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The liquidation value of Commonwealth REIT is well above the market price [ClearOnMoney]
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The liquidation value of Commonwealth REIT is well above the market price

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Commentary

The liquidation value of Commonwealth REIT is well above the market price

17 Dec 2011 by Jim Fickett.

The liquidation value of Commonwealth is probably at least twice the current stock price. This is based on an estimate that the property portfolio is worth at least 75% of what was paid for it, which in turn is based on a comparison of when property was acquired with a general commercial real estate price history. The high liquidation value does not necessarily mean the stock price will rise, but it does mean that the current very high dividend (about 12%) is affordable for a long time, should management choose to continue it.

There is a good high-level overview of calculating the liquidation value of a company in Graham and Dodd's Security Analysis. The main idea is to take liabilities at face value and assets at some discount, with the most liquid assets getting the most optimistic valuation. In just a little more detail, Graham and Dodd recommend taking cash and marketable securities at 100% of market value, receivables at an average of about 80% of book value, inventory at an average of 67%, and plant and equipment at an average of 20%.

Valuation of Commonwealth

That is for a generic company. The main question in valuing an REIT is what price to put on the property. Since most of the properties could probably be sold fairly readily and would produce income immediately for a new owner, they should be priced at roughly current market value. Below I attempt to get a very rough idea of market value by looking at the business cycle variation in commercial real estate pricing. A smaller question on pricing the properties is how to treat depreciation. Book value usually treats property with a 40-year straight-line depreciation. But this ignores that inflation tends to raise prices, and it also ignores renovation, on which Commonwealth, at least, spends a good deal. I assume that renovation and inflation roughly balance depreciation, and leave all three out of the calculation.

Here is a recent graph, from Calculated Risk, of CRE prices over the last decade.

And here is a table of Commonwealth's property purchases and sales over the same period, in millions of dollars, from the annual reports:

Year Purchases Sales Net purchases
2001 26 11 15
2002 444 1 443
2003 799 0 799
2004 825 0 825
2005 476 20 456
2006 457 11 446
2007 307 4 303
2008 394 347 47
2009 615 215 400
2010 870 616 254

Clearly, looking at the last 10 years, much of the property was bought when prices were higher than currently. Taking a weighted average suggests that property bought from 2001 to 2010 is now worth roughly 85% of the purchase price. This is indeed a very rough estimate, and these data cover only the most recent 10 years, not further back. To be on the safe side, I value property at 75% of purchase.

Here, then, is the liquidation value estimate (as of end-2010).

Assets

  • Cash at 100%, $0.20bn
  • Rent receivables, net of doubtful, at 80%, $0.15bn
  • Equities at market value, $0.17bn
  • Acquired leases, at 80%, $0.18bn
  • Properties, including those held for sale, at 75% of purchase price, $4.85bn
  • Other assets (small number) ignored

Liabilities: $3.46bn total.

Assets - liabilities = $2.09bn. At the end of 2010 there were 56 million shares outstanding, giving a value of $37/share. The share price ended Friday at about $17.

Consequences

A stock can have a market value much less than the liquidation value for a long time, as long as neither shareholders nor a takeover force change. So the fact that the liquidation value is apparently much higher than the current market price does not necessarily mean the share price will rise.

It does, however, indicate that there are considerably better assets backing the stock than might be immediately apparent, and that is important information when considering the dividend – currently $2 per share per year, a 12% yield.

First, if the stock price reflected net assets, a 12% dividend would clearly be unrealistic, but if net assets are really at least double what is indicated by the stock price, then the dividend might be in the right neighborhood of what can be supported by genuine income.

Second, with perhaps $37 in net assets backing each share, a dividend of $2 per share is affordable for a long time, no matter what income really is. There is no guarantee that management will continue to pay a high dividend, but the above analysis shows that such a choice is at least available.