Harvey Capital 2024 Mid-Year Update
A commentary on our performance during the first half of 2024
Harvey Capital I LP investors,
This will serve as the mid-year update for 2024. The annual update, which will go out in early January each year, will be a more comprehensive update with performance figures, the P&L and balance sheet. This update is meant to be more of a narrative type of update to keep everyone in the loop as far as how your funds are being stewarded. As always, if anyone wants more specific information or a question answered, please do not hesitate to reach out to me at any time! Let’s dive into things.
In the first quarter we invested in 2 properties that currently make up about half of our portfolio. I touched on the first one in the 2023 annual update (which you can read here) and about a month and a half after this one we invested in another. Both are operated and controlled by DSP Real Estate, a fantastic group based in Ashburn, VA.
These are called built-to-rent or built-for-rent (BTR/BFR) properties and became very popular during the Covid years. They are single-family or townhouse communities that are built for the express purpose of renting to tenants. In our case for both properties we invested in, they are 2023-built townhome communities. If you want to check these out and get an idea of what they look like, go to westwindva.com for the first investment we made (95 homes), and meadowsberkeleyridge.com for the second (148 homes).
Should you drive through these communities, you would likely think these were all townhouses individually owned by different people. However, they are owned by a single group (which we are a part of) and are operated as an apartment community.
For people that do not want to be tied to a 30-year mortgage and have all the cons that come with homeownership, but also don’t want to live in a traditional apartment building, this is the best of both worlds. You get a home that is yours, with a backyard, garage (in the Martinsburg property), neighbors, etc. And you do not have to own it, you can simply sign a 12-month lease and have the flexibility to move out when the lease ends. These have been soaring in popularity as more and more people shy away from purchasing homes. And being that these are newly built products that are top of the market with higher asking rents, the tenants that are attracted to these typically have higher credit and are less likely to stop paying or cause damage to the property.
We were able to get our hands on these properties solely because of what interest rates have done in the last couple years. The high interest rates have created lots of opportunities in the real estate sector, which I’ll touch on a bit later in this update. Had interest rates not risen to where they are now, the institutional investors that normally compete for these kinds of properties would have snatched these up for a price that would not make sense for us. Luckily, we are in a high-rate environment where lots of larger players are taking a wait-and-see approach.
When these 2 developments were started in 2020/2021, interest rates were at an all-time low and the demand for these kinds of products was extremely high among large investors. DR Horton was the builder and the group that both properties were purchased from. Fast forward to 2023 when they were delivered, and rates are almost double what they were, which severely impacted the market value of these assets.
If no debt were used when purchasing these kinds of assets, then more emphasis would be placed on the underlying fundamentals (ie. how much income they generate and if it is expected to grow in the future). However, real estate is typically purchased with a combination of debt and equity, with the debt making up 60-80% of the purchase price for these kinds of assets.
Since debt makes up most of the purchase, the cost of that debt heavily impacts how much a buyer is willing/able to pay for assets such as these. If I buy a $2,000,000 property with $500,000 down and $1,500,000 debt that generates $100,000 annually after all property-related expenses but before debt service, the debt is going to play a big part in whether the returns are adequate or not. Assuming the loan is interest-only and is $40,000 annually, then my cash-on-cash return is 12% in this scenario, which is great.
However, if rates jump up and the debt service is now $90,000 annually, my cash return is now 2% and I’d be much better off investing in government bonds which are currently yielding more than double this amount and are considered risk-free.
This is a very rudimentary example of what has happened in the real estate world over the past couple years. Interest rates have risen to levels where many investors have panicked and pressed pause on new investments, and the ones that are still buying are faced with higher interest rates and less competition and can pay prices that are a lot lower than they have been in recent years.
Again, had these properties been brought to market a few years ago, they would likely have traded around double what our group paid. It is amazing to me how short-term interest rate fluctuations have such a drastic impact on values, even if the underlying fundamentals are spectacular. When I was in the mortgage business, there was a popular saying, “marry the purchase price, but date the rate.” This means that if you find a great deal on something and it appears like it will generate fantastic returns even in a high interest rate environment, you should not let the high rate impact your decision. I would much rather get a great discount on a property using a loan at 6% than overpay for something using a rate of 3%. You can always refinance a property if rates drop, but you can’t go back in time and change the fact that you overpaid for something.
