Imperial Government

As real estate securities analysts, most of the things we do have some basis in being knowable. For example, we analyze business plans, visit assets, build models, talk to tenants and reach conclusions about a company’s portfolio, prospects, management and stock valuation. While none of this is completely knowable, it’s partly knowable.

In the last 10 years, however, under the current administration, there has been a very concerning trend of government agencies reaching into the real estate business, often with politically motivated goals. This has introduced an aspect into the business that is less predictable. Some instances are effectively zoning or permitting processes where, if the applicant (usually a company) has followed the rules, they ultimately get building permits or the equivalent thereof. Other instances are not so simple. There are dozens of examples we could talk about, but one in particular raises such concern that it bears discussion.

Some of the portfolios we manage own shares in a company that is developing the Cadiz Valley Water Conservation, Recovery and Storage Project (project description). For readers not in California, the State has an environmental review and vetting system – The California Environmental Quality Act, or CEQA for short. It is the result of decades of legislative efforts; it is costly, complicated, slow-moving and open to the public. It has its failings, but it is an established legal framework under which all the parties to the process operate.

At 30,000 feet, CEQA requires large real estate infrastructure projects to create an Environmental Impact Report (“EIR”) (CEQA process flow chart). For the Cadiz project and many others, these reviews are multi-year and multi-million dollar undertakings. They also provide fodder for the environmental plaintiffs industry, which sues project participants on many approved EIRs. Imagine putting together a 3,000 page review of anything, and environmental lawyers can probably find a potential nit.

What happens in practice is large projects like Cadiz are sponsored by government agencies, in this case the Santa Margarita Water District and the County of San Bernardino, so the defendants in these environmental lawsuits are generally government agencies.

The process is generally something like the following:

  • Hire qualified, independent scientists and consultants to establish the project impacts under applicable local and federal law;
  • Design or redesign the project to mitigate these environmental impacts;
  • Create a 3,000 page document that covers any real, imagined or perceived environmental impact that your project may create;
  • Pull this together into a draft copy and publish it for comment for 90 days; during the comment period, hold open meetings for citizens, project participants and other concerned people to address the lead agency (in this case the water district) face-to-face; and
  • Collect all the feedback, consider reasonable commentary, incorporate plan design changes to address these reasonable concerns and put out a final copy of the EIR.

A scheduled vote is then held and a branch of the California government approves or rejects the project. This effort, start to finish, is typically two-to-five years, although in many cases it is much longer. In the case of Cadiz the vote was in 2012 and the project was unanimously approved. In the immediate time period after the approval, the environmental legal industry geared up and sued. No matter that a branch of the California government approved it. There were six challenges, all of which were dismissed in an Orange County court in 2014. (Judge Andler’s dismissals)

As expected, the losing plaintiffs appealed, as there is no material cost to do so and part of the effort may be focused on delay. In the Cadiz case, that appeal was heard on March 23rd and we believe the plaintiffs’ appeals will be dismissed.

At a high level, this should concern any right thinking person, as we start with a two-to-five year EIR process and add at least two-to-three years of litigation. So in California, any project of meaningful scale has a six-year approval process. We would imagine that if we had this conversation with Texas Governor Rick Perry, he would say that’s just great and remind us that Toyota is moving from California to Dallas.

Having said all this, at least the process is final, right? You get a certified EIR and off you go. Technically yes, but in the case of the Cadiz project, no. The Bureau of Land Management (“BLM,” a federal agency) is actively working to interfere with a state-approved project.

There are two particularly troubling aspects to this. For a California project like this, CEQA is law, plain and simple. The reason California has CEQA is to provide a slow-moving, open vetting process; not to engender backroom politics by other, including federal, agencies.

To transport water from the CEQA-approved project, the project sponsors (Cadiz and the various water agencies) are proposing to build a pipeline in an existing railroad right-of-way. Of course, the pipeline is covered in detail in the approved EIR. According to members of Congress and the U.S. Senate, the BLM is attempting to reinterpret 140 years of non-controversial railroad right-of-way law initially put in place by Congress in 1875. (1875 act) In short, this law allows railroads to lease space to other commercial users along their right-of-way (typically 100 feet of surface and subsurface on either side of the rail line). Historically, the railroads had the right to do this as long as it did not interfere with rail operations. More recently, the Solicitor General of the Department of the Interior issued a document called the “M 37025 Opinion,” which provides: “A railroad’s authority to undertake or authorize activities within an 1875 Act ROW is limited to those activities that derive from or further a railroad purpose” (M 37025 Opinion). This is the legal standard and allows railroads to lease space to all sorts of commercial users. The example provided in the M 37025 Opinion is MCI’s fiber line, which was clearly built for commercial purposes, but allows as a railroad benefit some of the fiber capacity for the railroad’s use. Cumulatively there are easily more than twenty thousand miles of railroad rights-of-way in the western United States. It is estimated by Congress that there are 3,500 existing utility uses on railroad rights-of-way over federal lands, which Cadiz believes are similar to its proposed pipeline.

