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Thursday, September 20, 2012

Buying on the Cheap

The business that I think is the most interesting and exciting over the next decade is the real estate business. We have seen prices collapse over the past four years as the credit crisis unfolded. Sales have shown some signs of picking up but are still well below the historical norm. Commercial Real Estate is still suffering from high occupancy rates and many have stayed foreclosure only by perfecting the game of extend and pretend. The brokers and agents I talk to around the country tell me that outside of major markets like New York, Boston and Washington DC it is much harder to make a living. The number of agents and brokers has declined over the past four years simply because it is a much tougher way to make a living than it was in the boom.

When an industry falls apart the way real estate has the most important question you have to ask is if the business is necessary and will come back when the cycle changes. In the case of buggy whip manufacturers or beta max video cassettes the answer was no, the business was no longer necessary and would not experience another positive cycle.  When the oil industry sold off in the 90s as oil went below $20 the answer was that the industry was necessary and would see an eventual turn upwards. A lot of money was made by long term investors who got into the oil business when the conditions were poor and the outlook muted. I think this is the case for the real estate business today.

Over the past several years I have been aggressively a buyer of real estate related securities with mixed results. Some like management and investment company WP Carey (WPC) have done very well. Others like Commonwealth REIT (CWH) have not done as well in the shorter term. In my personal and client accounts we own hotels, retail malls and office buildings though REITs like Sunstone (SHO), Ashford Hospitality (AHT), Kite Realty (KRG) and others. We have exposure to the brokerage and consulting business through our stake in BGC Partners (BGCP). We also have exposure to both CRE financing and residential mortgages through stakes in Northstar (NRF) and Invesco Mortgage (IVR). I love everything about the industry and have been able to get invested when the issues were safe and cheap. Unless the world truly ends I expect to do extremely well with these positions.

When I was running my cheap stock screens this week I noticed another name I will be adding to portfolios. Brookfield Office Properties (BPO) currently sells at just 80% of tangible book value. I think this is an attractive entry point for a collection of premier properties in some of the world’s best markets. They have 122 properties totaling over 80 million square feet of office space including some of the worlds best known buildings. In New York alone they have more than 19 million square feet and almost 8 million in the strong Washington DC marketplace.

Because of their prominent position in key markets they have a 93% occupancy rate and their average tenant has an A credit ratings. If not for the semi distressed LA Market the occupancy rate would be much higher. Even in that market it is worth noting that the company as a 15% vacancy rate while the average building is 20%. The average lease still has more than 7 years until expiration so much of their cash flow is locked in for a substantial period of time. The leases that are rolling over in the next few years are priced about 20% below current rates so there is some upside potential for revenues via rent increases. In 2013 they have more than 3 million square feet of space expiring in the World financial center in Manhattan. Although many view this as a significant challenge I think it may well turn out to be an upgrade in cash flow for the company. They have had no problem leasing space in other New York properties and I think that 3 million square feet will lease up quicker than many expect.

This is a world class collection of office properties available for less than the tangible book value of the underlying real estate. The dividend yield is a little lower than I like in a REIT and just 3.6% but if world does not end the dividend will gown and the value of these properties should take the shares much high rover the next decade. At the current price I think it is safe and cheap. Investors who like the real estate business should start scaling into the stock.

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