EQC - Equity Commonwealth: Sam Zell's Cash Box Comes With Free Offices Despite Possible RE Opportunities

2023-12-04 10:00:00 ET

Summary

• EQC is a cash box that is collecting high interest while it waits for an opportunity to deploy cash in possible forced selling opportunities in real estate.
• The book value is almost all cash and trades at a P/B below 0.9x, so cents on the dollar with their office RE coming for free.
• An opportunistic approach means there is an upside if they happen upon a buying opportunity, which becomes likelier by the day at very elevated current rates.
• The upside would be the undervaluation of any acquired asset plus the current NAV discount that cannot be justified undergirded by cash plus RE book values that are decades old.
• Interim rates preclude opportunity costs, and the only risk is a bad deal, but they'd happily liquidate instead which would base-case close the nice NAV discount. EQC is a no-brainer.

Going long Equity Commonwealth (EQC) is a dominant strategy in the current financial markets, acting both as a hedge against uncertainty thanks to its massive cash balances collecting elevated interest, being an opportunistic cash position in a leveraged market ripe with potential forced real estate sellers, and also trading for cents on the dollar, with this massive cash box trading below its net cash value in market cap by 3%, and below book value by around 12% with some remaining office properties being completely ignored by markets despite decades of being at book value. Finally, it gives retail investors a way to get exposed to the acumen of Sam Zell's long-time lieutenants to take advantage of some possible desperate sellers, with Sam Zell, unfortunately, having passed away in May 2023.

The EQC cash box will earn risklessly on its cash in a higher rate environment as an all-weather exposure as we enter into still an uncertain 2024, and could also earn supernormally in adverse economic scenarios when opportunistic real estate buying, which for years EQC has determined has not been possible hence the languishing price and longstanding war-chest, again becomes possible as some real estate portfolio owners can no longer endure the pressure of higher rates, difficult credit conditions and vacancies in subsectors of real estate like offices.

While the private real estate market still hasn't declined in line with REITs, Cohen & Steers (CNS), a major REIT ETF manager and also manager of private real estate strategies, says we're probably halfway to the bottom in private markets . With the bottom of private real estate markets probably coming in at some point in 2024, activity by the new captains at that point could cause an instant close in the book value discount that has been mounting with investor impatience, and longer term see further appreciation as the opportunistic merits of what they might pick becomes appreciated. The NAV discount really should close since their assets are so easily defined, being mostly cash and conservative book value figures from acquisitions that are decades old.

Where management's discipline can be assumed, and high rates on cash eliminate the implicit costs of lost opportunities, the only real risk is of a bad deal - but Grave Dancing prices if that's what EQC can get, tend to carry enough margin of safety to preclude that risk on average. The risk of an undisciplined and value-destructive acquisition is low as the management is completely happy with paying a liquidating distribution to shareholders if they cannot find opportunities, where a liquidating distribution should not be taxed and would also be a value catalyst as it would close the to-cash discount of 3% plus the value of the real estate assets, which have not been marked-to-market in over 20 years in some cases.

The conservative liquidation-case upside would be around 13.6% for the common stock net of preferred obligations, and the liquidation case as downside protection with no real opportunity costs lets investors be relaxed about the exact future. EQC is a perfect all-weather exposure.

As already some years have passed with no action but the Fed determined to worsen economic fundamentals which are entirely correlated to the velocity of the inflation wheel, it only becomes likelier that some solid real estate idea will come along especially as we get deeper into the downcycle pressure mounts on owners in the industry. A high conviction, safe, no-brain discount buy.

The EQC Story and Valuation

2015 was the year they made their most substantial dispositions of almost half their properties, and since then they have disposed of more than 95% of all their previous holdings , raising that capital and accumulating rent earned in the interim, paying out some of that in the form of occasional dividends, a return of capital not a return on capital, as well as some buybacks which are easily value-accretive thanks to the fact that the office properties still owned by EQC can be clearly defined as coming for free with the cash box when buying the equity.

The current portfolio is marginal, but it's worth mentioning that the occupancy rate is at around 80% in line with most office properties in the US, and the portfolio consists of some office buildings in D.C., Denver and Austin. The net value of the remaining real estate is 10% of the value of current cash and cash equivalents and the book value is $2.36 billion. The current market cap is around $2 billion as of writing. The valuation case should already be obvious given the less than 0.88x P/B, and investors should acknowledge that while quite marginal, the remaining RE assets have been on the books for at least a decade if not more in some cases, and therefore likely have market values meaningfully above book.

