A Weak Second Quarter Should Mark the Bottom for Colony Capital, But Future Dilution is a Key Issue

Colony Capital reported a 2020 second quarter net loss of $2.04 billion or $4.33 per share, compared with a much smaller loss in the prior year quarter.  This year’s loss was driven by $2.0 billion of impairment charges taken across all of the company’s business segments, except digital and included a $515 million goodwill charge taken against its Other Investment Management (OIM) business.  It also recorded a $274.7 million other-than-temporary impairment charge against its 36.4% stake in Colony Credit Real Estate (CLNC).

Excluding these charges, Colony posted a loss in adjusted funds from operations (according to my definition) of $18.0 million or $0.04 per share, compared with a greater adjusted FFO loss in the prior year.  (My definition of adjusted FFO does not adjust for unrealized hedging losses, restructuring charges amortization of deferred financing costs and debt discounts and similar items included in the company’s definition of core FFO.)

Besides the write-downs and losses on loans receivable and commercial real estate securities, Colony has seen a deterioration in the net operating income of its real estate assets, including its healthcare and hospitality properties.  The declines in the healthcare properties were relatively modest; but the drop in the hospitality properties was significant, driven by the plunge in average occupancy to only 30.2% from 58.6% at in the March quarter and 78.6% in the June 2019 quarter.  On a positive note, CLNY reported that average occupancy improved from about 22% in April to 39% in June and its properties generated positive net operating income (before furnishing, fixtures and equipment costs) in June.  Assuming that the trend continues, CLNY’s hospitality segment should generate positive NOI in the third quarter.

Colony also reported further progress in its efforts to grow its digital business.  A company-led investor group agreed to invest $1.2 billion in Vantage Data Centers, which operates a portfolio of 12 stabilized, state-of-the-art wholesale data centers in the U.S. and Europe.  On the conference call, management outlined how it is investing at current market rates in new properties whose profitability will grow significantly as they approach stabilized occupancy levels.  This, management says, should generate superior returns for Colony investors.

As noted, Colony wrote down the value of its 36.4% stake in Colony Credit Real Estate (CLNC) by $336.5 million to $335.5 million or $6.99 per share.  That compares with CLNC’s 8/15 closing share price of $6.32.  Colony CEO Marc Ganzi praised CLNC CEO Mike Mazzei and COO Andy Witt and their team for the progress that they have made over the past 90 days in stabilizing the business.  Like CLNY, CLNC has raised liquidity to cover potential cash shortfalls and also to have capital available to buy assets when the timing is right.  CLNC has made a special effort to communicate with its borrowers and tenants to understand their situations, gauge their continuing abilities to stay current on their obligations and work with them to as necessary to provide temporary accommodations, including forbearances and payment deferrals.  This helps CLNC in its own financial planning.  Yet, many of CLNC’s subordinated and preferred investments are at or near default and many of its senior loan investments will move closer to default the longer the economic downturn lasts.  A quicker economic recovery would help CLNC to preserve and recover the value of its investments.

In July, Colony announced a strategic partnership with Wafra, Inc., which is backed by the sovereign funds of Kuwait and other Middle East nations.  Under the arrangement, Wafra will initially invest $253.6 million for a minority stake in Digital’s investment management business, which will entitle it to participate in 31.5% of the net management fees and carried interest of the Digital IM business.  Wafra has also agreed to invest $150 million in Digital Colony Partners and other digital asset deals, in some cases assuming Colony’s investment commitments.  Along with these commitments, Wafra will receive warrants to purchase up to 5% of Colony’s outstanding shares at strike prices ranging from $2.43 to $6.00 (or 4% after the conversion of the new 5.75% Notes due 2025).

The Wafra investment is another example of steps taken by Colony to reduce potential payment obligations and improve its liquidity position.  This follows (1) the amendment of Colony’s banking agreement to ease covenant restrictions to avoid a potential default and ensure access to available funds and (2) the $300 million issuance of the 5.75% Exchangeable Senior Notes due July 2025 to pre-fund the upcoming maturity of the 3.875% Convertible Senior Notes due January 2021.  By making these moves, Colony has bought time to allow its real estate properties and investments to recover from the economic impact of the pandemic.

Despite the large reported loss, Colony’s shares have performed quite well over the past week, rising 23.4% to close at $2.69 (as of 8/14/20).  The shares have now more than doubled off the March bottom but remain well below their 52-week high of $6.14.  On a year-to-date basis, Colony is still down 43.4%, worse than the 12.9% decline in the Dow Jones U.S. REIT Index.

Although I believe that CLNY still has further upside, investors should be cautious about the outlook from here.  With the losses booked in the quarter, the company’s tangible book value per share has fallen from $4.19 at the end of March to just $1.11 currently.

Colony took significant asset write-downs on properties representing about 35% of the total net carrying value of its real estate.  On that $3.7 billion of properties, it wrote off $1.45 billion or 39% of the carrying value.  Although it believes that it has now addressed the overall recoverability in the value of its non-digital real estate assets, it did not rule out the possibility of future right downs.

