By Spin-Off Insights :
Howard Hughes ( HHC ) was assembled by a group of savvy investors and spun off from General Growth Properties in 2010. They own hard assets (Master Planned Communities and other strategic assets) across the U.S. and unlike most real estate developers, execute a low-risk business model by recycling cash flow generated from land sales and operating assets into high return development opportunities within their asset base.
Valuing HHC isn't as simple as applying a multiple on Funds from Operations because their assets are still relatively under-monetized. This dynamic gives investors who are willing to do the work to calculate NAV an opportunity to own this growing business that has characteristics unique to many spin-offs at a discount.
Howard Hughes Owns Unique Assets And Executes A Low-Risk Business Model
Howard Hughes' concentrated asset base of Master Planned Communities and one-of-a-kind properties are uncommon for a publicly traded real estate company.
Owning five different Master Planned Communities (MPCs), all in different phases of maturity, allows Howard Hughes to effectively control small cities. This enables management to balance supply and mitigate risks that burden other developers. Also, they own world-class assets in supply-constrained areas with the South Street Seaport District in NYC and Ward Village in Hawaii.
When putting their entire portfolio together, they have 50 million square feet of vertical entitlement remaining, which is nearly 12 times the square feet they have developed since the spin-off. Needless to say, they have a long runway for growth within their current portfolio.
Furthermore, unlike other developers, they do not have to rely on meaningful levels of recourse debt because they execute a self-funding business model where they can use cash flow from land sales and operating assets to fund new projects. These attributes further insulate them from the economic cycle that pushes other developers to the edge.
You Won't Find HHC In A Traditional Value Screen: GAAP Accounting Conceals The True Value
HHC hides from many investors because they do not have a clean income statement that makes them show up in traditional analytical valuation screens (P/E, EV/EBITDA, P/FFO, etc). Also, book value is not an accurate indicator of HHC's economic value because their assets were marked a long time ago, which means the marks are not representative of today's market value. For example, the value of their assets increases as they mature due to increased scarcity value and HHC's efforts to continually improve the local communities.
However, if investors compare the potential future cash flow that can be generated by HHC's asset base relative to today's valuation, then they will see that a discount exists.
Aligned Management Team
In 2017, the CEO, David Weinreb, made a $50 million payment to HHC to acquire almost two million warrants. Additionally, HHC's President and CFO have also purchased warrants from the company. As a reminder, most companies just give away entire equity packages to executives but in this instance, management took money out of their pocket to align it with shareholders. The stock needs to appreciate meaningfully above the blended warrant strike price of roughly $125 per share for the management team to significantly benefit.
In total, the management team and board of directors are nicely aligned with shareholding by having a combined 22% economic interest in the company. This alignment of interest incentivizes management to focus on growing HHC's value per share .
Trades At A Discount To NAV
Many investors get intimidated trying to value HHC because typical metrics such as net income, Funds from Operations, EBITDA, etc., do not offer any help. Simply put, the current earnings of the business are drastically different than the future potential cash flow generated by their asset base.
Also, as discussed above, book value is not an accurate indicator of economic value because their assets were marked on the books a long time ago and are no longer representative of true value.
Stock market participants focused on current multiples of certain income statement metrics or book value will not see the economic value of HHC's assets and are missing this opportunity.
In order to make an estimate of HHC's net asset value (( NAV )) management provided a helpful framework at the 2017 investor day .
Within this framework, investors need to make a handful of different assumptions that can materially impact the estimated NAV range. However, a back of the napkin analysis shows that HHC currently trades at a discount to its NAV, while still leaving plenty of additional upside from future development opportunities within their MPCs.
- Undiscounted/Uninflated MPC Value.
- Management provides this metric, which is roughly calculated by multiplying the sales price by the remaining acreage
- They use the undiscounted/uninflated MPC value because the underlying assumption is that the rate of land appreciation approximates the discount rate.
- If investors did not choose to use this value and instead chose to do their own calculation, then they would need to make assumptions around the timing of land sales, the rate of land value appreciation, and discount rates.
- For our NAV calculation, we use the undiscounted/uninflated value to approximate the land value of the master planned communities.
- Operating Assets Cap Rates
- We use a 6.5% cap rate.
- This is in-line with a blend of cap rates for apartments, office, retail, industrial, and hotel.
- It could prove conservative given Howard Hughes' premier locations in capacity-constrained areas.
- Seaport District Cap Rate
- A 5% cap rate is in-line with premier real estate in New York City.
Key Project Completions Should Drive NAV Higher And Narrow The Discount
Over the next few years, they will finish a handful of important, valuable projects that will grow NOI and NAV. Historically, management's estimates of future NOI, which is presented in the supplemental information each quarter, have been reliable. Management builds up their estimate from projects that are either finished and just need to be stabilized as well as from projects under construction where they typically have leases pre-signed.
Achieving these milestones will make HHC's value more readily apparent to the market.
- ~$70 million of net operating income (NOI) from retail, office, and hotels currently under construction. This NOI should be fully stabilized within the next few years.
- ~$68 million of NOI from retail, office, and hotels that are already finished will stabilize within the next year.
- ~$50 million of NOI from the South Street Seaport project. It will be completed and fully stabilized by 2021.
- A few hundred million in cash flow by 2019 from Ae'O and Ke Kilohana condo towers in Ward Village.
Also, during this time they will continue to find additional opportunities to utilize their 50 million square feet of entitlements to develop projects and grow NOI.
They operate the business through three business segments: Master Planned Communities (NYSE: MPC ), Strategic Developments, and Operating Assets.