Speaking to the fundamentals of these properties, they are phenomenal. The 148-home property in Martinsburg, WV in particular is doing fantastic. When I visited the property in late March, we spoke to the property manager and they were asking prices on their new leases that were $300-400 higher than the expiring ones. This was way ahead of schedule and translates to a lot of value created in the form of more income and value in the form of what an asset is worth. If I take a $300/month rent premium and apply it to all 148 homes, that is $44,400/month or $532,800/year in additional income. If we conservatively discount that by 20% to account for the variable expenses such as management fees, we are left with $426,240 per year. Assuming this property sold at a cap rate of 7% which is slightly higher than what our group paid for it (meaning the sale price proportionate to the operating income is lower, so this is conservative), this amounts to just over $6,000,000 in value created. While $300/month doesn’t sound like much, it can translate to a lot of value when scale is involved. And if cap rates reduce over time, either naturally or from interest rate decreases, this premium could be substantially higher.
Another thing to mention about these 2 properties is that all the homes are individually parceled. So, while our group collectively owns and operates the communities as a single apartment complex, the homes can be sold off individually. The appeal here is that the residential market could outpace the commercial market. If that is the case and the upside outweighs the frictional costs and hassle of selling each property individually, then this could be a great way to cash our chips in. The kicker here is that DR Horton required a “lockout” period where the homes cannot be individually sold for a number of years. This is because they are still developing communities in these areas and do not want to add more competition to the homes they are trying to sell. Either way, it is great to have this option available to us down the road.
To sum all this up, these are both institutional class-A properties purchased at phenomenal prices that should pay us while we hold them, and even more when we sell them. Both have long-term fixed rate non-recourse debt as well, however we are purely equity owners in these properties and are not on any loans. Let’s hope and pray that people continue to need places to live and sleep!
The next largest position held is an investment in a publicly traded liquidating trust (similar to a REIT) called Copper Property CTL Pass Through Trust (ticker: CPPTL). I believe there is a fairly large gap between price and value on this one and I’ll explain why below.
CPPTL is a liquidating trust formed in connection with JC Penney’s Chapter 11 bankruptcy reorganization. On the trust’s effective date of 1/30/21 they had purchased and owned 160 retail properties and 6 large distribution centers. Here is what the purpose of the trust is, according to the Trust Agreement found in their public filings:
Trust was established for the purpose of collecting, holding, administering, distributing, and liquidating the trust assets for the benefit of the certificateholders in accordance with the Trust Agreement.
Background on CPPTL
JC Penney filed for bankruptcy protection and shortly after this they were acquired by Brookfield Property Partners and Simon Property Group for $300MM cash and the assumption of $500MM debt.
CPPTL was then formed and 160 retail properties and 6 distribution centers were sold to this trust, which is publicly traded. It appears this was a way to separate the properties from the operating business (JC Penney retail) and maximize value.
All assets of the operating business are owned by Penney Intermediate Holdings LLC, which leases the properties on 2 master leases established on 12/7/20. The 160 retail properties were on one master lease, and the 6 distribution centers were on the other master lease. The distribution centers have all been sold, so moving forward my discussion will only entail the retail spaces, however. I should also note that I looked at Penney’s (the tenant) financials and they seem to be very solvent with no risk of default in the foreseeable future. They also have strong parents in Brookfield and Simon.
The master lease for the retail properties is an absolute NNN lease with a 20-year term, with extensions that can make the lease a total of 45 years. Starting 12/7/23 there was a CPI (consumer price index) adjustment and this will happen every year moving forward where the lease payment is raised based on the CPI increase, not to exceed 2% per year.
Why I believe there is value
I believe the best way to value this is based on a cap rate value, as that is how commercial real estate will be valued by potential purchasers. However, when I look at this based on book value, it is also signaling that this is cheap.
Based on book value from their most recent quarterly filing (ending 3/31/24) they have $.66/share of cash and $11.81/share of real estate, totaling $12.47/share in book value. As I write this, it is trading for $9.40/share. There is no debt either, which I’ll get to later and explain why I think that is so magnificent.
