There is more to life than money, but there is not more to investing. Starting next quarter, Gramercy Property Trust (GPT) holders will begin to get money back from our best investment idea, GPT, when they start to pay dividends. Our best investment idea is unrecognizable from where it was a year ago. Management had a big job to do and they have done it.
In GPT, we bought a net-net security for a price that was an extreme discount to its intrinsic value. My initial plan was to advocate for simply liquidating the company. I doubted that anyone would be able to improve upon such a solution to the wreckage of a non-paying REIT that had barely managed to limp out of the financial crisis. I was wrong. Few people would have tried to salvage and then grow this into a successful company. Fewer would have succeeded.
But the board of GPT made the decision to bring in a skilled management team to restore GPT to full citizenship REIT status. They hired CEO Gordon DuGan and President Ben Harris who had succeeded at this type of opportunity in the past. Gordon and Ben decided to take it on. I decided to support their efforts. Here is what happened: they did exactly what they said they would. They got rid of the extraneous assets. They grew their cash generating real estate assets and did so while paying prices, reasonable prices – most notably in a large deal with Bank of America (BAC). Oh, and one more thing:
They will pay preferred dividends next week and then common dividends next quarter. This will allow them to begin to trade on a more normal basis – with all of the trappings such as sell side coverage which will launch with favorable ratings and commentary, institutional REIT funds rising in the holders list, and a larger market cap and float allowing for more visibility and liquidity.
The original premise of this idea was that yields were low and prices were high nearly everywhere. So, where could one go to find a security that would start off without a yield but would turn into one with a yield?
The real return on government debt dips ever deeper into negative territory. High yield bonds could be sued for false advertising based on their very name. Quality, high dividend equities are fully priced. MLPs, among the best values following the Lehman collapse, have fully recovered. Where can a bargain seeker turn for yield? Oh and why should we care about yield anyway?
Looking at conventional investor behavior, it is hard to find any type of yieldy security on sale at the moment. I’d be thrilled to have someone list counterexamples in a response. However, it appears as if there are any number of foundations, endowments, advisors, and even families who are currently demanding yield at any price who are, in the process driving those yieldy securities to any price, in some cases prices that are now decoupled from value and decoupled from risk. It is a frustrating fact for someone who primarily seeks safety that when one overpays for ostensibly safe securities, they become risky securities. Unlike a few years ago when the marketplace was littered with securities that were at the time both high yield and low risk, such opportunities appear to be gone for the moment.
But why should we care? This craze for all things yieldy appears to be a bit arbitrary; a price-insensitive demand on the market to provide what it is that we as investors want for our own convenience in order to correspond with our needs as individuals and institutions. By why should the market care? Why should the market offer us opportunities where we want those opportunities to be located? In most instances, the market does not even know who we are let alone care about what we want. To say that we want to make an advantageous bet and to say where that bet is to be found is mighty demanding and probably foolhardy. So, there are not currently safe, yieldy opportunities; too bad for us. Let’s not try to see something that is not there.
Well and good to avoid a pitfall, but can we exploit this mania for gain? I suspect so. Securities with low or no yield could be cheap and securities with high yields could be expensive, but this state could last longer than I’m able to predict or tolerate. So, my solution is to find securities that are on the verge of changing teams so that I can collect the difference between the out-of-favor security that will shortly become the beneficiary of our current era’s latest fad. I want to find something that has no yield but is soon to have a high yield and will almost certainly be loved by conventional investors.
My favorite example of how to put this idea into practice is my favorite and largest individual investment for 2013: Gramercy Capital Corp., a commercial REIT with both common and preferred stock (GKK and GKK.A respectively) that is safe, cheap, and ignored. The common currently trades at about $ 2.75 and the prefs trade at about $ 30.57. The bad news (which is why they are available to buy for their current prices) is that they do not have any yield whatsoever. Dividends have been suspended because there are not currently any need to pay them under the rules governing REITs until there would otherwise be taxable gains that need to be distributed to shareholders.
Here is the good news: over the course of the next year, GKK will be able to pay off the accrued dividends to their preferred holders and turn their regular dividends back on. While no one seems to have any interest in buying this pref now, it will be in demand as a regular dividend player. Between receiving the accrued dividends and a market re-pricing, there is probably another $ 10 or so of value to be collected from this safe and cheap preferred stock.
The common stock will probably begin paying regular dividends within a year as well. This REIT survived the financial crisis, has restructured itself to thrive in the future, and will be well regarded as a sensible investment… after they turn on their dividends. The stock will probably be worth about $ 6 per share by the time that they finish the process of resuming dividends. The major risk factor to that outcome would be if a larger competitor lobs in an acquisition offer closer to $ 4 per share before then. Such an offer would be easy to justify based upon easily obtainable cost savings. While the common stock is a safe investment, the corporation’s future is still vulnerable because it is not yet sized appropriately as a standalone entity.
