HPP Share Sale

The first is about west coast focused office REIT HPP. On June 11/12 HPP announced an absolutely massive ~$660 million sale of shares and warrants, which was almost 2x their then market cap. The shares and warrants priced around $2.22 per share. This was and is just a crazy raise - I’m not sure there has been anything like it since 2009. The level of dilution of existing shareholders is absolutely massive. My NAV for HPP before the raise was ~$6.5 / share, and Green Street had them at $6.7 or so I believe, so the raise was well below NAV.

HPP is one of the worst performing REITs since pre-covid.

Surprisingly to me, the market reacted positively to the and the stock rallied up from ~$2.5 to $2.75 right after and is trading for around ~$2.65 today. I suppose investors think this takes a good number of bankruptcy scenarios off the table, as HPP intends to use the funds to pay down debt.

I however took a much more dim view of the raise - while HPP still trades below its new diluted NAV of ~$3.75, I am very disappointed and shocked management elected to pursue massive dilution instead of selling assets. In my view there are really only 2 interpretations here. The first is that my NAV is very wrong, that they tried to sell a number of assets, failed, and thus resorted to the raise. I don’t think that is correct, as there have in fact been a number of decent trades in SF recently (a large portion of HPP’s assets are in SF & Silicon Valley) and fundamental momentum in the city & valley seems to be turning the corner driven by the AI boom. But obviously I could be wrong here!

The second is that management could have sold more assets, but elected for a massive dilution as this was some combination of easier for them and allowed the business to retain a larger scale, which of course allows them to justify higher salaries.

Neither option is good, in fact I’d say they are both terrible. Either the new NAV is much lower (and therefore probably below the current share price), or management has proven they do not care about shareholders at all. So I sold all my shares here.

Long term I do feel like there could be significant upside to the NAV as the tech office markets recover, albeit over a 6-8 year period given the depth of the hole. So one might wonder - given this massive dilution what else could management possibly do to vaporize shareholder value? Unfortunately I think the answer is ‘a lot’, due to HPP’s studio business. This has always been an oddity in the REIT world, but recent performance has been an absolute disaster. The reality is that HPP invested heavily in in this space at peak values & utilization rates, and continues to pursue new development projects here despite poor fundamentals and capital markets. A return to strong studio demand growth is by no means guaranteed long term - new productions have proven quite mobile in order to benefit from tax break offered by various cities (Atlanta being a notable example of this). There may also be potential structural issues long term with media production in a streaming world. Furthermore supply growth has been massive and continues to be significant in spite of the poor fundamentals fundamentals. Given management’s awful track record I am very concerned that they will continue to misallocate capital into this sector.

Perhaps I may come back to the stock in the future if we can get through some of the overall recession risk & management can prove they are committed to not lighting more capital on fire. But for now I am done with this investment.

ILPT Refinances

The other big piece of news as relates to the portfolio was with Industrial Logistics Properties Trust. This is a highly levered industrial firm with a mix of standard warehouses, long term Fed Ex’s and ground leases in Hawaii, created via a disastrous merger several years ago.

ILPT has traded well below its NAV due to I believe a combination of the overly high leverage, and an outside manager with a poor track record. Even if you allow some discount for the manager, it still traded for pretty cheap levels. Even today after the rally it is around a ~7.2% cap rate - that isn’t a huge spread from fair value on an absolute basis, but the high leverage makes for a very large stock NAV spread. The Fedex portfolio and Hawaii assets provide a good amount of stability which allowed me to feel more comfortable with the higher leverage levels.

ILPT had floated the idea of selling assets to reduce debt over a few years now, and I had been expecting ILPT to begin to do so once rates began to fall. Obviously rates have not fallen, and the firm began to come closer to it’s debt maturity dates. I was hoping ILPT would sell some assets to pay down debt into the current market, which is fairly robust in terms of activity albeit at prices well below peak a few years ago.

Instead ILPT has elected to pursue what I viewed as sort of a worst case scenario, which is to refinance the entirety of the debt and continue scraping along with their high leverage levels.

Again interestingly, the stock rallied significantly on this news. I don’t really understand why this might be - even if they couldn’t actually get a refi done, being forced into BK by the lenders would actually probably be a net positive as there is plenty of equity value and it could force out the external manager and lead to a sale of the assets. But I suppose other investors may not appreciate the value here and a simplistic debt refinancing = good may be driving the price action here.

Regardless I have taken it as an opportunity to sell most of our holdings at a very nice gain. It looks like management is committed to scraping by with minimal free cash flow in order to maximize the size of the asset base. I shouldn’t be terribly surprised by this given RMR’s weak track record (this is the manager), but I was hoping that this scenario was fairly straight forward and that given their incentive fees they would be aligned to try and raise the stock price via asset sales, debt paydowns, and the institution of a real dividend. But instead they whiffed. They did announce a dividend increase to ~$0.20 per share and we may get another one from here but by my calculations ILPT’s payout ability is still fairly limited, and leverage levels remain very high.

Again perhaps in the future I may come back to this stock, but right now there are better opportunities with superior risk reward ratios out there.