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Selling Commonwealth [ClearOnMoney]
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Investment

Selling Commonwealth

31 Dec 2011 by Jim Fickett.

I will sell my holdings in Commonwealth REIT next week. My total loss, after transaction costs and dividends, is 34%. The company is destroying value and shows little sign of having a clear strategy to rectify the situation.

It is important to distinguish between unfortunate outcomes and mistakes. In the former case, one makes the best decision one can, with the information available, yet things still turn out badly. In that case, chalk it up to a complex world, and move on. In the latter case, emotions get in the way, and one makes poor use of the information available. In that case, one must learn from the experience. With Commonwealth I made a mistake, mostly because I was impatient to add an REIT to the portfolio.

The main reason I'm selling is that Commonwealth is not a good business – they are destroying rather than creating value (Negative free cash flow at Commonwealth). There were warning signs of this in my original analysis, and I should have taken them more seriously.

Sometimes poor results in one period are laying a foundation for better results later. What is the overall strategy of Commonwealth? There is nothing of substance to answer this question in the annual reports (another warning sign). The following statement in the Q3 earnings conference call is the clearest strategic statement I can find.

As most of you know from the last couple of years, we have been aggressively trying to reposition CommonWealth’s portfolio at a high-value CBD [Central Business District] office properties. Since the beginning of 2008, CommonWealth has acquired $3.1 billion worth of properties and the majority of these acquisitions have been CBD office properties. We have partially funded these acquisitions with the sale of $1.4 billion of largely suburban office properties and remainder of these acquisitions have been funded through a combination of both debt and equity financings.

In the third quarter of 2011, our business strategy is starting to show real results. This is the first quarter where the largest percentage of our consolidated NOI [net operating income] came from CBD office building, representing 41% of consolidated NOI during third quarter. Also this is the second quarter in a row where our CBD office portfolio was the only operating segment which generated positive same-store NOI growth with 5.7% growth in same-store NOI in the third quarter.

However during the quarter, our pace of acquisitions has slowed considerably, we have increased our sales activities. Since the time we reported second quarter results, we have sold 13 suburban properties with approximately 1.3 million square feet for an aggregate sale price of $167 million. We also currently have under agreement to sell 16 industrial properties located in Dearborn Michigan, and think to buy 570,000 square feet for $6.5 million. …

Well, generally the CBD is stuff is a longer or more expensive, but we are getting more and we are better – we are getting better net effectives. I mean look, the short answer is that in the suburban markets is you don’t have – it’s not landlords market and we have to work a lot harder to get tenants and returns on those deals are much skinner, especially when you’re looking at large square footage tenants in suburban markets. They have enormous amount of – I guess, they have enormous amount of options.

So Commonwealth is in the midst of trying to shift the portfolio of properties from suburban to central. There is little evidence that this is clearly thought through. Maybe it is, but I'm suspicious that Commonwealth is panicking in the face of the downturn, and trying to move to properties that hold up better in bad times. Whether they have really considered the full cycle or not, it does seem that their timing is rather bad – they starting buying premium buildings in 2008, before prices had really fallen much, and are selling suburban buildings now, when prices are still near the bottom.

So, unfortunately, I see little evidence of a clear strategy, and no evidence that the trend of value destruction will reverse.

The stock is now so low that the former, fairly reasonable payout has become a 12% dividend. In some ways, then, it seems a poor time to sell. Nevertheless, staying in is a pure gamble.

The recent steep fall in the price came after a recommendation from Stifel Nicolaus to sell. That recommendation was probably prompted by a series of dilutive stock offerings. Here is an exchange between Stifel and Commonwealth from the Q2 conference call:

John Guinee – Stifel

… Two questions, how should we factor in your next equity offering or your next preferred offering, and how should we rationalize if these things continue to be diluted?

Adam Portnoy [Commonwealth President and Managing Trustee]

… acquisitions are going to slow down greatly because at some point, as you pointed out, I don’t want to just keep issuing equity this dilutive. I know that’s not what I’m – that’s not what I continue to do, it’s not what I want to do, I don’t think it helps, it’s very painful to do. …

John Guinee – Stifel

And are all these republic and presidential candidates are signing no tax increase pledges, will you sign a no dilutive equity offering pledge?

Adam Portnoy

No, John, I won’t but…

John Guinee – Stifel

It pops up.

Adam Portnoy

… I can’t give dilutive equity deals continuously, I know that. If I do that, it will just – it will destroy shareholder value.

So further dilutive equity offerings are quite possible and could cause the price to fall further.

The high dividend is key to the current attractiveness of the stock. Will it last? Commonwealth is required, in order to retain REIT status, to pay out 90% of REIT taxable income. I estimate 2010 REIT taxable income (net income with capital gains and losses, as well as non-cash items, excluded) as $37 million. The 2010 dividend payout was $126 million. So it is entirely possible that the dividend could shrink considerably, which might also cause the stock price to fall.

Although it is no fun to crystallize a loss, it is time to walk away from the gambling table.

I would still like to have a significant REIT component in the portfolio, and will be looking for a higher quality holding.