The Six Pillars of Our Strategy
Below are the six pillars of our strategy that function as our roadmap for success.
- Sharp focus on igniting the virtuous cycle
- Self funded business model
- Disciplined Capital Allocation
- Liquidity & Financial Stability
- Aligned Incentives
- Positioning our assets for the long haul
Sharp Focus on Igniting the Virtuous Cycle
As mentioned above, as our MPCs generate cash flow from land sales to homebuilders (after which homes are built and then sold to new residents, which spurs growing demand for commercial amenities in our small cities), we deploy our capital into our substantial development pipeline of more than 50 million square feet of entitlements and deliver these commercial amenities at outsized risk-adjusted returns. This enables us to leverage our development platform to produce a growing stream of operating income and increased demand for homes in our communities as we bring commercial offerings, such as office, retail, multifamily and hospitality online. Further, by delivering these amenities, our communities grow in desirability, which increases the value of our remaining residential land as more people seek to live in our MPCs. This fuels added commercial development that further increases the value of our residential land in a self-funded virtuous cycle that repeats itself over and over again.
By maintaining a sharp focus on continuously igniting this virtuous cycle, we believe we will be able to continue investing our capital at significant risk-adjusted returns.
Self-Funded Business Model
We generate cash flow from our three business segments:
- Residential land sales in our MPC segment
- Net operating income in our Operating Assets segment
- Condominium sales profit in our Strategic Developments segment
This is an important differentiator for HHC compared to REITs and other typical public real estate companies, as our free cash flow enables us to self-fund the equity of our strategic developments without the need to raise equity and dilute shareholders…a rare attribute for a development company. We believe that our large built-in pipeline of entitlements will enable us to grow our NAV over time without having to expend capital on acquisitions for external growth. As such, our business model is largely self-sustaining and has enabled us to grow over the last eight plus years without issuing any equity. Instead, we retired a portion of our shares through buybacks in 2012, in which we reduced the diluted shares outstanding by over 9%, and in early 2018.
Additionally, we look to own and hold our operating assets in our MPCs for the long term rather than sell them, allowing us to maintain our dominant positions and high level of control in our communities.
Disciplined Capital Allocation
Our overarching goal is to drive the growth of our net asset value on a per share basis. As such, capital allocation is one of the most important levers for our growth and success. When we think about how to allocate our capital, we break down our options into three categories:
- Internal Investment Opportunities
- Investing in HHC through Share Buybacks
- External Acquisitions
Given the competitive advantages mentioned above, we are generally able to deliver the best results by investing in our deep pipeline of existing opportunities. While real estate development can be considered a potentially risky investment, we believe that our developments, especially those within our MPCs, have a substantially lower risk profile due to the following factors:
- Many of our projects are substantially pre-leased or pre-sold before we commence development. As of 2018 year end, our under construction office portfolio was 48.6% leased and our under construction condominiums in Ward Village were 86% pre-sold.
- As the master developer, we have almost no competition in our MPCs. We have control over much of the remaining commercial land and land-use restrictions on those commercial assets that we do not own.
Since inception, we have invested $1.8 billion into our internal developments, generating $170 million in NOI and a 9.6% return on cost. Because of our low-cost basis in the land relative to its market value, of the $1.8 billion, we only invested approximately $370 million of cash equity in these projects, which is projected to generate a 25.2% return on equity assuming a 5.5% cost of debt. These investments and returns are based on the book value of our land and exclusive of condominium development as well as projects under construction.
Another area where we explore investing our capital is in the acquisition of our shares. Over the last year, we have traded at a price that we believe represents a meaningful discount to NAV. As such, acquiring our shares represents a potential opportunity to create long-term value. In January of 2018, we purchased 475,920 shares of our common stock in a private transaction with an unaffiliated entity at a purchase price of $120.33 per share, or approximately $57.3 million in the aggregate. While we do not have a formal buyback program in place, we continue to be opportunistic in looking for meaningful blocks of shares that we can acquire at an appropriate price. However, we are also mindful of our balance sheet and the implications of all of our capital allocation decisions, including share repurchases.
Finally, while we spend time diligently searching for appropriate risk-adjusted return acquisition opportunities, most often, the opportunities that we analyze have lower returns and a higher risk profile than investing in our communities as these acquisition opportunities lack the same control characteristics. With that said, from time to time, we are able to find a diamond in the rough, most often in the form of an acquisition that can be tucked into one of our core assets. Our September acquisition in The Woodlands of Lake Front North for $53 million is a consummate example. The opportunity consisted of two vacant office buildings that total 258,742 square feet as well as approximately 3.4 acres of developable land. This transaction added to our already dominant office market ownership in The Woodlands at a price well below replacement cost. At the time, we had been anticipating a return in demand for office space and were considering building Four Hughes Landing for $321 per square foot. For context, we were able to acquire these two buildings for approximately $185 per square foot excluding the cost of tenant allowance and the value of the developable land. Given the quality of the buildings, we felt strongly that we could lease them at similar rates to what we would achieve on a new construction. As of March 1, 2019, these two buildings were 91% leased. We expect that these buildings will stabilize north of our targeted 8% yield on total acquisition costs. In addition, we recently signed leases at Lake Front North with energy giants Entergy and ExxonMobil.
Another item worth mentioning is that all our capital across the company is pooled and our executive management team, along with our Board of Directors, allocates that capital where we believe we can generate the highest risk-adjusted returns, whether holistically across our existing assets, for share repurchases or externally on acquisitions.