So Cadiz, the Arizona and California Railroad, and the Santa Margarita Water District submitted a proposal that had more than a handful of attributes (e.g., water conveyance pipeline, fire suppression system, access road, power line and supported facilities, and a steam-based excursion train) they felt should qualify as “further[ing] a railroad purpose”. In particular, the railroad along this route features crossings constructed of creosote-soaked wooden trestles, which are flammable. Trestle fires are common. Hence, the pipeline is designed with automated fire suppression equipment to assist the railroad in preventing or containing fires.

In our opinion, it is reasonable to conclude that automated fire suppression is preferable to having railroad employees hop in a truck, race miles to the fire and throw sand on it. Yet the BLM argued in their non-binding letter of response that since the traditional method was the throwing of sand, adding automated fire suppression would not “further in part, railroad use.” (BLM letter) The BLM director that made this statement has since left the California office of the BLM.

Congressional reaction has been swift in condemning this (Congress letter to BLM). Nine Congressmembers, both Democrats and Republicans, have co-authored a letter to the BLM Director saying that the ruling is contrary to the M 37025 Opinion. Congressmen Tom McClintock and Tony Cárdenas in particular have met with the head of the BLM in Washington in person to convey the same opinion. Senator Orrin Hatch is also on record as being “deeply disturbed” by the actions of the BLM.

What is particularly troublesome to members of Congress is that the BLM’s action has clouded the title of all existing uses within railroad rights-of-way. The discretion applied by BLM to reject the opinion of the railroad that the Cadiz project furthers railroad purposes means that BLM, not the railroad, will be the arbiter of the question. This diverges from the M 37025 Opinion where the railroad’s opinion formed the basis of the determination that the fiber optic cable was providing a communication railroad benefit.

Consequently, in addition to the initial backlash from the legislative branch as to the Cadiz project, the issue is being subsumed within a larger cause that has enlisted many members of Congress in an effort to explore every available legislative and administrative means to clarify the scope of railroad rights-of-way.

The problem goes beyond the railroads themselves. Hundreds of millions, if not billions of dollars have changed hands in consideration for the use of these rights-of-way. How would the BLM propose to unwind those transactions if the railroads did not have the authority to lease in the first instance? How will projects be financed in the future? The impact of the BLM’s action effectively is that now every potential use of a railroad right-of-way will have to secure sign-off from the BLM before it may be financed to remove the cloud. But now even if the BLM were to sign-off, its decision would be subject to second guessing by parties in the Courts. The issue seems ripe for action by Congress.

The Cadiz project itself has widespread approval, with at least 30 politicians in favor as well as dozens of community leaders (support for project). As far as we can tell, the only current political opposition is from Senator Feinstein (whose office made no comments and asked no questions of either the Santa Margarita Water District or San Bernardino County, the parties reviewing the Project under CEQA). She has recently indicated her opposition was based on her belief that the project would damage the environment. Since the EIR is approved under California law and indicates the opposite, we fail to see how her opposition has any merit.

Ultimately we believe the project will be approved, hence our investment, but this federal process is adding time and has strained our faith in the operation of the federal government.


Disclosure:

This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities. Views are as of April 13, 2016 and are subject to change at any time based on market and other conditions. The author’s assessment and opinions of a particular company, security, and/or other information discussed in this article is not intended as research or advice. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance or results. The securities and companies discussed are for illustrative purposes only and do not represent all of the securities purchased, sold or recommended for advisory clients. The reader should not assume that any securities discussed were or will be profitable. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement, including forward-looking statements, to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes.

This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially. The following factors, among others, could cause actual results to differ from those implied by the forward-looking statements in this presentation: changes in general economic conditions; political factors; changes in specific markets; legislative/regulatory/policy changes (including, but not limited to, environmental laws/regulations/policies and laws/regulations/policies relating to railroads, rights-of-way, land management, and real estate); and changes in generally accepted accounting principles. While forward-looking statements reflect AACA’s good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance.

A Tale of Two Stocks

A tale of two stocks and a tale of two investors that, we believe, demonstrate the sometimes illogical nature of perceptions and how those perceptions can drive valuation.