In this thesis, we only use book values so the resulting figures are conservative, and the low P/Bs mean we support the company's buybacks and recognise this as pure and riskless value for investors who can deal with sitting patiently for something to happen. When something happens, even if it's a unfavourable scenario of a REIT liquidation, the upside would be 12%. Value destruction can only happen with a bad acquisition. In the meantime, investors are compensated for their time with the earning cash balances, and therefore waiting is not anti-economical for EQC equity holders. If in a bull scenario, an undervalued asset is bought as opportunities hopefully become available, this just gets added on top as upside.

The book value of EQC's RE portfolio is 10% of NAV, and the upside is 12%, so the Austin, Denver and D.C. offices come for free when buying EQC.

EQC was presided over by Sam Zell until May 2023, when he regretfully passed away, leaving the company to be managed by his two long-standing lieutenants. Zell was responsible for the largest ever real estate transaction in history at one point, before an ill-fated acquisition of the Tribune Co., but was still a billionaire in the real estate investment game at the time of his death.

While he was an extraordinary investor, we don't agree that his passing will catalyse the liquidation of the REIT or somehow precludes possible performance when secular forces kick into gear. Even if it does, we note that there are no punishing tax effects of liquidation distributions, so the event of liquidation would actually close the to-cash discount and generate riskless value - again a great merit to the thesis. What is key is that the company has acknowledged front and centre that it considers liquidation a valid option if deals cannot be reasonably sourced:

Since 2014, we have used these proceeds to retire $3.0 billion of debt and preferred shares and have $2.7 billion of cash and cash equivalents and marketable securities as of December 31, 2018. The set of opportunities that we pursue in the future may include acquisitions of office as well as other property types in order to create a foundation for long-term growth. Alternatively, we may decide to sell or liquidate the Company if we believe a sale or liquidation will maximize shareholder value.

10-K 2019 Business Section

The reality is that not engaging in real estate transactions for the last several years was an excellent move that actually led to outperformance. Sam Zell went to cash over the span of a few years, the time needed in private and less liquid markets, at the tail-end of a ridiculously long-running bull market. Now that cash is king, generating substantial yields off low-risk fixed income. We don't think the talent of the management is gutted as of now, and see no reason why the company wouldn't be able to take advantage of opportunities in the market as they appear - they haven't yet for almost anyone.

Currently, all sponsor and private transaction activity is depressed (only sequential improvements in some select places with a pretty weak post-Thanksgiving season ), so there's really no surprise at all that they've been idle for some time especially with the outsized effect of LevFin markets shuttering for a year on REPE and RE funds from the compounded COVID-19 excesses to the sobering Ukraine war. Sam Zell's nickname was the Grave Dancer , it's fair to presume that it's in the company's DNA to make acquisitions when forced sellers come to market, which has yet to happen given concomitant metrics like restructuring activity and mandates still not having popped off. It would have been imprudent to make massive outlays when there was true uncertainty in the markets.

Current Financials

The current financials are very easy to explain. Their cash and cash equivalents are tracking prevailing rates. Because the rates have gone up so much, interest income has grown massively, even though distributions and buybacks have meant that cash and cash equivalents have come down by around $400 million.

The PE of this stock is around 21x annualising the 3-month data, consistent with an earnings yield of around 5%, which together with the intrinsic accretion coming from a 3% buyback yield at more than a 10% discount to book is pretty close to the prevailing Fed Funds rate. It's like a very slightly (imperceptibly so) inefficient money market fund but with that basically competitive rate you also get substantial optionality and deal-flow access that the managers can use to select a hopefully undervalued investment.

Their interest income is primary right now, currently 2x what they earn on rents, where rents now mainly just cover the fixed costs of the company. So it really is just a cash box that thanks to its REIT status means the tax burden is also very limited, and it's not really inefficient for them to continue holding that cash on behalf of shareholders on an all-weather basis.

Environment

The environment is not great for real estate. REITs in general are down substantially, driven by more exceptional declines in office REITs and other subcategories. Alexander's (ALX) is down almost 50% since before COVID-19, and that is premier office properties in NYC including the Bloomberg offices. Even housing-focused REITs in major US cities like Douglas Emmett focused on LA are getting smashed . European REITs like Merlin Properties (MRPRF) are down around 25% from pre-COVID levels . As a category, they're down ~20% overall according to Cohen & Steers.

But these are REITs, the dynamics in the private markets are a little different and appear for now more resilient, but it can be chalked up to timing effects and illiquidity and it is virtually inevitable that prices will continue to fall in line with the declines of publicly traded RE exposures. Indeed, as mentioned before, private investment activity by sponsors is totally depressed, and the slowness by sellers to expect that their assets aren't worth what they're used to is likely reflected in the slower rates of decline. Prices will equilibrate.

