When the Howard Hughes Corporation (HHC) was spun off from General Growth Properties during its bankruptcy process in late 2010 it was an underfollowed, relatively unknown collection of unrelated real estate assets mostly located within a few master planned communities in Hawaii, Maryland, Nevada, and Texas. The communities were vibrant residential and commercial hubs in their respective local markets and HHC owned thousands of acres of vacant land that would allow for decades of future development, either by the company itself or by third parties who would buy the land or partner with HHC.
The investment thesis was very compelling for long-term investors willing to wait 5, 10, or even 20 years; HHC will sell vacant land to homebuilders and use the proceeds to build and lease office buildings, retail shopping centers with ample restaurants, multi-family residential buildings, hotels, etc. to make the area even more desirable. The population growth would lead to ever-increasing land prices and the process could be repeated until there was no land left to build on, creating plenty of value for shareholders.
The key aspect that set HHC apart from other real estate developers was that they owned the vacant land already, enough for 2 or 3 decades of construction activity, which meant they could fund commercial construction projects with cash generated from land sales, not by borrowing from banks and racking up debt like most of their peers. That strategy would allow for less leverage and more value would accrete to equity holders rather than creditors.
The success of HHC stock in the eyes of their investors over the last decade varies greatly depending on when each of us got in (as one should expect). Most of my clients have made money in the name, but I also bought some when sentiment was high and it was fully priced in the near-term (the idea was that for a such a long-term investment, the entry point was a little less important than in other situations) and those blocks are flattish at best and slightly down at worst.
The exact buy price probably would have been relatively unimportant had the thesis played out exactly as expected. But, that has not been the case. Now I am left with a stock that is up nicely from its 52-week lows and remains included in many accounts I manage (as well as my personal portfolio). The question is, should we sell or keep holding it?
First, let me share some data to illustrate why HHC has not been the very unique public real estate developer many had hoped for since 2010. The bull thesis (that HHC would handsomely outperform other similar public real estate stocks) hinged largely on the idea that debt financing needs would be reduced due to a constant stream of cash coming in from vacant land sales. On the face of it, this looks like it should have played out, as HHC has booked cumulative land and condo sales of $4.32 billion from 2011 through September of 2019. Gross profit on those sales comes to a whopping $1.85 billion.
Flush with cash, HHC did what it said it would do; build a heck of a lot of leasable commercial real estate and own the properties long term to generate a consistent stream of rental income (that Wall Street would theoretically love). Sure enough, HHC's rental income had risen from $95 million in 2010 to $396 million by 2018.
If HHC had simply reinvested the $1.85 billion and generated an incremental $300 million of annual rental income (worth about $3 billion of equity value at a 10x multiple on gross revenue), the total return for shareholders on that investment would have been 62% and proven out the bullish thesis in a powerful way.
So far so good, right? Maybe, but there is one problem; debt at HHC has soared right alongside land sales, construction activity, and rental income. Rather than build properties with minimal debt financing, setting themselves apart from their peers, HHC has funded their construction costs via traditional methods. At the end of 2010, total net debt on the books was merely $34 million ($285 million of cash against debt of $319 million). As of year-end 2018, that figure had swelled to a stunning $2.68 billion ($500 million of cash against $3.18 billion of debt).
If you realized what HHC was in the early days once it started trading, it was undervalued enough that none of the above mattered. The stock closed its first trading day in November 2010 at $38 and nearly doubled to $73 by year-end 2012. However, since then the ever-rising debt load has held back the stock, which closed out 2013 at $120 and has been treading water ever since (albeit in volatile fashion which has afforded investors trading opportunities along the way):