The stocks are BioMed Realty Trust (BMR) and Alexandria Real Estate Equities (ARE). They are the only two public companies currently focused on ownership of lab/life science space in the US. For the last two decades, they have had a duopoly in this real estate sector. Alexandria effectively gave birth to the industry in 1994, and BioMed’s executives (who were former Alexandria executives) later followed suit. For many institutional investors they were interchangeable, although, as one would expect, both companies would be keen to point out differences and advantages. While lab/life science is a niche, it is a relatively sizable one. BioMed, at the time of its purchase by Blackstone in January 2016, was valued at $8 billion and Alexandria is currently valued at about $10 billion.

The two investors in our tale are: the stock market at large and Blackstone; and the crux of the story essentially revolves around valuation perception of these two.

Blackstone purchased BioMed and the deal closed at the end of January this year (the deal was announced October 8, 2015). They paid $23.75/share, which was 103.6% of the last consensus estimate of net asset value (NAV) published by SNL Financial. The characteristics of the companies are duopolistic with a limited supply of new space, cluster markets (all US inventory of this type of space is in six markets), barriers to tenants moving out, and secular demand drivers. So Blackstone’s calculation that it was worthwhile to pay a slight premium for BioMed to enter the business was very logical, in our opinion.

Blackstone is currently among the largest buyers of real estate in the US, and, based on our experience (they purchased Excel Trust, a public shopping center company with whom I served as an independent director), we believe Blackstone is both sophisticated and thoughtful, thinks for the long-term, and is not prone to overreaction.

Flash forward to February 29, 2016 (the time of this writing) from last October when the BioMed deal was announced. As shown in the chart below, the remaining public company, Alexandria, is now trading at 76% of consensus NAV, which is approximately 1.6 standard deviations cheap. The market price of the shares have tracked closer to NAV more than 95% of the time over the last 10 years (the average valuation over the last 10 years—including the Great Recession—is 97% of NAV). Also, if we remove the Great Recession, the shares have never traded this cheaply. So Blackstone thought Biomed was worth 104% of NAV but the stock market thinks Alexandria was worth 76% of NAV. Between the two companies, in our opinion, Alexandria has the better portfolio as evidenced by the fact that Alexandria’s average same-store net operating income growth has been about 33% greater per year than BioMed’s for the past 10 years of reported data (40 quarters Q4-2005 to Q3-2015; the average annual same-store net operating income growth for ARE was 5.39% and BioMed was 4.06%). This makes no sense to us that Alexandria would trade about 28% cheaper than BioMed.

The public markets seem to have become caught up in a hailstorm of short-term, confusing and frequently false data reads. China, the Fed, interest rates, et cetera, have caused a significant disconnect in public market perception. Given the discrepancies between what Blackstone thinks about value and what the market seems to think, we think Blackstone is more likely correct.

ARE Market Price/Estimated NAV per Share
February 28, 2006 – February 29, 2016

In the last 10 years, 95% of the time, shares have traded above Feb 29th’s price to net asset value.

chart_areprice-estimatednavpershare_031516

 

Data prepared by AACA, compiled from SNL Financial

 

This material is for information purposes only and its content should not be relied upon in making any investment decisions. The information provided is not a complete analysis of the market, industry, sector, or securities discussed. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes.

 The author’s assessment of a particular security is not intended as research. This commentary and the information contained herein is not, and does not constitute, directly or indirectly, a public or retail offer to buy or sell, or a public or retail solicitation of an offer to buy or sell, any fund, units or shares of any fund, security or other instrument, or to participate in any investment strategy. All data in this document, including that used to compile performance, is obtained from sources believed to be reliable but is unaudited and not guaranteed as to accuracy. The performance data cited represents past performance, which does not guarantee future results. The securities discussed are for illustrative purposes only and do not represent all of the securities purchased, sold or recommended for advisory clients. The reader should not assume that any securities discussed were or will be profitable.

Burl East on a Special Edition of STA Money Hour

Burl East, CFA, Chief Executive Officer of American Assets Capital Advisers, was interviewed on a special edition of STA Money Hour by Michael Smith and Luke Patterson. Mr. East talks about the current outlook on real estate in general and where AACA sees value and risks. Mr. East also talks about his current “long-short” real estate securities fund that he subadvises for Altegris Advisors, LLC. If you are interested in real estate as an investment, this interview will be well worth your time.

 

Click here to listen now.

 

Buy the (P/NAV) Dip

Net asset value (“NAV”) is one of the core valuation metrics for real estate investment trusts (“REITs”). The metric aims to determine the inherent value of a REIT by assigning approximate liquidation values to the underlying real estate. To do so, investors must derive a series of go forward expectations such as net operating income (NOI) and cap rate assumptions to estimate a current market value of the underlying real estate.