What can we watch for? Gramercy’s management team is in the process of trying to sell their legacy CDO business. If they are able to announce a sale at a good price before the end of 2012, that will be an auspicious sign that they are on track to complete the transformation from something that no one appears to care much about to an investment that many will want to own. Thus, Gramercy Capital Corp’s common and preferred stock top my list of best investment opportunities for 2013.
To Date, Gordon and Ben have succeeded in making this plan a reality. Here is some of the thinking behind the business.
"Growing durable dividends is the focus of our company"
- Gordon DuGan, CEO
In March, DuGan enunciated his focus on creating recurring, durable cash flow from net leased real estate to service a dividend. He has been active in net lease real estate for over a quarter of a century. This model is low risk. In terms of risk versus return, it is one of the best businesses for investors. It will offer a yield, have low volatility, and be a strong value proposition with growth. He began to build up GPT’s cash flow quickly. At the time, it was only a matter of "when not if" they would pay dividends. Now we know that steady growing dividends will begin imminently.
"A value investor in the stock market tries to buy stocks for less than their intrinsic value. We try to apply the same basic principles to the real estate market."
- Ben Harris, President
I speak with GPT management on a regular basis, but recently I asked GPT’s president if he would answer a few questions "on the record" for the benefit of anyone interested in reading about such things. Here are some of the things we discussed.
Some of the investors who took large, early positions in Gramercy around the time of the current management team’s arrival are value investors. Can the precepts of value investing – buying securities in the capital markets at a discount to their intrinsic value – that brought us to Gramercy be applied to what Gramercy does in the real estate market? If so, how and why are values hidden? Where does the price system fail to recognize and price in value?
A value investor in the stock market tries to buy stocks for less than their intrinsic value. We try to apply the same basic principles to the real estate market – that is, we try to acquire single tenant net leased real estate properties that we believe offer outsized risk-adjusted returns at a price that we believe is less than the intrinsic value of the asset. We specifically focus on industrial and office assets because we believe the heterogeneity of these assets gives a value investor the most opportunity to find opportunity.
The real estate market is like any other investment market. There are lots of different participants with different strategies, motivations, capital sources, etc. Many net lease investors follow formulaic strategies with "bright line" criteria around minimum lease term, tenant credit, location or asset type. We believe this kind of formulaic investing creates distortions that can be exploited by a savvy investor willing to do the work to understand where value exists.
For instance, certain net lease investors invest with very strict minimum lease terms and will reject a property solely because the remaining lease term is less than a minimum threshold, regardless of the quality of the asset or the likelihood of renewal. We think this is an overly simplistic rule that creates opportunities to acquire assets at attractive levels that do not meet arbitrary minimums, but have effective lease terms significantly longer than the primary term or have very compelling residual values that are not reflected in the market price. We look for assets that are difficult for a tenant to replicate due to a unique location, special zoning, unique physical attributes, below market rents or a significant tenant investment in the facility that all contribute to a higher probability of renewal. We look to exploit these opportunities to actively "manufacture" longer leases through lease extensions or renewals.
Our cross-dock truck terminal investments illustrate this strategy. Truck terminals need to be located in major transportation hubs in infill locations and are difficult to entitle due to their heavy truck traffic, low property taxes and noisy, 24-hour operations. This makes the entitling and construction of new terminals in major MSAs difficult and means that existing, functional terminals in in-fill locations tend to have high lease renewal rates and can also be re-leased quickly if vacated. We believe this gives these assets a "practical" lease term that is longer than the contracted lease term. When we buy truck terminals we also look to acquire terminals at a discount to replacement cost to add an additional layer of security because it increases the switching cost for a tenant to move to a new facility if one could be constructed. We recently acquired six highly functional cross-dock terminals in major MSA’s in a series of separate transactions with an average lease term of approximately 6 years. All are leased to national carriers, all are in in-fill locations and all were purchased at a significant discount to replacement cost. While there is always a risk that a lease may not be renewed, we saw an opportunity to assemble a portfolio of high quality truck terminals in major markets where the market wasn’t properly valuing the "stickiness" of tenants in these types of assets. We saw an opportunity to acquire a portfolio where the intrinsic value – in this case the likelihood of lease renewal – wasn’t reflected in the price of the asset.
