Description

Summary

Our analysis suggests NLOP could liquidate Office properties worth ~$43/share over the next 2 years and generate ~ $70M - $110M in cumulative cash flow, resulting in $47 - $50/share of cash distributable to shareholders, 70% above $28.76 closing price (7.26.24) at the midpoint. Further, given modest lease expiration in Year 3, we believe there is little penalty should the process take 3, rather than 2 years to culminate, as another year of cash generation far outweighs lost cash flow from lease expiration. Our valuation is anchored by property-level valuation, and we present our estimate for every property in the body of the writeup.

While the stock has rallied sharply from early forced selling and taken legs higher on successful asset sale announcements, we believe the cone of uncertainty has substantially narrowed. Early asset sales have come in much better than our expectations*, even in a weak environment for Office asset sales. We believe the largest source of remaining value is represented by either long-leased assets or those which are locationally advantaged, and these two categories represent ~$490M of our $820M estimate of Gross Asset Value. Of the remaining $330M, more than half of the value we ascribe is represented by the present value of contractual rent. 

*Two notable exceptions were the European assets. We assign punitive cap rates to the remaining 2 unencumbered European properties and include them in the “Challenged Properties” category.

Property Breakdown

In broad strokes, NLOP has five categories of properties**. We find it helpful to break these down as the key metrics which drive each category are different. For long-leased assets, cap rate is the primary driver. The locationally advantaged assets are primarily a function of the market rate for commercial real estate in their respective markets, and value per square foot may take prominence over the cap rate on the existing lease. Challenged properties are a function of the runoff value of current leases plus an assumed vacant/fire-sale price. Finally, non-recourse mortgaged properties are essentially equity call options on whether a building sale could cover outstanding debt. 

Below we present a breakdown of every property in the portfolio. This should give the reader ample opportunity to change key assumptions and derive their own Gross Asset Value.

** Please note all references to individual properties are sourced from NLOP SEC filings, including their supplemental. All references to value and sales processes of properties are a combination of our assumptions, and publicly available real estate data from LoopNet and various broker websites. 

Category 1: The Stalwarts

These are long-leased properties and the majority have strong strategic backing, e.g. Corp HQ, disaster recovery, data center, large plots of land etc. NLOP has sold 6 long-leased US properties to date for a 7.5% gross cap rate. 

When we mentioned the cone of uncertainty shrinking, the Stalwarts are the primary reason; These properties are relatively straightforward financial transactions with no need for alternative zoning or changes in business plan. This category more than covers the $243M of remaining debt, excluding non-recourse mortgages. 

We are most bullish on CVS as we believe the market may be missing the fact that the lease has a one-time step-up in rent to account for the large-scale renovation currently underway (upon completion). We assume an incremental $700K of NOI, a ~16% step-up, but our bias would be to the upside. As a reminder, CVS extended for 16 years in 2022 in return for a $20M NLOP contribution towards their $32M renovation. Institutional Property Advisors is selling this property, and currently lists it as Under Contract on its website.  

Note: iHeart, Master Lock, Safelite, and APCO are Corp HQ. CVS/JPM data center infrastructure. 

Category 2: Location-Specific Stories

This category of properties is situated in attractive locations where the underlying market may be more important than the specific lease. 

We include two properties in NLOP’s most valuable markets, Google Venice and Omnicom Playa Vista. We also include 2700 West Frye in Chandler AZ, which is about to go vacant but where we think there is a high probability of re-leasing on similar terms to the prior Caremark lease. We believe Arcfield in Valley Forge could be sold for multi-family redevelopment, and the property is listed “Under Contract” by JLL. The newly vacant Woodlands property likely has a floor in the $80 psf range given the strength of that sub-market. Finally, the remnants of the Blue Cross Minnesota workout have multiple potential redevelopment uses, including Office, Light Industrial, or multi-family.  

We believe the Woodlands and Blue Cross properties are being actively marketed for sale* and feel comfortable with our base case valuation. What we like here is that our estimated proceeds of $40M come with no associated NOI, and hence those two transactions are ~$5M accretive to free cash flow given foregone interest expense. 

The two buildings in the LA metro are of most interest. Google sits on Main St in Venice and market comps are in the $800 psf range. The Frank Gehry designed location is known colloquially as the “Binoculars building” and can likely command either much higher rent or a sales price that will raise eyebrows. We use $661 psf but would not be surprised to see a sale that clears much higher. 

Omnicom Playa Vista was where we found one of the more interesting tidbits in our early diligence. NLOP had initially filed a Draft Registration Statement in November 2022, 10 months before their Form 10 which most investors read. They chose to highlight three properties indicative of portfolio strength: Fedex, CVS, and Omnicom. The company stated at the time: “We believe current rent under the existing lease is materially below market. NLO believes this property also offers significant re-leasing upside in the future.”  When the company filed their Form 10, they chose to only discuss Fedex and CVS. 

