Mack-Cali: Cheap Or Inexpensive?

Bobby Darin once sang in his version of "Mack the Knife"

On a sidewalk, blue Sunday mornin'

Lies a body oozin' life

Some, someone's sneakin' 'round a corner

Tell me, could that someone be Old Mack the Knife?

I was going through REIT earnings when I saw Mack-Cali's (CLI) earnings and the song popped into my head. Rather than Bobby's lyrics, I heard:

On a statement, from my broker

Lies an investment oozin' life

The REIT hasn't turned the corner

Tell me, could that REIT be Mack ("CALI") the Knife?

The Mack Cali Company owns or has interests in 276 properties consisting of 266 office and office/flex properties totaling approximately 30.7 million square feet and ten multi-family rental properties containing over 3,400 residential units, all located in the Northeast, as well as land to accommodate additional commercial, multi-family, and hotel development.

A little over a year ago, I gave up on using Mack Cali as an investment in the office sector. Since then, the company has proven that inexpensive does not mean cheap.

CLI data by YCharts

Or longer term versus the Vanguard REIT ETF (VNQ):

CLI data by YCharts

This is Mack the knife.

Admittedly, the office sector has seen better days and the lack of fundamental growth in the economy and the resultant slack demand for office space has hurt returns in the sector. But before we ascribe their performance to their sector, let's take a look at the company versus office peers Piedmont Office Realty (PDM), CommonWealth REIT (CWH), Highwoods Properties (HIW), Liberty Property (LRY), SL Green Realty (SLG) and Boston Properties (BXP):

CLI data by YCharts

Mack Cali has returned 1/10th the next lowest peer over the last five years.

A financial/metric view of Mack-Cali versus peers:

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On the surface, we see a decent balance sheet and what appear to be cheap metrics. As I said earlier, however, inexpensive does not always mean cheap.

Let's take a closer look at Mack Cali.

Mack Cali's properties are predominately located in New Jersey and 87% of their base rent is from the area:

As a result of their geographic concentration, a look at the New Jersey economy is in order (from the NJ DOL):

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Employment has come back in the state, but not very strong, recapturing only 58% from the low point. By sector, we get the following picture:

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Professional and business services as well as financial activities (two large users of office space) have grown, but again, not significantly. This is important when considering their top ten tenants by annual base rent:

This lack of job recapture has had a serious impact on office space demand which has resulted in weak occupancy rates:

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Unfortunately, it is going to get worse, as management stated on the most recent conference call:

Certainly the most eminent situation is the Morgan Stanley lease which is in Harborside and it's approximately a little more than 300,000 square-feet. As you are aware, Morgan Stanley consolidated into 1 New York Plaza. So that lease is not going to be renewed and that's a fairly sizeable revenue source.

Weak occupancy rates will flow through to their funds from operations:

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And therefore dividends per share:

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Which will be factored into the price and result in a lower Price/Funds from Operation multiple:

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Lower FFO/sh and a lower multiple is how we got to the first, second and third charts which show tremendous underperformance.

Is there any hope?

In order to overcome their weak business, Mack Cali made the decision to branch (diversify) into multi-family. A little over a year ago, the company announced it was diversifying in a significant way into the multi-family space:

Mack-Cali Realty Corporation today announced it has signed a definitive agreement to acquire the real estate development and management businesses of Roseland Partners, L.L.C., a premier multi-family residential community developer and operator in the Northeast

This strategy was re-emphasized in the last earnings call:

We continue to remain keenly focused on our strategy of monetizing select office properties in order to provide capital for our diversification into the multi-family sector. As we discussed on this call last year, in July we sold Liberty Corner Corporate Center in Bernards Township, New Jersey. The four-story, a 133,000 square foot office property was sold for $18 million.

Their May 2013 presentation lays out the rationale for the move into multi-family"

Growth: We believe there is continued growth potential in the sector as opportunities continue to outpace those in the office sector

Residential Preferences: Greater desirability for Class A, well amenitized, urbanized multi-family product (Renters by Choice)

Stability: Operations of multi-family assets have had less historically cyclical volatility than office

Unique Synergies: Repurposing of existing Mack-Cali office holdings and land inventory into accretive multi-family development

Capital Allocation Diversification: Selling lower quality office assets and reinvesting via 1031 exchanges into higher quality multi-family assets

Does the swap make sense at this point in the cycle (sell office - buy multi-family)?

Currently we are seeing what I will call "cap rate differential compression" - a mouthful of words to say that the cap rate difference between office and multifamily properties.

(click to enlarge)

Or simply expressed as the difference between office (yellow line above) and multifamily (white line above):

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As the charts above show, there has been a compression between office and multi-family, reducing the potential "opportunity cost" of the transaction. The ability to sell office at a cap rate close to multi-family provides lower cost FFO diversification.

While diversification is good, and can build a consistency to dividends and returns, diversifying into multifamily also serves to accomplish multiple expansion.

Let's look at this in a multiple basis. The move comes as multifamily REITs trade near their highest P/FFO multiple, a decent rationale, and one (somewhat) supported by the lack of significant cyclicality in multifamily. Consider that Mack Cali trades at a 8.6x forward P/FFO and the multifamily sector forward P/FFO average is 17x.

Using these multiples, and current FFO/sh, I have come up with the following "rough" valuations (base case and downside):

As the table shows, the "base case" has decent upside to both the target and the PV. The downside, however, is not so favorable. I believe that the actual outcome will be somewhere in between - but biased to the downside and as a result, I do not believe that the outcome makes sense at this price. Should the price fall and trade at a lower multiple (think 6-6.5x) it might make more sense due to the impact that occupancy, repurposing (and the capital required), and NOI/FFO impact should have.

Bottom Line: Mack-Cali has been Mack the (falling) Knife, but there is an end in sight. While I believe there is more pain to be sustained in their narrowly focused office portfolio, the diversification into multifamily should help them get back on their FFO feet and watch their valuation climb. I would be patient, however, and wait for a cheaper entry point (6-6.5x FFO) or signs that multifamily has become a more significant portion of their NOI/FFO.

Source: Mack-Cali: Cheap Or Inexpensive?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.

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