Book value tells us the inputs and what was paid for all the assets currently owned, but doesn’t tell us the market value. In this instance, should I buy a share at current prices I would be getting these assets for roughly 75% of what the initial shareholders paid. However, if the assets are worth 50% of book value then even though I’m getting them for less than what the initial shareholders paid, I’m still overpaying. While paying below book value for something can be a signal that it is cheap, it isn’t definitive.
Cap rate value should give us a more accurate view of whether these are trading below their intrinsic value. Since this is a liquidating trust with the intent to sell the assets, cap rate value seems the most logical as this is how a buyer would analyze these retail properties. Currently, there are 126 retail properties remaining in the trust (108 are owned fee simple and the balance are long ground leases) generating $100,617,426 in rent for 2024. The weighted rent per sf is $5.99 and all of this info is available on the trust’s website in an Excel doc.
On a weighted average basis, from 2021-2024 present there have been 34 retail properties sold. The average sale cap rate, which is calculated by taking the annual lease amount for that property and dividing by the sale price, was 6.33%.
Now, only 7 properties were sold in 2023 and 2024 YTD. My belief is that these properties sold easier in 2021/2022 when rates were lower and they capitalized on this low-rate environment. 2023 was a strange year in real estate for sales as rates were increasing and it seemed as if people were trying to catch a falling knife as it relates to determining values. Now that rates have stabilized (albeit high) there will likely be more sales activity, and when they likely come down in the future, there will be even more. As a sidenote, it gives me peace knowing they are not just looking to fire sale these properties and are being smart about what the market is doing to maximize value for shareholders.
If we take the 2024 annual rent of $100,617,426 and apply a 7% cap, that gives us a portfolio value for the remaining 126 properties of $19.17/share. 8% cap rate is $16.77/share. 9% is $14.91/share. This doesn’t include cash held either, it is just real estate.
My opinion is that an average cap rate of 9% is very conservative, and still provides a lot of upside to the current share price. For context, the recent 6 sales that occurred in 2023 and through Q1 of 2024 were at an average cap rate of 7.92%. And this was in an extremely high-rate environment, which obviously affects real estate values in a big way since it is heavily debt-driven.
On the income side of things, the operating earnings, which excludes any gains from dispositions and adds back depreciation was $1.63/share in 2021, $1.14/share in 2022, $1.12/share in 2023, and $1.11/share in 2024 when annualized. The reason for the drop from 2021 to 2022 was because the 6 distribution centers were sold in 2021 and they generated substantial income. I also normally include depreciation as an expense, but since these are absolute NNN leases where the tenant is responsible for all building maintenance and must keep the asset in good condition, there is no landlord responsibility here for capex dollars, maintenance, etc.
So, while the properties are strategically sold, they are generating $1.11/share in earnings or 11.80% based on what it is currently trading for.
Downside protection
I believe valuing the remaining portfolio at a 9 cap is very conservative, and the fact that it is generating double digit cash returns is pretty incredible. In essence, I get to clip a 12% coupon while waiting for the value to be unlocked through these sales. And since earnings must be distributed based on the rules of a liquidating trust, there isn’t any worry that management would destroy value by a silly acquisition or anything like that.
I put even greater emphasis on the fact that there is zero debt here though. That is largely unheard of in real estate and the fact that these assets are generating double digit returns unlevered is amazing, in my opinion. If rates drop and the capital markets really open up I would expect a lot of these to start trading well below the 9% cap rate figure I estimated here, which would provide a lot of value based on current share prices.
CPPTL also releases monthly/quarterly info regarding Penney Intermediate Holdings LLC (tenant) and they appear to be solvent with no indication they will default on the lease any time soon.
Overall, I think the market has written this off due to ignorance based on it being connected to physical retail (which is depressed before and since covid) and the high interest rates which has impacted real estate values. But a debt-free portfolio of real estate generating double digit returns just based on operating earnings, with a lot more upside value on the horizon is what I think the market is missing. Over time I expect the price and value to converge, either from assets liquidated and cash returned, or from a rise in share prices.