Master Planned Communities (MPCs)
They develop and sell residential and commercial land. Their five MPCs include The Woodlands, Bridgeland, and The Woodland Hills in Houston; Summerlin in Las Vegas; and Columbia, Maryland. MPC developments require decades of investment to build vibrant, desirable communities. As of yearend 2017, their MPCs included roughly 11,000 remaining saleable acres of land.
This segment contains 57 different income-producing assets, consisting of 13 retail, 25 office, 6 multi-family, and three hospitality properties, and 10 other operating assets and investments. The vast majority of their operating assets are located in their Master Planned Communities and include retail, office, entertainment, hospitality, and other types of assets they rent to tenants.
This segment consists of 28 development or redevelopment projects. The majority of these projects are located in their MPCs, but there are a couple of key developments outside of these areas such as the South Street Seaport development in New York City and Ward Village in Hawaii.
HHC's Reinforcing Virtuous Cycle
These three segments complement each other and create a virtuous cycle.
1) People build families and live within HHC's communities, work in their office buildings, shop at their retail destinations, and go out for entertainment at their various venues and restaurants. The conveniences and amenities within HHC's communities create demand to live in the MPCs, which HHC satisfies through selling land to home builders (MPC Segment).
2) This allows more people to move to the MPCs, which in turn creates opportunities for HHC to develop additional commercial real estate such as retail, restaurants, office, hotels, storage, etc (Strategic Developments Segment).
3) HHC rents out these commercial properties, which then become stabilized, cash flow-producing assets (Operating Assets Segment).
Then, the cycle repeats.
The additional commercial amenities and conveniences increase demand for the remaining residential land, which HHC then sells to homebuilders, which in turn drives more demand for commercial assets, thereby increasing the value of the remaining residential land. Thus, the virtuous cycle is reinforced.
HHC's Self-Funding Business Model
In stark contrast to most developers, a huge benefit of HHC's virtuous cycle business model is the ability to self-fund operations. They generate cash flow from land sales to homebuilders, which they use to invest in the development of commercial assets. Then, these commercial assets turn into a growing stream of operating income, which they can also use to reinvest in additional development projects.
It is important to note that HHC mitigates away the typical risks associated with development as they are not building on speculation and have little direct competition within their markets. Since they control the land within their communities, they only develop when there is demand for an asset. This ensures that areas do not become overdeveloped resulting in asset depreciation. Instead, the value of their assets continue to rise as the population increases and additional employers move to their cities.
A clear example of their business model in action is during the oil downturn in 2014-2016. One of their most valuable assets is The Woodlands master-planned community outside of Houston. As one of the premier centers for oil & gas in the world, Houston was significantly impacted by the downturn. The city suffered negative absorption in the office market, but during this same time period, management stated that office buildings in The Woodlands realized positive absorption. This speaks to HHC's ability to control supply and maintain the vibrancy of their communities.
Metrics To Monitor
With so many different assets and moving pieces, investors can find it difficult to track HHC's progress. However, there are only a handful of key metrics in each segment for investors to monitor.
Master Planned Communities
The key metrics are acres sold and price per acre. By monitoring these metrics, investors can understand how management is balancing the short-term cash inflows of selling land and growing the community vs. maintaining price discipline in order to maximize the long-term value of their assets.
The key metrics are new construction starts, completions, and Ward Village condo sales (96% pre-sold on 4 existing projects under construction). By monitoring these developments, investors can see how long it takes to turn raw land into a new cash-producing asset.
The key metrics to monitor are annualized net operating income (NOI) and growth in NOI. Investors can see the NOI contribution from each individual operating asset and can follow assets as they flow from strategic developments to operating assets. For 2017, NOI was roughly $157 million, up from $49 million when they were spun off from General Growth Properties in 2010.
Land development has historically been a difficult business requiring significant start-up capital and knowledge to navigate local zoning and permitting regulations. All the while, one down cycle can put a developer into bankruptcy.
HHC Is Different Than A Typical Developer
While this is true for most developers, it is not the reality for HHC. First, the significant upfront investments in their communities to put in roads, drainage, utilities, etc., have already been made. Second, they have significant control over community planning, the timing of land sales, and development schedules.
As a result, they are not dependent on finding the next big development site in a new location and committing significant capital to get the project up and going. Instead, they can thoughtfully analyze their current portfolio to determine where demand is for certain types of assets and then develop the desired assets in a low-risk process.
2010 Spin-Off from General Growth Properties (NYSE: GGP )
HHC came to be as an orphan spin-off from GGP when GGP emerged from bankruptcy back in 2010. A variety of high profile investors, including Pershing Square, were involved in the spin-off. Essentially, they selected a variety of discrete, yet highly valuable assets that were not core to GGP and formed Howard Hughes. While known in some value investing circles, to this day HHC is still an underfollowed company as it doesn't fit cleanly into any type of style box or meet the needs of many income-focused investors allocating to real estate.
The Main Risk To Consider
The health of their Real Estate Markets
Real estate is a local business so the strength of the local economies where the assets are located is very important. Therefore, they are exposed to Houston, Las Vegas, New York, Hawaii, and to a lesser extent a variety of other markets. However, this is mitigated by their diverse asset base, ability to control supply within their communities to balance demand during any periods of weakness, and the company's conservative leverage profile.
Howard Hughes is a unique real estate development company with a long runway for self-funded, attractive investment opportunities within their existing asset base. This should help manage the ups and downs of real estate cycles while rewarding the aligned management team and long-term investors.
See also Watts Water Technologies, Inc. 2018 Q2 - Results - Earnings Call Slides on seekingalpha.com