Hudson Pacific Properties Is A Fair Location To Park Cash
February 2, 2017

Investment Thesis

The margin of safety is minimal, but given the high valuation of other office REITs, Hudson Pacific Properties (HPP) is a fair location to park cash. Management is cost conscious and, to date, has been bringing greater value compared to cost of the shareholder dilution.

Introduction

Office REITs are trading at a dear valuation. Over 90% of the office companies that compose the NAREIT index are trading at higher multiples than book value. And to purchase a position in an office REIT, at the current average multiple of 15 times the funds from operations, would leave thin room for error and should serve as a reminder of the past. Since the '80s, the only time REITs traded at a multiple higher than 15 times was in 2006-2007. The exorbitant market price is not due to a stellar performance. In total, office REITs' average return on equity was 10% in the past two years.

Risk is looming. First, oversupply is apparent in major metropolitan markets. In Washington, DC, there is twice the development activity and available office space than demand, reports JLL, a real estate brokerage firm. Second, future monetary pressures (read: inflation) may increase the interest rate environment, squeezing profits. Third, competition from shared-office companies, such as WeWork and Mindspace, continues to challenge the traditional business model.

Yet the investing public seemingly ignores any future warnings. "The biggest trend for commercial real estate in 2017 - and beyond - is the ongoing technological disruption of the industry. E-commerce is taking roughly 50% of the growth in overall retail sales, which is eroding the underlying value of retail real estate," notes David Shulman, an economist. "On the office side, square footage per employee continues to come down, creating latent vacancies in its wake, and hoteliers have to deal with the fact that Airbnb is here to stay."

The exorbitant prices are apparent in large, small and mid-size office REITs. Boston Properties (NYSE:BXP), with $16 billion in real estate assets and $918 million in funds from operations, traded at 2 times the book value and had a multiple of 21 times the funds from operations. Smaller REITs, such as First Potomac Realty (NYSE:FPO), with little over a billion in real estate assets and $55 million in funds from operations, traded at 1.5 times the book value, with a multiple of 18 times the funds from operations. Midsize companies, such as Equity Commonwealth (NYSE:EQC), with $3 billion in assets and $200 million in funds from operations, traded at par the book value and 18 times the funds from operations.

What can be done? For the passive investor to purchase an index fund, one such as the iShares U.S. Real Estate ETF (NYSEARCA:IYR), would be sensible. The office asset class represented 10% of the index composition, so, perhaps, opportunities would unfold in other asset classes such as medical office buildings or data centers. For the active investor, catalyzed by a low interest rate environment and a 7-year increase in market value, continued development of office properties could be the right course of action. But your correspondent has chosen to focus the attention on a single office company, Hudson Pacific Properties.

Position

Executive Summary

Management: Victor J. Coleman, boss of Hudson, knows a thing or two about selling at the right time. In 2006, he sold his former company, Arden Realty, Inc., to GE Real Estate at a $5 billion valuation. It is rumored that he pocketed over $20 million from the deal. And if true, then Hudson is run by an individual who could golf and relax, but has chosen to do otherwise. It is a rare quality that often spreads throughout the company and management team. Also, whether or not the 2006 sale was sheer luck, timing the market is a quality that often sticks.

Real Estate: Gross real estate per share (excludes depreciation) increased to $67 from $36 a share. Hudson owns 54 office properties and 2 media properties, totaling 14.9 million square feet. The weighted average lease term is 4.9 years, and the weighted base rent is $38.84 per year. Tech companies such as Google (GOOGL), Square (SQ) and Cisco (CSCO) represent 36% of the annual base rent. The real estate portfolio occupancy rate is over 90%. Hudson has 886 leases, of which 70% represent leases of 10,000 square feet or less.

Liabilities: Liabilities increased to $29 from $15 a share over the past 5 years. Hudson modestly leverages its real estate portfolio. It has $1.55 billion in unsecured loans and $723 million in mortgages, and only 8 properties carry mortgages. In 2015 the company redeemed 5.8 million of preferred shares that carried an interest rate of 8.375%. Proceeds of $147.3 million from an unsecured line of credit were used to retire the preferred shares. More important than the annual savings of $5 million, the preferred shares redemption demonstrates a cost-conscious management.

Income Statement: Revenue increased to $5.9 from $3.77 a share, while operating expenses per share remained at $2.65. Operating expenses include expenses from the operations of the office and media buildings, and general and administration expenses. Funds from operations increased from $1.07 to $2.13 per share, and net operating income, a performance measure which does include the interest expense, increased to $3.85 from $2.35 a share. Rental income from office properties represented 88% of total revenue.

Cash flow: Hudson invested in over $3 billion of real estate properties over the last 5 years. And, typical to a real estate investment trust, the investing activity was financed by issuing debt. In 2015, the company invested in $1.8 billion of properties and issued notes payable for $1.65 billion. And operating cash flow increased to $2.03 from $1.09.

Valuation: Peer companies, such as Equity Commonwealth, Gramercy Property Trust (NYSE:GPT), Columbia Property Trust (NYSE:CXP), Piedmont Office Realty Trust (NYSE:PDM) and Brandywine Realty Trust (NYSE:BDN), traded at 1.13 times the book value in 2015 in line with Hudson's market valuation of 1.13 times book value. The company's 5-year average price to funds from operations ratio was 17 times, and the company traded at 15 times in 2015. Premium to net asset ratio was 1.88 times.

Risk: Given the high occupancy rate, further growth in funds from operations will be dependent on property development and acquisition. These endeavors are often risky compared to purchasing and stabilizing a portfolio of real estate. And risky endeavors often command a steep shareholder dilution. Because the margin of safety (the difference between the cost and value) is barely visible, a share price decline, or a minimal share price increase, is likely.

Analytics

Solvency: measures the percentage of total assets financed with debt. The higher the ratio the higher the financial risk. A troubling ratio would be above 65%. Leverage is defined as line of credits plus mortgage divided by gross real estate.

Profitability: reflects a company's competitive position in the market, and by extension, the quality of its management. Operating margin is rental income minus operating expenses divided by rental income. FFO margin is funds from operations divided by revenue. The lower the amount, the higher the difference between revenue and FFO.

Valuation: relates the share price to the earnings measure such as funds from operations. All calculations are divided by the number of shares outstanding. Cap rate is defined as net operating income divided by share price. Price to book value is share price divided by total assets minus total liabilities.

Peer Group: Includes: Equity Commonwealth , Gramercy Property Trust , Columbia Property Trust , Piedmont Office Realty Trust and Brandywine Realty Trust .

Figure 1: HPP Share Price

Figure 2: Total Return Comparison

Figure 3: Property Distribution

Figure 4: Trading Statistic

Conclusion

Hudson Pacific Properties should grab your attention. Over the past 5 years, real estate per share increased to $67 from $36, while liabilities per share increased to $29 from $15. Its income statement entails a similar tale. Revenue increased to $5.90 from $3.77, while operating expenses remained at $2.65. Given the alternatives, a share in Hudson may be a reasonable location to park cash.

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