When the Howard Hughes Corporation (HHC) was spun off from General Growth Properties during its bankruptcy process in late 2010 it was an underfollowed, relatively unknown collection of unrelated real estate assets mostly located within a few master planned communities in Hawaii, Maryland, Nevada, and Texas. The communities were vibrant residential and commercial hubs in their respective local markets and HHC owned thousands of acres of vacant land that would allow for decades of future development, either by the company itself or by third parties who would buy the land or partner with HHC.
The investment thesis was very compelling for long-term investors willing to wait 5, 10, or even 20 years; HHC will sell vacant land to homebuilders and use the proceeds to build and lease office buildings, retail shopping centers with ample restaurants, multi-family residential buildings, hotels, etc. to make the area even more desirable. The population growth would lead to ever-increasing land prices and the process could be repeated until there was no land left to build on, creating plenty of value for shareholders.
The key aspect that set HHC apart from other real estate developers was that they owned the vacant land already, enough for 2 or 3 decades of construction activity, which meant they could fund commercial construction projects with cash generated from land sales, not by borrowing from banks and racking up debt like most of their peers. That strategy would allow for less leverage and more value would accrete to equity holders rather than creditors.
The success of HHC stock in the eyes of their investors over the last decade varies greatly depending on when each of us got in (as one should expect). Most of my clients have made money in the name, but I also bought some when sentiment was high and it was fully priced in the near-term (the idea was that for a such a long-term investment, the entry point was a little less important than in other situations) and those blocks are flattish at best and slightly down at worst.
The exact buy price probably would have been relatively unimportant had the thesis played out exactly as expected. But, that has not been the case. Now I am left with a stock that is up nicely from its 52-week lows and remains included in many accounts I manage (as well as my personal portfolio). The question is, should we sell or keep holding it?
First, let me share some data to illustrate why HHC has not been the very unique public real estate developer many had hoped for since 2010. The bull thesis (that HHC would handsomely outperform other similar public real estate stocks) hinged largely on the idea that debt financing needs would be reduced due to a constant stream of cash coming in from vacant land sales. On the face of it, this looks like it should have played out, as HHC has booked cumulative land and condo sales of $4.32 billion from 2011 through September of 2019. Gross profit on those sales comes to a whopping $1.85 billion.
Flush with cash, HHC did what it said it would do; build a heck of a lot of leasable commercial real estate and own the properties long term to generate a consistent stream of rental income (that Wall Street would theoretically love). Sure enough, HHC’s rental income had risen from $95 million in 2010 to $396 million by 2018.
If HHC had simply reinvested the $1.85 billion and generated an incremental $300 million of annual rental income (worth about $3 billion of equity value at a 10x multiple on gross revenue), the total return for shareholders on that investment would have been 62% and proven out the bullish thesis in a powerful way.
So far so good, right? Maybe, but there is one problem; debt at HHC has soared right alongside land sales, construction activity, and rental income. Rather than build properties with minimal debt financing, setting themselves apart from their peers, HHC has funded their construction costs via traditional methods. At the end of 2010, total net debt on the books was merely $34 million ($285 million of cash against debt of $319 million). As of year-end 2018, that figure had swelled to a stunning $2.68 billion ($500 million of cash against $3.18 billion of debt).
If you realized what HHC was in the early days once it started trading, it was undervalued enough that none of the above mattered. The stock closed its first trading day in November 2010 at $38 and nearly doubled to $73 by year-end 2012. However, since then the ever-rising debt load has held back the stock, which closed out 2013 at $120 and has been treading water ever since (albeit in volatile fashion which has afforded investors trading opportunities along the way):
The company ran a strategic review process in the second half of last year that resulted in a stock price spike, allowing me to pare back and/or hedge most of my positions in HHC. There was a glimmer of hope after no buyers for the company emerged in that management announced it would sell non-core properties, focus on its main master planned communities, materially cut G&A costs, and use excess cash flow to repurchase stock that they felt was undervalued. That plan resonated with me and gave me hope that the debt pile would stop rising so fast and perhaps some equity-friendly moves were on the horizon.
That optimism was short-lived, however, with the December 30th announcement that HHC agreed to acquire from oil giant Occidental 2.7 million square feet of office space for $629 million, to be funded with $231 million of equity and $398 million of additional debt.
Bulls would argue that given their plans to sell part of the assets being acquired (a campus outside of the Woodlands), the remaining deal to buy 2 office towers within their most mature community is a good move. And considered by itself, perhaps they are right. My issue with it is that it represents more activity that does not set HHC apart (using internally generated cash flow to grow their commercial property portfolio). Having HHC borrow money to buy existing buildings at fair market prices is the playbook that every other real estate company is employing, which means the long-term unique investment thesis for the company remains elusive.
There have been other missteps too. The South Street Seaport in New York City was supposed to be a trophy asset for the company, as it held a long-term ground lease and planned to rebuild much of the area around Pier 17 as a premier destination for locals and tourists alike:
What management had originally thought would generated above-average returns quickly turned into a money pit. The original construction budget of nearly $500 million was supposed to generate double-digit returns, but delays and redesigns has seen the cost estimate surge past $700 million. Management is still maintaining the goal of the property eventually earning $40 million to $50 million annually (making it an average project, at best), but the Seaport is currently losing money and will take years to reach that goal, if it ever does.
To make matters worse, we learned last year that HHC has decided to move away from its typical business model (leasing space to tenants) and instead has co-invested in many of the Seaport businesses, even choosing to operate some themselves. They claim there is more upside potential by structuring deals as joint ventures, but they are supposed to be landlords collecting rent and leaving the risk for the business owners. Now they have business losses offsetting rental income, which will reduce returns on the project further.
The nail in the coffin for me was their $180 million purchase of a parking lot adjacent to the Seaport in mid 2018. As they began due diligence on erecting a building at the site, they discovered that the parking lot had once been the site of a thermometer factory and contained toxic levels of mercury, as well as petroleum leaks. Parents of student from a nearby school are freaking out at the prospect of a demolition project potentially exposing children to toxic chemicals, which is delaying HHC’s timeline for hiring professionals to clean up the site. Count me as one who hoped HHC would find a buyer for the Seaport last year when they shopped the company’s assets, but no such luck.
All in all, without a path forward that includes revenue growing materially faster than debt, I am not sure there is a unique story here for HHC investors anymore. Between December 2013 and September 2019, rental revenue has grown by 165% while gross debt has grown by 139% and net debt by 282%. It is hard not to think that is a major reason why the stock price has barely budged during that time. Unless and until the financial strategy changes, maybe HHC isn’t all that special. While it seemed like the ultimate long-term buy and hold stock when I first discovered it back in 2011, today it might no longer warrant such praise.
Full Disclosure: At the time of writing, the author and some of his clients were long HHC, but those holdings are currently under review for possible sale and positions may change at any time.