If we take the most conservative view of a 9-cap value on the remaining real estate + $.66/share of cash that equals $15.57/share plus another $1.11/share in annual net earnings. If we take the 7.92% cap rate value that was the average sale cap rate for the 7 properties sold in 2023/2024, the cash + liquidation value of the real estate is $17.59/share plus the $1.11/share in annual net earnings. Obviously, the income will reduce as assets are sold, but that is currently what the portfolio is yielding. All this can be bought for $9.40/share currently, which is an unbelievable discount unless there is something I am missing here.
They also pay distributions out monthly and just announced their July distribution will be sent out shortly and is $.279/share, which amounts to an annualized return of 35% on our average per share cost basis. Now, this is a liquidating trust as mentioned, so the goal is to sell the remaining assets until nothing remains and the trust’s value is zero. June included 1 sold property. So, in theory the market price per share should reduce proportionate to the per share asset value that was disposed of. For example, if I own a publicly traded company that owns 10 houses all at the same value of $1 per share, after each home is sold the market price per share should come down $1 until everything is liquidated and the value is zero. However, this is not what is happening.
For the recent property I mentioned that sold in June, the annual lease income was $1,022,352 and it sold for $13,364,078. This represents a 7.65% sale cap rate. This means that this lease income is now gone and the trust’s remaining value has decreased. If we take the more conservative 7.92% cap rate average for 2023/2024, this means the trust’s market value has declined $12,908,484. There are 75MM shares outstanding, so this means that the value of the trust decreased $0.172/share with this asset sold.
The market, however, has just priced this at $9.04/share after the announcement of the recent distribution, which is $0.36/share lower. If the market were to price in my estimation of the decrease in value with the recent sale the price per share should be around $9.23.
If I go back to my simpler example from earlier, this is analogous to us being invested in the company that owns 10 houses all valued at $1/share. Except, instead of the market value decreasing by $1 when a home is sold, the market value decreases $2. This wouldn’t make much sense to anyone with an understanding of what these homes were truly worth.
This is what is happening here and it has created (what I believe is) a fantastic buying opportunity. Now, you may be a bit skeptical and question whether the market is right or if I am right. Believe me, I am wondering the same thing. But through prayer, thought, logic and my understanding of commercial real estate values I am really struggling to see how the market is right in this situation.
My theory is that commercial real estate is pretty sour in many (if not most) people’s minds. If you look below at the performance of several ETF’s for the different sectors since the beginning of 2022, you’ll see real estate is the 2nd to worst performer. This is likely a fairly good proxy for current investor sentiment.
A lot of this is warranted with the higher interest rates hampering returns for the groups using lots of leverage to amplify their returns. There are tons of negative headlines surrounding real estate, especially in the retail and office segments. Retail as a business, such as stores that exist in malls are struggling too and JC Penney is obviously in that category with their bankruptcy filing in 2020.
This negative sentiment seems to be lumping everything that is even tangentially connected to commercial real estate and brick-and-mortar retail shopping together. And luckily for us, CPPTL is connected to both of those! But as mentioned this trust has zero debt and it appears to be trading far below its true value. So, while for a lot of REIT’s this market reaction is justified, I don’t believe it is in this case and we will hopefully stand to benefit from it over time.
There are a few other smaller, and short-term positions we hold in various debt/equity investments that I’ll spare details on. If you read the prior update you can get an idea of these. If anyone wants information on those, please feel free to reach out to me.
My focus moving forward is to try to uncover more mispriced opportunities such as this liquidating trust. With rates still high and public sentiment low on commercial real estate, it seems this (public REITs) is fertile ground to try to turn over a few rocks and hopefully find something interesting. And if prices remain low for CPPTL, we will continue to build up our position in that as it appears to be one of the best opportunities I’ve ever come across.
The next update can be expected at some point in early January, marking the year-end update. If anyone has any questions please feel free to reach out to me any time. You can email me at will@harvey-capital.com or give me a call/text at 703-677-7991. Take care and God bless!
In Christ,
Will Harvey III
IMPORTANT: This communication is for informational purposes only and is intended solely for the general knowledge of the recipient. It does not constitute an offer to sell or a solicitation of an offer to buy any securities, nor shall any securities be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful. Any offering of securities will only be made pursuant to a confidential Private Placement Memorandum (PPM) and other definitive legal documents, which must be reviewed by the prospective investor.