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American Real Estate, Russian Prices

Twenty years ago, a close relative of mine bought several apartments in a residential suburb of Moscow.

Russia was undergoing a severe crisis then. The state had defaulted on its debt and the ruble collapsed amid total economic chaos. Countless banks and enterprises were forced out of business, while former KGB directors went hand in hand with oligarchs and politicians to plunder the country.

To cut a long story short, you couldn’t make it worse even if you tried — albeit Russians’ creativity is rightly known as limitless whenever it comes to design inventive recipes for disaster.

Questioned by anxious business partners about his venture, my relative maintained that he couldn’t care less about short-term distress. In average, he was paying three years of net cash-flows to acquire these ideally located properties, so he figured the macro picture might as well take care of itself at some point in the future.

Needless to say, twenty years later this bold investment operation has proven incredibly successful.

History does not repeat, but it does rhyme. A minor difference though: today this kind of deals — real estate selling for three years of net cash-flows — springs up at investors’ fingertip in the safest jurisdiction in the world — the United States — and within an asset class that until very recently kept being perceived as the ultimate safe haven — commercial real estate.

One such idea would be Washington Prime Group, a listed real estate investment trust spun-off from Simon Property Group four years ago and apparently priced by the market as a mundane liquidation trust.

Here the long thesis is remarkably straightforward: maximum pessimism, distorted perception, strategic assets, sound balance sheet, excellent management, trading at three times cash-flow after-tax (FFO) for a 20% dividend yield and a 50% discount — at least — on private market value.

Led by one of the finest professionals in the industry — Lou Conforti, whose unorthodox management may precisely be the prescription the company needs — WPG owns 57 million square feet in so-called class B and class C malls.

Naturally, these unsexy properties sometimes sitting in the midst of sparingly populated areas are loathed by investors, as the alleged “retail apocalypse” inflamed by the rise of e-commerce rages over America and eats mall-owners’ lunches.

Yet facts speak otherwise in the case of WPG. Occupation rates, sales and base rent per square feet remain stable; the latter even increases once the properties get refitted. The portfolio of tenants is well-diversified — the largest weighs 3,2% of rent revenue — and no major series of lease expirations loom within the five-years horizon.

Bold call: death of retail may very well be the future of malls after all. Lou Conforti has shown in a compelling presentation that Washington’s properties stand out as highly desirable because they serve as key magnets for community life in semi-rural counties and suburban areas. When they’re not, management isn’t shy of selling them or handing keys back to the lenders.

In that respect, these properties are prime targets for profitable redevelopments, for instance into remodeled shopping venues, food courts, offices, theaters or gyms, among other options. Management claims that such investments yield returns north of 8% to 10%. If proven true, the departure of anchors such as Sears or Macy’s represents an opportunity rather than a risk.

The company’s vast portfolio of unencumbered properties and its flexible indebtedness give plenty of leeway, while a thoughtful capital allocation — demonstrated by timely acquisitions and dispositions — remains aggressively oriented towards refitting the most promising assets.

Should some major issue arise for good, a distribution cut by half would still imply a dividend yield of 10%. We’ve seen worse, especially in this era of anemic long-term rates; Conforti seems to think likewise as he just made large stock purchases on the open market for his own account.

As about private market value, assigning a cap rate twice higher than current practice and a discount of 50% on base rent — better safe than sorry — still yields a considerable margin of safety.

A lot remains to be done and the proposition is everything but risk-free. But at this price, we’re more than adequately compensated to hold tight and bank on a turnaround.

(Long WPG at an average price — adjusted for distributions — of $4.3 per share.)

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