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Commonwealth REIT: throwing off cash but not building value [ClearOnMoney]
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Commonwealth REIT: throwing off cash but not building value

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Investment

Commonwealth REIT: throwing off cash but not building value

22 Apr 2011 by Jim Fickett.

I disagree with those who expect a big jump in the Commonwealth stock price. However the company is paying a 7.5% dividend, and there is no reason to think that dividend is in danger for now.

In an earlier post on Commonwealth, I mentioned John Dorfman's quick analysis, and showed this graph:

Over the 11 years from end 1999 to end 2010, total return, with dividends reinvested, was 7% CAGR. Note, though, that most of that gain was long ago, and total return has been about zero since 2004.

Dorfman argued that, “With shares selling for less than book value, I think it is a bargain.” David Sterman, a former senior analyst at Smith Barney, makes an even stronger argument:

Most importantly, the company's portfolio of buildings is worth more than $3 billion, even after accounting for the company's debt load. But investors are assigning just $1.53 billion in market value to shares, meaning this stock trades at half of book value. You don't come across that kind of discount very often.

Action to Take –> CommonWealth REIT has the most upside here – a double – simply based on the market truly reflecting the value of its assets.

Does this argument hold water? The assumption is that the price of the stock will rise to at least match book value. Neither Dorfman nor Sterman go into detail on their book value calculation. For an REIT, many people use historical (un-depreciated) property values minus debt. I have used shareholder equity, which works out to almost the same number in the case of Commonwealth. Here is the history of the stock price as a fraction of equity per share:

This history shows that Sterman's analysis is much too optimistic. The stock price usually sits at a considerable discount to equity, so there is no evidence that the stock price will double. On the other hand, the current discount to equity is greater than usual, and that suggests, at least, some margin of safety in the price.

I think Dorfman is correct that this is a good time to move into the commercial REIT market. As mentioned before, the vacancy rate appears to have peaked, and this conclusion is supported by progress in the employment situation. Commercial real estate prices are moving sideways but, as vacancies come down, they are more likely to rise than fall.

(Data from Moody's; graph courtesy of Calculated Risk; click for larger image.)

The stock is currently paying a 7.5% dividend, but there is a caveat. Management seems to be paying out, over the long haul, more than they should, and the high dividend may be at least partially offset in the long run with a weakly performing share price. The next graph shows shareholder equity, cash flow from operating activities, and dividends/distributions, all on a per-share basis.

It would appear that equity, the ability to earn money, and the ability to pay distributions are all in long-run downtrends. This is not a fatal objection, but it does suggest that the dividend is not all it appears to be.

The worst is probably over for the drop in cash flows, due to the recovering commercial real estate market, and distributions are only about half of cash flows, so there is no reason to think the current dividend is unsustainable.

One component of the company's strategy seems to me ill-conceived. They are currently making a large investment (about 15% of their portfolio) in office and industrial buildings in Australia, as an indirect play on China's growth. This is probably fine for the very long term but in my opinion both China and Australia are currently in the middle of an unsustainable boom, and I would guess the timing is not the best.

Conclusion

The dividend is obviously quite attractive. Probably the worst is over for cash flow, and the current dividend is sustainable. So the main question for the investor is the future of the stock price.

The commercial REIT space is likely to enjoy a tailwind in the next couple years, and the stock price is lower than usual relative to equity, providing some margin of safety. Both of these facts might suggest that the stock price is unlikely to fall. On the other hand, the long record of management in failing to increase value suggests that there is some risk. Further, another recession, especially if connected to a slowdown in China, would probably hit the stock price hard.

All told, I think the risk of a significant drop in price is, as long as the recovery continues, fairly low, so that the dividend make this stock attractive. I will take a 3% position on Monday, but with a cautious attitude, and probably not for the long term.

Footnote on data

All data not otherwise attributed is from the company's 10-K's, retrieved via Edgar.

In the above calculations, share prices are from the last trading day of the year, stockholder equity is also from the end of the year, and the number of shares is the weighted average for the year. When figuring total return, I conceptually reinvested all dividends declared for the year on the last day of that year, ignoring the dates on which dividends were actually paid. In two cases, then, there is a small mismatch on time, but this does not affect the conclusions.