The magnitude of the write-offs reflects both the quirks (or flaws) in the accounting standards and Colony’s assumptions about its intended holding period for the assets.  Under the accounting rules, the company is not required to recognize an impairment until the carrying value of the property exceeds the sum of the expected undiscounted cash flows of the property over the holding period.  When that threshold is breached, the property has to be written down to fair value, which often is equal to (or close to) the discounted expected cash flows over the holding period.  The difference between undiscounted and discounted cash flows can be large, especially if the reduction in the expected holding period is significant.

In Colony’s case, the decision to liquidate its non-digital real estate meant that the holding periods of these properties would be reduced meaningfully, from say 10 years or more to perhaps two years or less.  On top of this, the lower occupancy rates caused by the pandemic reduces the expected near-term (and possibly medium- to long-term) cash flows for many of these properties.

Colony’s assessments of the fair value of the properties were based upon a combination of third party appraisals, broker estimates (with discounts based upon Colony management’s judgment), capitalization of expected NOI (at discount rates ranging from 10%-12%), and discounted cash flows (using terminal value cap rates of 7.0%-11.25% and discount rates of 8.5%-12.0%).  The valuation measures seem conservative, especially against typical pre-COVID capitalization and discount rates.  On the one hand, Colony may be conservative in its fair value assessment.  On the other hand, we do not know whether it will be forced to take impairment charges on the remaining the 65% of real estate carrying value that did not suffer impairment charges during the quarter and if it does, whether the impairment charges will approach the average 30% of pre-write-off carrying value.

The large percentage write-off is consistent with the company’s decision, made during the second quarter, to accelerate its transition to digital.  This means that it will move more quickly to sell its non-digital real estate and investments and also that they will be willing to accept lower prices on those assets.  During the conference call, CEO Marc Ganzi said that the company assessed the new equity value of hotel portfolio at only about $50 million, which is significantly below my estimate of about $900, based upon pre-COVID cap rates.

While a quicker transition will allow management to focus its attention on the digital business sooner, it would provide the company with less capital to redeploy to digital or reduce outstanding recourse debt and preferred stock, if the asset sales are executed at or near currently depressed market valuations.  Accordingly, Colony will be more dependent upon attracting new capital to the digital business, which would likely result in even greater dilution for its shareholders.  If Colony generates cash from its non-digital real estate properties and investments that is only sufficient to pay off its non-recourse debt, it will leave the company with about $1.3 billion of stranded recourse debt and also the $1.0 billion liquidation value of preferred stock, which will stand ahead of the common shareholders against the net equity value of the digital business, its 36.4% equity stake in CLNC and the value of the non-digital investment management business.

This is a key issue for Colony’s shareholders.  In order to provide the liquidity and address its approaching debt maturities, the company has given a 20% equity stake to the holders of its new Exchangeable Senior Notes.  Since the exchange price of $2.43 per share is below Colony’s share price of $2.68, the notes have traded up to 142.39, giving noteholders a 42.4% return in less than one month.   

Similarly, Mr. Ganzi asserts that Colony can grow its Digital Investment Management revenues at 20%-30% per year and its fee-related earnings at 30%-40% per year for the next three years.  However, he did not say whether that forecast is after the 31.5% of fees and carried interest that will now be attributable to Wafra.

To be sure, if Colony is to complete its pivot to digital quickly, it will most likely have to sell many of its non-digital properties and investments at a discount to their potential post-pandemic valuations.  At present, there is plenty of private capital looking for investment opportunities, but that capital obviously wants to buy at distressed prices.  The more Colony holds out for better prices, the smaller the number of potential buyers.  If it waits entirely until prices normalize (or return to pre-pandemic levels), it may be selling into a smaller pool of primarily strategic buyers.

Although it is unclear how quickly occupancy rates will improve across the breadth of its healthcare, hospitality and other real estate properties and investments, I believe that it is reasonable to conclude that – barring a resurgence in COVID-19 infections from a second wave, which is unlikely to occur in my opinion – the worst is probably over, even for those properties like hotels that have suffered the most from the economic impact of the pandemic.  The pace of the improvement from here will depend upon when economic activity normalizes.  Medical office buildings appear to be well on their way to a full recovery, but the pace of normalization in senior housing is still slow (but there is evidence of pent-up demand for move-ins).  A more meaningful recovery in hospitality depends upon the return of the business traveler.

Despite the continuing uncertainties, it is likely that the immediate financial pressure that both Colony and CLNC faced during the earliest stages of the pandemic will continue to recede; but the bigger question for shareholders is what prices Colony will receive for its non-digital asset sales and how much more dilution its shareholders will face from future capital raises.

August 27, 2020 (from a research report originally published August 17, 2020.)

Stephen P. Percoco
Lark Research
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Linden, New Jersey 07036
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