Another relative value trade that we have been looking to exploit is the relationship between contract rents and the underlying market rents for the assets we acquire. Many net lease REITs put significant emphasis on tenant credit and lease term and comparatively less analysis of contract rents per square foot versus market rents. This strikes us as strange because many net leased assets are created in sale leaseback or build to suit transactions where rent levels are set on terms that often do not reflect the underlying market rent for similar space and can result in contract rents that diverge, sometimes significantly, from market rents for similar space in the same market. We also see this in how transactions are publicized – significant emphasis is put on lease term and tenant credit with rarely any mention of rent per foot or other traditional real estate metrics used by typical real estate investors. We believe this presents a significant opportunity (and significant risk) because we believe in today’s yield-starved environment net lease investors are showing a bias towards near term yield at the expense of long term value. We think there are great opportunities to take the opposite side of that trade – in other words, we think people are overpaying for lower quality, incrementally higher cash flows in the form of over-rented net leased assets and, conversely, undervaluing higher quality more sustainable cash flows in the form of net leased assets leased at under-market rents or assets with compelling residual values.
As an example, a FedEx (FDX) warehouse trades at a given cap rate based upon its lease term and not on whether its rents are at, above or below market. We look to acquire the FedEx warehouses in good markets where the rents are at or below market. We acquired a warehouse in the Philadelphia MSA where the lease had recently been renewed and rolled down to market levels. We could acquire this property at the same cap rate as other FedEx warehouses with contract rents well in excess of the rents that you could get from a new tenant. The difference in return will not be apparent right away – both assets pay the same yield during the primary term. Over time however, the asset with below-market rents will have a higher likelihood of renewal and will also be able to attract a new tenant at similar rent levels if the tenant doesn’t renew. This cash flow is inherently more durable and it can be acquired at for the same price as the over-rented asset.
The office building we purchased in Morristown, New Jersey, is another good example of hidden value in the underlying real estate. We acquired a Wells Fargo (WFC) branch office building at a 7.2% cap rate ($ 117 per square foot) in a wealthy suburb of New York City. The original Wells Fargo rents were established in a portfolio sale leaseback where rent was allocated on a per foot basis without any regard for market rent for individual assets. While a 7.2% cap rate seems to be in-line with other Wells Fargo assets that trade in the market, Wells Fargo is currently paying a rent that is significantly below market – we just leased the portion of the building not occupied by Wells Fargo for $ 13 per square foot NNN versus $ 6 per square foot NNN for Wells Fargo. The Wells Fargo lease runs through 2024 and has renewal options so we will not be able to monetize the value of the space right away, but over time, the intrinsic real estate value of the asset, which we believe is significantly higher than the $ 117 per square foot that we paid, will begin to be reflected.
Another area where we look for value investments is in specialized assets that fall outside traditional net lease investor parameters but offer unique utility to a tenant or an industry. These assets can offer very compelling risk-adjusted returns but may not be understood by the broader market or are out of bounds for most investors. As an example, we acquired an auto auction facility located in South Dallas and leased to KAR Auction Services (KAR) for 16 years. The property is basically a 175 acre car dealership and is used to conduct and process wholesale auto auctions. We think KAR is a great company and Dallas is one of their top markets. As an added bonus, the property is a 175 acre site with all necessary infrastructure located in close proximity to the recently constructed Union Pacific intermodal terminal making it a potentially interesting industrial redevelopment play if KAR doesn’t renew their lease at the end of the term. This asset doesn’t fit in traditional investor baskets – I am not aware of any REIT with an allocation to auto auction sites – but by approaching the asset with an open mind, and doing the work to understand the Company, the site and the redevelopment potential, we found tremendous value that could be acquired at a very attractive yield.
Here are the early returns for this idea, largely as a result of the skilled execution by DuGan and Harris:
While GPT was our best idea and largest investment for 2013, we also published a favorite short idea for the year, the Direxion Daily 20 Year Plus Treasury Bull 3x Shares (TMF), which is also pictured above. So far this year, TMF has declined in price by over a third. It also served as a hedge for GPT, declining in price in the second and third quarter while GPT struggled as a result of concerns over potentially rising interest rates.
What is next for our favorite long and short ideas? It is clear that GPT’s management took on this challenge in part to enrich themselves alongside other GPT owners. To succeed in their goals, they will need to get GPT to $ 9 per share before June 30, 2016. The figure below shows their progress toward this goal.
This progress indicates to me that they will probably succeed, either through organic growth or by eventually selling the company. There are numerous potential buyers well known to GPT’s management that are available to step in at the right moment. If GPT management executes a transaction well, they could end up with both a substantial premium for GPT owners as well as substantial jobs in the acquiring REIT.
As for TMF, it is a leveraged version of a bond – US government debt – that is low yielding junk. The debt will never be paid off. The ability to roll it over will come into question during the life of newly printed 30-year bonds. The likelihood that a real crisis is avoided is probably lower than the likelihood that GPT is unable to maintain their common and preferred dividends in the future. As Shelby Davis said in an earlier era, "bonds promoted as offering risk-free returns are now priced to deliver return-free risk." There is no safety to be found based on asset classes, only based on prices. That is why we bought GPT and that is why we shorted TMF.
Additional disclosure: Chris DeMuth, Jr. is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.