the GAAP NOI figure at the time of the merger call.

However, I don’t believe that even this is “cheap” as I expect NOI to decline significantly going forward.  In terms of GAAP NOI, the main drivers I envision are reduced rents and reduced occupancy.  In terms of cash NOI, I would also add increased free rent periods going forward as another driver of headwind.  (And I’m not even considering increased TI packages as a “penalty” for cash NOI).

Historically, office is a class of CRE that lags for several reasons, including the longer average lease terms relative to, apartments, SF rental, self-storage, and of course lodging.  Asking rents tend to lag even further, as free rent periods and TI packages tend to flex substantially first before asking rents even move.  And in nearly any class of real estate, volume typically leads pricing.  We have seen volumes dry up so far in both asset sales and in leasing in Houston.  There have been virtually no asset sales of size and relevance in Houston of late.  The August Q2’16 legacy PKY call noted volume for the year of “around $200mm and this is a market that easily should be doing $2B of gross volume per year…it’s just slow…buyer and seller expectations still aren’t seemingly meeting each other…not a big pipeline of sellers that are interested in trying to test the market at this point.  And the buyer pool today is certainly thinner than it had been in the past.” 

Both companies evaluated selling the new PKY’s Houston assets.  But there were no “bids” that they viewed as sufficiently attractive.  So instead they “sold” the remaining Houston assets via the spin.  As noted by the PKY CEO on the April 29 merger call when asked about conducting a parallel process to sell the Houston assets now that the upcoming spin had been publicly announced: “Obviously if we thought it would make sense to sell them, we would have just sold them and the whole point of this is to not sell in this market…with that said…if somebody came along and gave us a value that we thought was where we think values will ultimately go, of course [we would sell them]”.  

Legacy PKY also essentially acknowledged on their Q4’15 call that they missed a good opportunity 12-18 months prior to execute a sale transaction and that pricing relating to Houston in particular would now be much tougher.  I think that legacy PKY comments predating the spin may also be instructive.  They talked about successful sales of other Houston assets prior to the spin and how they had maximized value by doing such.  (In fairness, they characterized the sold assets as more “non-core” in nature), but I think the point remains that they recognized where the market was headed, sold whatever they could, and held onto what they could not sell.  Specifically, legacy PKY alone sold 7 Houston assets for $179mm and lowered the total square footage of their Houston portfolio by 30% since the beginning of 2015.  Legacy PKY also talked on their Q4’15 call about wanting to sell Phoenix Tower during 2016 as they viewed it as lower quality than San Felipe and CityWestPlaza, but in connection with the merger, they pulled it off the market and noted that they would no longer be looking to sell it.  In sum, much of the reason for this spin was a lack of private market bids viewed as attractive.  Historically in real estate cycles, “the first sale is often the best sale.”

Leasing activity has declined as well, and you’ve seen a precipitous drop in occupancy already in the portfolio.  But we have not yet seen reported asking rents decline in the numbers supplied by the company.  I suspect it should only be a matter of time.  As noted by management on the Q4’15 call, “When [leasing] deal velocity eventually picks up in Houston, we believe it will result in a decline in average market lease rates and increased concessions.”  On the  Q2’16 legacy PKY call, they noted Houston sublease space available is at a 20 year high.  But so far, there has not been a precipitous drop in rates.  Instead, there has been a dearth of leases getting done.  This is consistent with volume leading price downward going forward.  As management stated, “…it’s going to be a few years before things get back into balance, kind of almost irrespective of what oil is.  Obviously, higher oil price will accelerate that and lower price will probably prolong that.  But ... oil spikes in one day is not going to change the fundamentals of the real estate for office in Houston in the near term.”  Management also noted on the legacy Q2’16 PKY call that they are not expecting to see positive net aborption in the Houston market till 2018.  This appears to be an acknowledgement that rents should fall in 2016, 2017, and 2018.  Especially since rents historically lag supply/demand fundamentals and since typically management teams err on the side of picking the bottom too early.

