At a time when investors are piling into real estate investment trusts because of their relatively high dividend yields, it’s hard to find many real estate stocks that I consider a bargain. However, this company has an amazing portfolio of prime real estate and an all-star management team that should produce healthy returns for long-term investors who can buy and wait. So instead of competing with the herd, I diverged and found a real estate company that pays no dividend, has limited operating history, and has yet to turn a profit — not exactly what most real estate investors are looking for these days.
Howard Hughes was created specifically to hold a disparate portfolio of real estate assets that would require a significant investment of time and money to realize their full value. Fortunately, when Howard Hughes was spun out, it was set up to succeed thanks to a solid balance sheet that holds relatively little debt for a real estate company. The businessLess than a year ago,Howard Hughes () was spun out of General Growth Properties () during the retail REIT’s bankruptcy reorganization.
This shouldn’t be a surprise since Bill Ackman, the CEO of the company’s largest financial stakeholder, Pershing Square Capital Management, played a significant role in organizing the new company as a member of General Growth Properties’ board of directors. Ackman is a well-known hedge fund manager who has recently been involved in activist positions in J.C. Penney () , Fortune Brands () , and Family Dollar () , and he now claims the position of chairman of Howard Hughes’ board. From that position, Ackman has been instrumental in handpicking management for the company, selecting seasoned developer David Weinreb as CEO, and designing an incentive program that aligned management’s interests with that of shareholders (more on that below).
Examples of Howard Hughes’ assets include:. The assetsThough the properties in Howard Hughes’ portfolio were undesirable to General Growth Properties, they would be considered prime assets by most real estate investors. That explains the laundry list of upper echelon investment houses, including Pershing Square, Brookfield Asset Management, Fairholme, and Paulson and Co., that have accumulated heavy equity and/or warrant positions in Howard Hughes.
The art of the dealWhile Howard Hughes’ portfolio is extremely diverse, the one thing that these properties have in common is that they’re extremely hard to value without a look at the company’s books and detailed knowledge of local real estate markets. However, I believe that the market is mistaken for a few reasons. Howard Hughes stock is trading hands for just 83% of the company’s book value. This suggests that the market is skeptical about the company’s ability to add value by redeveloping its properties and improve management of the operating assets.
First, many of Howard Hughes’ properties are recorded on the books for well below their obvious market value, providing a margin of safety to that 85% mentioned above. For example, Howard Hughes owns the historic South Street Seaport in New York City, which it carries on its books at $3.1 million. If you assume a 6% cap rate (the ratio of net operating income to property value), which is fairly conservative for the Manhattan real estate market, the property is worth more than $80 million. But the property generated more than $5 million in net operating income in 2010. If the property were redeveloped, it could be worth multiples of that amount. Additionally, Howard Hughes owns 20 acres of ranch land in Maui and holds 80% of the air rights over the Fashion Show on the Las Vegas strip — and carries them both on the books at a value of $0!.
Then when CFO Andy Richardson joined the company three months later, he picked up $2 million in warrants with a breakeven of $65.58 and the same lock-up period. Finally, when Howard Hughes’ CEO, David Weinreb, and president, Grant Herlitz, were hired, they had the opportunity to take a close look at the portfolio before deciding that it was prescient to invest $15 million and $2 million, respectively, of their own cash in warrants with a $48.56 breakeven, that wouldn’t vest for six years. This leads me to believe that this team of experienced real estate developers liked what they saw and believe that these assets have the potential to be worth a lot more than the $47 a share that the the stock is trading at today.
Though I’m not expecting huge gains in the near term, I think this is a great investment for someone with a five- to 10-year time frame and the patience to let management do their job. The Foolish bottom lineWhen I came across a company that owned a portfolio of trophy properties, with world-class management, selling at a significant discount to its book value, I felt like a little kid who just found a pair of Air Jordans in the bargain bin. A day after this article is published, I will be adding $1,000 worth of shares to the Total Realty Portfolio. Howard Hughes’ management team is highly incentivized and with Ackman leading the board, we can be confident that they will be motivated to create shareholder value.
At the time thisarticle was published Motley Fool Hidden Gems.
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