We value the property at $388 per square foot and would note two recent trades in the neighborhood: one for a vacant building at $381 psf, and one with a tenant in place at $496 per square foot. If management is correct in their assertion that rent is well below market, this building could likely be worth $10M-$20M more than we are assuming at $47M/7.5% cap rate. Note that there are 4.5 years left on this lease so the buyer would need to agree with NLOP’s assertion. 

*Blue Cross listed via Colliers, Woodlands via JLL. 2700 West Frye rental listing via Cushman & Wakefield

Category 3: Challenged Properties

Lest the reader think we are pollyannaish; we place 20 buildings in the Challenged Properties basket and our 17% average cap rate implies an End-of-Lease sale price per square foot of ~$53. Candidates for this grouping include those with some mix of short lease-term, sublease availability, known vacancy, lack of strategic importance or poor sub-markets. Note that end-of-lease value per square foot backs out the present value of remaining lease payments. The properties have 2.5 years of average lease term remaining. 

We feel comfortable that $53 per square foot is achievable despite the challenged nature of this category. Why? This analysis inherently assumes that none of these buildings can be re-leased, which will likely prove conservative. Buildings with a tenant-in-place are generally worth 2x-3x those that are sold vacant. Every $5 per square foot above or below the $53 assumption is worth $9M to Gross Asset Value.  

We note a handful of properties with upside optionality versus our conservative view. 

• Bankers in St. Petersburg

  • The company is planning to vacate this building to move downtown. The submarket should support a reasonable sale or a decent probability of re-leasing. (Source: $500 million financial firm to relocate headquarters to downtown St. Pete (stpeterising.com)

• Arbella in Quincy MA 

  • This is a Corp HQ in an above avg HH income market and the company has a very long tenure and deep community roots. (Source: LoopNet/Company website)

• Censlar FSB in Yardley PA

  • Class A product in an above-avg submarket. (Source: LoopNet)

• JP Morgan Tampa (4915 Independence Parkway)

  • This is the smaller of two JPM Tampa buildings; we believe the company has consolidated employees into the larger building with 6 years of lease term remaining, which we have listed under the Stalwarts category. JLL is currently marketing this building for lease at $26.50 Gross (likely ~$18-$19 net) versus JPM’s prior lease at $10.20. (Source: JLL website)

Category 4: The Big Kahuna

KBR is such a large property that we separate it into its own category. 

This is a >1MN sqft tower with an adjacent ~571K sqft parking garage located in the struggling Houston CBD. We believe this property is a turn-off to many new investors, as its outsized contribution to total ABR pre-conditions a negative bias on the rest of the portfolio. 

We share a bearish outlook on Houston CBD but believe 6 years of remaining lease term provides substantial protection. Our $154M building valuation incorporates $101M of rental present value from the tower and parking garage, leaving $53M for the assumed vacant sale at the end of KBR’s lease.

This is where nuance is important. First, what would be sold is not just a 1M square foot building, but a parking garage on the same size lot across the street. For those familiar with the downtown Houston CBD, many properties sit on equivalent sized squares. NLOP owns two of these ‘squares’, not one. 

Given that a vacant sale is most likely slated for redevelopment, we wouldn’t be surprised if the parking garage is worth as much, if not more, than the office tower. $53M divided by the 1.06M of Office square footage sounds optically high at $46 per square foot, but when we consider this is functionally for 2 lots, I believe the valuation makes more sense. Separately, I wonder if the larger assemblage might make the sum of the parts more attractive if a builder could somehow combine the lots. We believe One City Centre is under contract for $35-$40 per square foot and is functionally vacant (10% occupied with near-term expiry). 

Second, all the above assumes that KBR will move out; we do think there is a chance they decide to remain in their longstanding Corp HQ and perform a substantial renovation. Were this the case, it would require a substantial tenant contribution, but we believe any renovation and long-term renewal would be far superior economically to selling a vacant building. Headquarters moves are not easy, especially one of this size. 

Our bottom line on KBR is that we believe it is quite difficult to anchor an NLOP bear case on this property. Given the remaining lease term, and our punitive cap rate, we are already assuming 2/3rd of the value is simply in the remaining lease. If we were wildly off on our $53M end-of-lease value and instead the company can only achieve half this, it is worth $1.66 to the stock. 

