Sam Zell is not Stupid

Back in the day when I was running my fund for my organization - like, four years ago - we would meet with an occasional REIT analyst.  Like any analyst, he/she would hand over a marketing package, which would usually include a comparison sheet of financial data for his/her coverage universe, and we'd talk about his/her universe of companies. 

One of the curious and quaintly endearing traits of the REIT industry is that they steer the investment community away from using earnings as the primary valuation metric.  This is not particularly unusual, since other industries do so as well. For example, media analysts focus on earnings before interest, taxes and depreciation, or EBITDA. Also, technology analysts focus on "pro-forma" earnings, which means "earnings-excluding-normal-business-expenses-we-just-don't-like-a-whole-lot."  REITs also have their own unique obfuscatory earnings metric known as "funds from operations," or "FFO." 

FFO perhaps most closely resembles the Cash Flow from Operations line on the cash flow statement for a typical corporation.  Cash flow from operations begins with net income and adds back depreciation, amortization, deferred taxes, non-cash charges, changes in working capital, and various other balance sheet adjustments that don't effect cash.  Pointedly, it also excludes capital expenditures, which resides in the Cash Flow from Investing section.

Part of the REIT industry's rationale for using FFO is that real estate "earnings" shouldn't include depreciation, since real estate is an appreciating asset.  This, of course, is nonsense since real estate in its entirety is not an appreciating asset.  Land and location have been appreciating assets, for the most part, but buildings require maintenance and thus are depreciating assets (assuming a constant discount rate).  In other words, FFO is bogus. However, because REITs raise a boatload of money on Wall Street, the analysts will use pretty much whatever metric the real estate industry wants.  So when the REIT analyst came to see us, when we discussed valuation, we discussed price/FFO.

In ancient times - at the beginning of this decade for instance - when you compared the valuations for REITs, you would generally see 8x price/FFO, 9x, 10x, or maybe 12x for a "high growth" REIT, such as Speiker Properties, which had most of its properties in San Francisco and Silicon Valley (and was eventually purchased by Equity Office Properties).  Because investment ideas compete for capital, it makes sense to normalize valuations across prospective investment ideas.  Because FFO isn't earnings, to get a thumb-nail sketch of normalized earnings, we'd often just double the price/FFO multiple to get a comparable price/earnings (PE) ratio, a highly inaccurate albeit time-saving exercise.  Thus a REIT with a price/FFO multiple of 9x would be compared to a stock with an 18x PE. 

Apparently, in 2007, it is plain to see that those analysts were a bunch of pantie-waisted wimps!  8x FFO! 10x FFO!  Pansies! 

Just look at the price being paid today for a company that has half its properties in the suburbs!

Equity Office Properties Trust isn't coming cheaply to Blackstone Group LP, which will buy the real estate investment trust in the biggest leveraged buyout ever.         

Blackstone will pay 33.8 times Equity Office's funds from operations [emphasis added], a measure of cash flow, in the $39 billion takeover. The ratio is about double the average for shares of companies in the Bloomberg Real Estate Investment Trust Index.

Only one of the index's 138 REITs trades at a higher multiple, based on an analysis of data compiled by Bloomberg. Cousins Properties Inc., an owner of office buildings in the southern U.S., is the exception.

33.8x FFO!

On my rule-of-thumb FFO-to-earnings calculation, that's 77.6x earnings!

Blackstone is spending $3.95 billion of its own money on the takeover, another filing said. Funds run by Bank of America Corp., Bear Stearns Cos., Goldman Sachs Group Inc. and Morgan Stanley are providing $3.5 billion in equity-bridge financing.

All four firms are members of a group that is lending Blackstone $31.9 billion, or about four-fifths of the buyout's total cost. Units of Citigroup Inc., Credit Suisse AG, Deutsche Bank AG and Wachovia Corp. are participating as well.

So Blackstone is going to front about 10% of the money to buy EOP!  Not sure what happens to that bridge financing, but if stays entirely equity, debt will account for about 80% of the capital structure.

What will happen next is that Blackstone is going to fire out as many prime midtown Manhattan properties as they can since prices in midtown are nuts.

What I find fascinating is that one of the reasons why EOP was so hot-to-trot for Blackstone as opposed to taking the deal offered by Vornado is that the board wanted to get this deal done as quickly as possible.  When the board of EOP rejected Vornado's bid last week, the reason given was because it would take Vornado several months to close the deal while it would take Blackstone several days.  In other words, the board wanted to make sure they got their moola before the inevitable music stops.

For some, its all about being the biggest.  For others, it is not. Ladies and gentlemen, Sam Zell is not stupid.