June 30, 2014
Real Estate Value

Inmobiliaria Colonial: Playing the Recovery in Spain, at a Discount

Inmobiliaria Colonial (Colonial) is in the early innings of what should be a multi-year recovery in property values in Spain, and if one factors in the company’s enormous deferred tax asset, Colonial’s shares remain a compelling value investment. For nearly eight years, a dismal capital structure and incredibly challenging fundamentals in Spain have weighed down on Colonial’s high quality assets. The situation is rapidly changing as Colonial has completed a transformative recapitalization, and fundamentals in Spain are finally beginning to improve from trough levels.

Colonial is a real estate operating company, based in Spain and listed on the Madrid Stock Exchange, with a market cap of approximately €1.9 Billion. The company’s three primary assets include: one of the largest wholly-owned office portfolios in Spain that is largely comprised of class-A properties in Madrid and Barcelona, a 53% stake in Société Fonçiere Lyonnaise, which is a separately listed French real estate investment trust (REIT) that owns a class-A portfolio in Paris, and a 20% stake in a homebuilding business in Spain.

Capitalizing on the potential recovery of Spanish property values

Third Avenue Management (TAM) has followed Colonial for several years but never invested in it prior to 2014 because, notwithstanding its high-quality office portfolio, the company was saddled with too much debt resulting from a leveraged buyout in 2006. The company recently completed a €1.3 Billion capital raise through a highly-dilutive rights offering to existing shareholders, the proceeds of which were used to pay down the company’s credit facility. As a result Colonial is no longer burdened by debt. TAM’s Real Estate strategy purchased Colonial common shares ahead of the capital raise, bought additional rights as they became tradable, and ultimately, fully subscribed to its pro-rata share of the rights offering. All told, the strategy purchased more than 65 mm Colonial shares throughout the process, making it one of the largest participants in the recapitalization.

Colonial img 1

TAM’s significant participation in the recapitalization was based on its view that Colonial would be an attractive long-term investment after the capital raise. The company would be well-capitalized (with substantial cash resources and a loan-to-value ratio below 50%), run by a highly regarded management team with strong sponsorship (Villar Mir and the Qatar Investment Authority are large shareholders that share a long-term view), and positioned to meaningfully increase the underlying value of the company through corporate specific initiatives. We also believe there will be a broader based recovery in fundamentals.

Despite this, Colonial’s stock price remains at a discount to TAM’s conservative estimate of NAV, primarily due to two factors. One, property values in Spain have fallen considerably. And two, the company has substantial tax assets that sit off its balance sheet and are currently unappreciated by most market participants.

With respect to property values, a series of well-documented headwinds in Europe, and Spain in particular, have led to a collapse in property prices. As highlighted in the chart below, property values have fallen by almost 60% in Spain due to rising vacancy rates, declining rental rates, and higher cap rates. Conditions have stabilized as new construction has ground to a halt in recent years, limiting new supply and tenants are taking advantage of multi-decade low rental levels to snap up space in well-located properties. As a result, vacancy rates for class-A office space are falling and rents are starting to increase as is often the case in the early stages of a recovery. Due to the shorter-term leases in Spain, the impact of this recovery on property values could be quite substantial for those looking out over 3-5 years. While not our base case, it is conceivable that (1) Colonial will increase its occupancy rate from 80% to 90% over that time frame (in-line with other class-A properties now that it has the capital to fund the lease-up), (2) rents will increase by 20% from depressed levels (rents roll every 5 years, so most were last reset at trough levels), and (3) cap rates will fall by 0.50% (currently at high levels when viewed on both a gross basis and net basis relative to 10-year yields). In this scenario, capital values for Colonial’s properties would increase by approximately 40% from current appraisal values, without factoring in the impact of leverage. That proposition isn’t a secret though, which is why you’ve seen a number of private equity players looking for assets in these markets and a number of “cash-boxes” recently raised to invest in Spanish property. The advantage of Colonial over those other players, in TAM’s view, is that it already owns the assets and has an accomplished management team with the expertise necessary to maximize value. Therefore the company won’t have to “pay up” to participate.

Colonial Chart 1

In Colonial’s case, not only should shareholders benefit from a recovery in capital values for well-located properties, but they stand to do so on a tax-advantaged basis.  This is due to Colonial retaining more than €4.5 billion of deferred tax assets that were accrued under its previous ownership group.

The tax-loss carry forwards, highlighted in the table below, are utilizable over the next 18 years and will allow Colonial to shield income earned in Spain for the foreseeable future.  This is a hidden asset that could ultimately prove quite valuable.  To the extent the company sells down its ownership interest in their French REIT, further boosts its investments and profits in Spain, and accelerates the monetization of this net operating loss, it is TAM’s expectation that this tax asset will show up on other investor’s radars.

Colonial Chart 2

This is not to say that there will not be difficulties down the road.  In fact, TAM expects the fundamentals in Spain to continue to look bleak in the short to medium-term, especially when considering that unemployment rates continue to hover around 25%.  However, the proposition of buying well-located real estate at high yields that are based upon depressed cash flows and a discount to replacement cost is one that has worked well when investing in real estate in the past.  With a sound financial position, competent management and a discounted valuation, we believe Colonial to be a compelling value investment.

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