Category 5: Non-Recourse Mortgaged Properties

The last category is largely a rounding error, but we evaluated each property to determine whether the asset value covers the debt. Orbital ATK is the key property in this group. They just executed a 5-year lease extension at no cost and we believe maintain critical infrastructure which means they are also likely to renew 5 years from now. We believe both Orbital ATK and Merative can comfortably cover their debt, and thus we add their equity value to our Gross Asset Value. We assume all other properties are handing in the keys Further, we assume that the last several years of ABR will be captured in reserves by the lender, thus they are a total write-off, as is all associated debt. 

Upside optionality exists with both Acosta and Intuit. We believe Acosta is likely to extend given that stated lease term is < 2 years and this is their Corporate HQ, with many job postings listed online. Similarly, Intuit’s Texas property is their ProConnect regional HQ and this looks to be a highly amenitized facility. If these were re-leased and thus traded for a HSD cap rate, we think each would add $6M-$10M of equity value compared to our assumption of handing in the keys. 

Valuation Summary

* From 10-K: “The Lease Terminations, among other things, shorten the lease term of each of the Termination Premises from January 31, 2027 to the earlier of (i) June 30, 2024 and (ii) the sale of the respective property. In connection with the Lease Terminations, the tenant has agreed to pay NLOP termination fees of approximately $12.0 million to $13.0 million in the aggregate for all of the Termination Premises payable and determined based on the date of each property’s termination date.”

Addressing the Bear Case

1. Balance Sheet Concerns and “The Cost of Debt is a Red Flag” 

   1. WP Carey simply wanted Office exposure off their books, and this is largely why the opportunity exists. We think they took what debt was available at the time, with the knowledge that paydown would be rapid. 

   2. This is why property sales to date have resulted in lost rent, but free cash flow has hardly budged. Until the JPM facilities are fully paid down, asset sales reduce so much Interest expense (~12% blended rate) that in most cases each sale is accretive, not dilutive to free cash flow. 

   3. The $115M of non-recourse mortgages are largely irrelevant. As can be seen in Category 5, the company will likely hand the keys in for most of the non-recourse debt, while a presumptive sale of ATK Orbital or Merivate would leave some equity value after paying down the remaining mortgage. Bottom line, we think you need to hive off the $115M of remaining mortgages and simply think of this pool as individual call options that may deliver small amounts of equity value.  

2. “Office is Terrible”

   1. Yes, Office RE is challenged, but there is a price for everything, and we are increasingly learning that the market was way off in its initial valuation work. WP Carey was a responsible sponsor, there are many buildings in great situations, and they have proven to be adept at finding creative solutions where necessary – e.g. BCBSM, Valley Forge, DMG Mori et al. 

   2. Re-leasing has been quite respectable (all via recent company filings)

      1. The CVS 16-year extension and renovation likely added tens of millions of value.

      2. The 15-year extension with DMG Mori functionally traded a long renewal for a modest rent cut, and this building ended up trading at a 6.5% cap rate, once again adding substantial value. 

      3. The recent 5-year extension at ATK Orbital

      4. The creative solution at Blue Cross Minnesota, where the company substantially downsized but left 2 buildings in place with almost 13 years of term, garnering a low 7’s cap rate upon sale. 

3. Pace of Liquidation

   1. We are quite happy with pace to date, not too fast not too slow. We were somewhat worried that the early days would have a bolus of properties followed by a long lull. Judging by the number of live listings we are seeing from various sources such as LoopNet and broker websites, we believe there are anywhere from 3-7 properties that could trade in the next couple of months. 

   2. Time is actually on your side because of the substantial FCF generation.

4. External Management

   1. While we understand the general skepticism towards these structures, NLOP’s arrangement with WP Carey makes perfect sense. Why stand up a management team, leasing department and corporate overhead function when the company will only exist for a few years? 

   2. Using WP Carey’s asset management team to work out of these assets is a benefit versus similarly sized microcap REITS. WP Carey has familiarity with the investment thesis around each asset and local knowledge which provides continuity. Their efforts to date have been impressive.  

   3. The financial structure is quite reasonable. Per the Form 10, NLOP is paying a $7M annual asset management fee which steps down ratably with asset sales, plus a minimum of $4M annually for overhead (e.g. IR, legal tax and accounting). We estimate this second piece will run close to $8M per year. Given the increased administrative burden of liquidating a portfolio, we view $15M per year, with step-downs in place, as perfectly reasonable.  

** The thesis expressed above contains forward-looking statements and is intended for informational purposes consistent with the nature of this forum; it is not a recommendation to buy, sell, hold, or otherwise trade the securities of the referenced issuer.  The authors/their affiliates do not hold a position with the issuer such as employment, directorship, or consultancy.  The authors/their affiliates currently own a position in the referenced issuer's securities; however, that position may change at any time and without notice.

Catalyst

Continued property sales supportive of our valuation

Debt paydown

Return of capital