Cohen & Steers reports that they think that the private RE markets are already halfway to the bottom, and have been slow to allocate in their private RE strategies:

Our expectation has been that prices need to decline 25% to 30% and to generalize, we believe we're about halfway there. Needless to say, our objective is to start the non-traded REIT with a good track record, while taking advantage of an attractive investment period. In terms of our closed-end private equity opportunity fund, we continue to raise capital while waiting for private real estate prices to correct... Then as private real estate furthers its price correction, we expect buying opportunities to open up in 2024.

Joe Harvey, CEO of Cohen & Steers

The Most Important Thing

RE markets are rife with leverage and uncertain lenders, so things can get quite ugly for pressured owners. In this year's regional banking crisis, commentators pointed out that a lot of commercial property loans are with regional banks, and that deteriorating regional bank stability on top of deteriorating real estate fundamentals make a dangerous combination for the financial system.

While the bureaucracy is doing a good job of avoiding financial system distress thanks to the various measures instituted after the 2008 financial crisis, the reality is still that higher rates affecting variable rate debt, incoming refinancings across the board for corporates at higher rates for fixed debt, tougher credit conditions and lending standards, as well as worse tenant financial health, may start shaking off owners with less staying power in real estate markets as the gulley persists. Also, risks are as of yet understated with ratings changes lagging . The first big maturity wall is in 2024, then 2025, so a credit event may be looming with ratings changes catch-ups and refinancings.

While the metrics we follow in the advisory space such as restructuring revenue generally point to just a slow rise in mandates, RE is going to be more sensitive than the average sector and is likely in more distress, and we are seeing headlines already of Western markets taking big hits in real estate, with some developers going bust in Germany and with trillions of dollars in commercial real estate loans being ostensibly and in some cases concretely "troubled" . With the last leg of inflation likely to be harder to tackle than markets seem to be expecting, higher for longer is still the Fed consensus , and the time when the Fed decides to stop its tightening regime will likely be the moment when the economy is really showing evidence of pain including forced real estate selling. Opportunities will have already begun presenting themselves at that point. While the direction of inflation is slowly going down, that pain is needed for the economy to achieve inflation policy targets is more likely than not, and the soft landing narrative is still quite wishful thinking. But even if it's not, you still get the liquidation case upside and interim rates if markets don't get a chance to come down.

Since buying from a forced seller is the best thing in our world, being a forced seller is the worst . That means it's essential to arrange your affairs so you'll be able to hold on-and not sell-at the worst of times. This requires both long-term capital and strong psychological resources.

Howard Marks in The Most Important Thing

You definitely like cash in the current high-yield deposit environment where there are possibilities of forced selling, which EQC has been building long before any economic concerns have arisen.

Obvious, Asymmetric Upside

Rates will probably have to come down before we start seeing a lot of activity in real estate generally. Indeed, this is the reason why some large allocators are looking to Europe right now where rates looked to have peaked more definitively. But enough pain in real estate will likely have to be experienced first whereby sufficiently discounted deals that EQC might consider could come through before rates later come down, especially in the US, and bring allocators out of gridlock. EQC may even act before sponsors in general have the confidence to do so thanks to their large cash pile.

In the interim, the cash pile is being put to work in fixed income at rates competitive to a money market fund, and you can get access to this income-generating box for 88 cents on the dollar if you also include the book value of their remaining real estate holdings that haven't been marked to market in at least a decade and net of the aggregate liquidation preference on the preferreds. This discount is the basis on which they are doing quite substantial buybacks of shares (3% in 2023, more than 6% in 2022 based on current market cap).

It's been years of quite difficult economic conditions with no real crack in the economy yet. Something will have to give somewhere before the core inflation wheel is stopped (we've passed those easy base effects from before the Ukraine war), and action by EQC should close the immediate cash discount gap in addition to providing longer-term value if they indeed land on an undervalued opportunity. The base case upside is well defined, the downside is limited given the demonstrated discipline of management and the likelihood of margin of safety from their staying power position, and there is really only upside optionality. While a separate risk section would have been nice, there is nothing really to say except that it would be a bit boring for an equity investor just to earn a 5% rate for some years before an additional liquidation. Still a super-normal return in a liquidation scenario, just not an exciting one.

We stress that with EQC you really don't need to predict the future or have anything in particular happen for a pretty riskless upside. EQC is an obvious buy.

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