Third Avenue Management Comments on Newhall Holding Company
It is wise to avoid borrowing money against assets that do not generate predictable cash flow. During the 2008-09 financial crisis, very few leveraged land owners escaped bankruptcy, foreclosure or restructuring. High quality assets with inappropriate debt levels create opportunities for distress investors to buy the fulcrum security (the most senior issue in a capital structure that will participate in a reorganization) at a discount to intrinsic value and then exert influence over the restructuring process. In 2008, the Fund acquired the senior secured bank debt of Landsource, which owned one of the most prime land banks in the U.S., with the expectation that we would influence and participate in the reorganization under a Chapter 11 bankruptcy proceeding. The company emerged from bankruptcy in 2009 with no debt (our debt securities were converted into equity). The Fund is one of the largest equity owners (approximately 9.5% of the outstanding equity) and has representation on the board of directors.
Not only did we have influence over the restructuring process and long-term business plan, but we continue to have a seat at the table to help the company implement its business plan. The equity interests in Newhall (NWDHU) are not exchange traded because Newhall is closely held by seven holders that control approximately 78.5% of the outstanding units. The 21.5% that is not closely held occasionally trades "over-the-counter." The implied equity market capitalization (based on current pricing) is approximately $412 million. This compares to the 2007 pre-bankruptcy appraisal that valued the land holdings at $2.7 billion. Clearly, land values are dramatically lower than five years ago, but the current pricing for Newhall Units represents a mere 15% of the value in 2007. Newhall's primary asset consists of 27,850 homesites and 681 commercial acres in Valencia/Newhall Ranch, located approximately 30 miles north of downtown Los Angeles. The company also owns the Valencia Water Company, a public utility that presently services approximately 115,000 people and will be the water provider for all future customers in the district.
A simple approach to understanding Newhall's current valuation would be to subtract $175 million (estimated value of Valencia Water Company, non-Newhall assets and cash) from the $412 million market cap, resulting in a $237 million valuation for Newhall's 27,850 homesites and 681 commercial acres. Using a conservative valuation of $100,000 per acre for commercial land, the implied valuation for Newhall's homesites is $169 million, or about $6,000 per homesite. Finished lots for single family homes in Valencia are selling for an average of $225,000 and multifamily units are $150,000. Improvement costs and fees (the costs of converting unimproved land to finished, builder-ready lots) are roughly $150,000 for single family and $125,000 for multifamily. Simple math reveals that homesites (paper lots) should be worth $75,000 for single family and $25,000 for multifamily based on current market conditions. It would be improbable to bulk-sell over 27,000 lots (probably a 20-year supply) for the same price as if selling a few hundred lots. Therefore a bulk discount should be applied. Applying a 50% discount to the above "paper lot" values, and assuming two-thirds of the lots are single family and one-third are multifamily, the implied value for Newhall's 27,850 lots is about $812 million, or $643 million greater than the value implied by the market price of Newhall Units. This "back-of-the-envelope" calculation results in a total equity value of over $1 billion (compared to the market cap of $412 million).
Residual land value analysis is used extensively by appraisers, homebuilders and developers to estimate the underlying value of land. The formula for estimating land value is: Revenue - Profit Margin - Costs = Land Value. Applying residual land value analysis illustrates why land value is so sensitive to home prices. If home prices increase, land values tend to increase more dramatically, particularly if fixed costs (e.g., land improvement and building costs) are relatively stable. The opposite also holds true: as home prices decline, land values decline more dramatically. In 2009, for example, it could be argued that some land actually had negative value, because the costs to develop buildable lots exceeded what a home builder would be willing to pay for them. The table below illustrates how a 20% increase in house prices can result in 112% increase in residual land prices with no cost inflation, and a 76% increase with 10% cost inflation. Newhall's single family homesites might be worth $75,000 each in the current market environment, but the prospects for dramatic appreciation with even modest increases in home prices is very compelling.
The obvious question anyone should ask is: with all of the hidden value in Newhall, when will that value be realized by the Fund or recognized by the market? Based on firsthand knowledge, the business plan is on schedule and the company expects to begin selling the first lots in Newhall Ranch by the end of 2014. Prior to that time, the company will need to raise capital to begin construction of infrastructure (grading, utilities, roads, etc.). The company is exploring raising private capital as well as public equity (initial public offering), among other options (including business combinations with other owners of large masterplanned communities). We expect that any such transaction would serve to crystalize value and establish a market price more in line with intrinsic value.
From Third Avenue's third-quarter letter, Michael H. Winer Co-Portfolio Manager of Third Avenue Real Estate Value Fund and Jason Wolf, Co-Portfolio Manager of Third Avenue Real Estate Value Fund.