As one may expect, general bouts of market volatility allow for share prices of publically traded REITs to deviate from their underlying net asset value. Thus, REIT shares typically trade at either a premium or discount price to net assets value (“P/NAV”). Generally, whenever REITs are trading at an elevated premium P/NAV, we expect lower go forward rates of return; and whenever REITs are trading at a deep discount P/NAV, we expect go forward rates of return to be higher. Fluctuations in P/NAV can create opportunity when REITs are trading at a premium to consider reducing positions or consider incorporating hedges, particularly in those REITs that are poorly positioned in their respective markets. Additionally, as evidenced by the recent pick up in announced REIT M&A activity, P/NAV discounts can grant opportunity to a variety of external buyers. These opportunistic buyers can generate a profit by selling off individual assets in the private market at an amount greater than the price they paid for the company in the public market. Hence, all else being equal, we believe it to be prudent to invest in REITs when they are trading at a discount P/NAV.

The SNL US Equity REIT Index (“REIT Index”) P/NAV has historically been somewhat mean-reverting with share price trading within a band of the underlying NAV. Looking at the “post-financial crisis” time period (trailing five years, 4/30/10 to 3/31/15), the mean P/NAV of the REIT index over this period was a 6.3% premium. As of the most recent month end (9/30/15), The REIT index was trading at an 8.5% discount to NAV (about 14.8% below the REIT index’s mean P/NAV for the trailing 5-year period studied).

In the study time period, when the REIT Index was trading at a discount P/NAV, the forward six-month returns of the REIT Index were positive 100% of the time. When the REIT index was trading at a premium P/NAV, the forward six-month returns of the REIT Index were positive 73% of the time during the study time period. Negative forward six-month returns of the REIT Index during that period only occurred when the REIT Index had been trading at a premium P/NAV.

PNAVchart

As of the most recent month end (9/30/15), the REIT Index was trading at an 8.5% discount P/NAV, which we believe may suggest a positive forward six-month return.

PNAVchart2


Disclosure:

This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities. The performance data featured in this document represents past performance, which is no guarantee of future results. Views are as of the dates indicated and are subject to change at any time based on market and other conditions. All data in this document, including that used to compile performance, is obtained from sources believed to be reliable but is not guaranteed. Data is unaudited. This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially. 

The following factors, among others, could cause actual results to differ from those implied by the forward-looking statements in this presentation: changes in general economic conditions; changes in specific real estate markets; legislative/regulatory changes (including changes to laws governing the taxation of real estate); and changes in generally accepted accounting principles, including policies and guidelines applicable to real estate funds. While forward-looking statements reflect American Assets Capital Advisers, LLC’s (“AACA”) good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance. Furthermore, AACA disclaims any obligation to publicly update or revise any forward-looking statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes.

The SNL US Equity REIT Index. The SNL US Equity REIT Index (“REIT Index”) is an index comprised of all the publically traded US equity REITs and is considered to be generally representative of the US real estate market as a whole. Results for the REIT Index include dividends and the reinvestment of all income and are presented gross of fees. At times, the volatility of your investment may be greater than the volatility of the REIT Index. Unlike the REIT Index, your investment may be actively managed.

Burl East on a Special Edition of STA Money Hour

Burl East, CFA, Chief Executive Officer of American Assets Capital Advisers, was interviewed on a special edition of STA Money Hour by Michael Smith and Luke Patterson. Mr. East talks about the current outlook on real estate in general and where AACA sees value and risks. Mr. East also talks about his current “long-short” real estate securities fund that he subadvises for Altegris Advisors, LLC. If you are interested in real estate as an investment, this interview will be well worth your time.

 

Click here to listen now.

 

White Papers: Portfolio Management

A look at how REIT exposure may enhance risk adjusted portfolio returns.

Over the years we have had countless conversations with investors regarding their exposure to public real estate, primarily if, and how much to allocate. The purpose of this whitepaper is to frame the question within the rigor of the Markowitz Mean Variance Efficiency Frontier, the basis for Modern Portfolio Theory (“MPT”), for which Harry Markowitz was awarded the Nobel Prize in 1990. Derived from nearly 40 years of historical performance, our findings show that adding publicly-traded real estate to a stock and bond portfolio has historically improved a portfolio’s risk/return profile versus one comprised solely of stocks and bonds.

Download the Portfolio Management White Paper

Press Release: Ernest Rady Commits $100 Million to Benefit the Rady School of Management at UC San Diego

Ernest Rady, co-owner and co-founder of AACA, announced that the Rady Family Foundation has made a $100 million commitment to UC San Diego’s Rady School of Management.  Ernest and the Rady Family Foundation also gave $30 million to help establish the school in 2004 and gave an additional $5 million towards the school’s campus expansion.

Download Press Release