One specific example to give involves the CityWestPlace asset.  Reported in place rent for CityWestPlace for Q1’16 was $39.17 / SF.  But in talking about the large upcoming move-out of BMC on the Q4’15 call, they noted they’d previously been expecting ~$28 / SF net rates, but that going forward they “want to be ahead of the market” and “meet the market”, suggesting lower than $28 net rates.  They also noted expectations of full TI packages on the order of $5 / SF / per year of lease term at that time and noted that while free rent had disappeared in Houston during the boom, they would now expect 1 month of free rent per year of lease term.  Later, on the Q2’16 call, they noted expected TI packages could be more like $6-6.50 / SF per year of lease term, especially for a larger deal.  They also stated that given market conditions, it’s going to take longer than originally predicted to lease up the space vacated by BMC.

Much of the “bull case” for new PKY seems to revolve around the excess liquidity, “low leverage” on the order of ~4.5x EBITDA, and the ability of PKY to take advantage of a future Houston market dislocation.  However, management clearly seems to expect things to get worse for a while yet.  On the legacy PKY Q4’15 call predating the merger and spin announcement, they talked about any acquisitions or development going forward needing to be outside of Houston and of wanting to reduce exposure to Houston.  (That view has apparently changed post the spin.).  When asked on the merger call April 29 about potentially stepping in with share a repurchase immediately post spin, they demurred.  When asked about taking advantage of stressed opportunities in Houston right away, the PKY CEO on the April 29 merger call noted: “…as we view the market right now, Jed, we don’t think the timing to expand the footprint there would make some sense.  Our view … is that this year and next year will still continue to be soft…even if oil continues to recover, I don’t think the fundamentals are going to change that quickly on the ground.”

I found some additional Houston office market statistics from the PKY Q4’15 call in Feb’16 to be instructive.  The Houston market realized negative 1mm SF of net absorption in 2015 compared to positive 5.5 mm SF of net absorption in 2014.  Meanwhile, the Class A Houston office market delivered 11.6 mm SF of new office space in 2015 (of which only ~38% pre-leased), with an additional 6.7 mm SF of Class A Houston office space expected to come online in 2016.  For perspective, note that the total Houston Class A office market is 137 mm SF as of early 2016 (per the June 2016 slide deck).  So this suggests that 2015 alone represented over 9% incremental new supply at the time, and 2015+2016 combined would represent nearly 15% of incremental new supply in just two years!  Such a huge number is pretty clear evidence to me of the magnitude of the supply-demand imbalance that gave rise to such a boom in rents, NOI, and sales / SF values in the Houston market during this boom period.  I find it highly unlikely that such a boom will be “digested” in a short time and without significant declines to rents, NOI, and values / SF.

I think there are several ways to think about valuation.  First, we can think about TEV per SF on the 8.7 mm SF portfolio.  At the absolute high end of the valuation spectrum, I note that the undepreciated historical acquisition cost (plus subsequent improvements) equates to $232 / SF or $2,017mm.  This would imply a stock price 53% higher than today.  Considering that the acquisitions were all made shortly before a torrent of new supply was constructed and delivered, I believe it is safe to assume that this represents pricing far closer to peak than trough, and levels that we are unlikely to see again any time soon given the current supply/demand dynamics.  The current TEV is $1,530mm or $176 / SF.  As seen in the graph below, for many years before the boom, Class A office in Houston traded not much above $100 / SF.  A valuation of $150 / SF implies 24% downside to the stock and $125 / SF implies 48% downside.  $100 / SF implies 72% downside.  I would also suggest that valuations in the low $100s / SF range are not at all uncommon in other oversupplied office markets that are not unduly supply constrained.

Next we can think about valuation in terms of GAAP NOI.  We can start with Q2’16 LQA and sensitize to different drops in GAAP NOI that would be realized in getting to future NOI.  Again, such declines are likely to be a combination of rental rate declines and occupancy declines.  As seen in the table below, if we assume a 8.5% implied cap rate on future GAAP NOI, then the market is implicitly assuming less than a $3 / SF decline in NOI.  Declines of $5 / SF or $7 / SF imply share price declines of 27% and 49%, respectively.