In Value Investor Insight: “The market isn’t giving the Forest City adequate credit for de-risking their strategy”
Third Avenue Real Estate Value team is featured in the May 31, 2016 issue of Value Investor Insight. The team discusses Forest City Realty Trust’s “de-risked” operating strategy, its focus on core markets, and its valuable portfolio of diverse properties. Reprinted below with permission from Value Investor Insight.
Down to Earth
Long-admired real estate developer Forest City Enterprises’ rocky navigation of the financial crisis seems to have put investors persistently on edge. Has the time finally come to forgive and forget? By Ted Crawford
Long considered a commercial real estate development powerhouse, Forest City Enterprises took it on the chin in the financial crisis, forced to raise equity at dilutive prices after overextending both its balance sheet and development pipeline. From a high above $70 in 2007, the shares fell below $3.50 in March 2009.
Now a real estate investment trust, the company has made strides in climbing back into the market’s good graces. It generates predictable cash flows from a diverse portfolio of properties in desirable markets. Higher-profile examples include The New York Times Building in Manhattan, Atlantic Center in Brooklyn, The Yards mixed-use development adjacent to Nationals Park in Washington, D.C., and a life-sciences property portfolio around the M.I.T. campus in Cambridge, MA. Business has been good: driven by expense reductions and record industry-wide occupancy levels, Forest City’s net operating income grew 10% in the first quarter.
Even better, says Jason Wolf, co-managerof the Third Avenue Real Estate Fund, Forest City has “de-risked its strategy considerably.” It has sold non-core assets and reduced net debt to EBITDA from 13x in 2011 to 9x, a ratio likely to reach 7-8x over the next year or two. The debt makeup has improved, with mostly nonrecourse fixed-rate mortgages with 4% average interest rates. Its ratio of development assets to total assets has decreased from 20% pre-crisis to around 8% today.
With a focus on core markets, Forest City is now poised for growth. Wolf’s co-manager, Ryan Dobratz, expects its funds from operations (FFO) to increase 7-8% annually, driven by improving economics at operating properties, further cost cuts and the lower-risk monetization of its pipeline that comes from building out already established developments.
THE BOTTOM LINE
The market isn’t giving the company adequate credit for having “de-risked” its strategy in
recent years, says Jason Wolf, by selling non-core assets, cutting debt and focusing on
more mature developments. Using peer cap rates on operating assets and private-market
values on development assets, he pegs the company’s net asset value in the mid-$30s.
Despite all this, Dobratz says Forest City’s shares trade at their biggest discount to net asset value (outside of the financial crisis) in 20 years. Using peer cap rates of 5.6% on operating assets and valuing development assets based on private-market transactions, he pegs the company’s NAV in the mid-$30s. The large discount and today’s wide spread of spot cap rates over Treasury-bond rates, he adds, should provide some cushion if interest rates rise.
Two catalysts could drive new demand for the stock. As tax loss carryforwards burn off, Dobratz expects the company’s dividend to grow at nearly twice the growth in FFO, attracting yield-hungry investors. In addition, in September, real estate will become its own sector in the S&P and MSCI indices. Dobratz believes this will highlight equity funds’ systematic underweighting of real estate, which he estimates, if corrected, could bring $130 billion in fresh capital to the $1 trillion U.S. equity-REIT market. “Forest City has changed so much for the better,” he says, “maybe having an expanded audience will help recognize that.”
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