Liquidity and Financial Flexibility
This has been a historically long cycle of economic growth and rising home sales in many parts of the country. While the signals within our master planned communities are all still positive, we are prepared for the eventual end of this cycle whenever it may occur. As it relates to liquidity, this means maintaining financial flexibility that best positions us to withstand a downturn. A few guiding principles of our strategy are outlined below:
Maintain healthy cash balances to fund equity required for all in process development:
- We have adequate cash balances to complete all of our developments underway excluding any additional cash flow from land sales, condominium sales, and our operating asset NOI.
Keep leverage low and concentrated in our Operating Assets Segment
- As of year end, approximately 67% of our net debt was within our Operating Assets segment, which has the highest and most consistent cash flow.
- On a book value basis, this debt was conservatively leveraged at 53% of net debt to book value.
- We have a conservative debt yield of 10.1% in the segment and a debt service coverage ratio of 2.5x.
We maintain overall leverage of approximately 35% net debt to enterprise value and have done so since 2011. Over that time, we have grown revenues by more than 155% and total assets by more than 258%. Despite that rapid growth, we have maintained discipline in our balance sheet.
Minimal MPC Land Debt: We have no net debt on our MPC land business as our cash and receivables from municipal utility districts are greater than our nominal debt balances.
Non-Recourse Debt When Possible: We use project-specific construction loans for each of our new developments, avoiding recourse when possible to both minimize the equity contribution to any one project and isolate the risk to that specific development.
- We have worked hard to minimize both our near-term maturities as well as our exposure to floating-rate debt. To that end, in September 2018 we closed a secured, non-recourse corporate credit facility with loan proceeds of up to $700 million comprised of a $615 million term loan and an $85 million revolver. In addition, we have the right to increase the revolver by $50 million through the facility’s accordion feature. The five-year financing carries an interest rate of LIBOR + 1.65% and refinances approximately $609 million of existing debt that carried a weighted average interest rate of LIBOR + 2.20% and a weighted average remaining term of 1.7 years.
- By lowering our cost of capital and extending term, the new financing enhances liquidity as well as both financial and operational flexibility.
Additionally, our goal since inception has been to shift the company’s source of cash flows from a dependency on land sales to a more balanced funding model consisting of land sales, condominium sales, and a growing reliance on more stable, recurring NOI from our operating assets. We will become even less reliant on those other sources of cash flow and more insulated from a potential housing downturn in the coming years as we work to bring on line and stabilize our operating assets and reach our stabilized NOI target.
David O’Reilly, HHC’s Chief Financial Officer, Grant Herlitz, HHC’s President, and I have each invested a significant amount of our personal capital in HHC. In 2017, I made a $50 million investment in the company in the form of long-term warrants. Grant purchased warrants for $2 million and David O’Reilly purchased warrants for $1 million upon joining the company in 2016.
The three of us collectively own approximately 1.5 million shares and approximately 2.1 million warrants in the company, representing a meaningful portion of our net worth and approximately 6% of total outstanding shares. As evidenced by our investments in the company, we remain inspired and confident in HHC’s prospects and share your frustration when the stock price trades the way it has over the last eight months.
Positioning our Assets for the Long Haul
Ours is a long-term business. As the largest single real estate owner within our communities, we are responsible for creating self-sustaining ecosystems. The decisions we make today will leave an impact on our communities one or two decades from now and beyond. As such, we act with a long-term horizon in mind and are constantly thinking about how we can position our assets for success in the future, ensuring that they stand the test of time. This includes a commitment to thoughtful design, sustainability, and dynamic customer experiences across our portfolio.
Having review the six pillars of our strategy, I would like to compare our business model with a few different but related sectors to which we as a company are compared. First, while we do have some exposure to homebuilders (they are the end buyers of our residential land), we own the scarce asset that homebuilders need in order to manufacture their product. We typically generate cash margins of approximately 74% to 99% when we sell our land and can afford to hold this long-term appreciating asset. We can remain patient sellers of our desirable asset and wait for the most attractive price. As illustrated earlier, over the long-term, land values in our supply-constrained communities increase in value as residential land sales and commercial development create a virtuous cycle. To that end, a temporary disruption in the price or pace of sale of our land is not expected to have a material impact on our net asset value if we remain disciplined in our approach. Over the long-term, our MPCs should increase in value. Time is the friend of our business.
On the other end of the spectrum, our business model is very different than that of a REIT. A REIT’s NAV growth is restricted by limited free cash flow and typically governed by same-store NOI growth or external acquisitions. We reinvest our free cash flow, unburdened by a required dividend, into new developments at significant risk-adjusted returns. We spend more than $1 billion on development annually, driving long term NAV growth. We are very thoughtful about risk as we develop in small cities that we control with limited competition. Additionally, we only develop to meet demand and most of our construction is on a Guaranteed Maximum Price (GMP) basis, so the risk burden of a cost increase is held by the contractor. We have a tremendous amount of growth opportunities with our 50 million square feet of development entitlements so do not need to use capital to make external acquisitions to drive growth.
Due to our tax shields, we have not paid significant federal income since our inception and do not expect to pay any meaningful federal income tax in 2019 due to a number of factors. First, our carryover net operating losses and other tax assets have not been fully utilized due to both tax planning and lower taxable income in prior years compared to book income. Second, as we place large assets in service such as Pier 17 we are able to take advantage of extremely favorable bonus depreciation laws.
Focusing on our Core Assets
We will continue monetizing our non-core assets and recycling the cash generated from the sale of those assets into higher return opportunities, whether in our communities, acquisitions, or stock buybacks. In 2017, for example, we sold a portion or all of six of our non-core assets for approximately $88 million. I would expect this trend of monetizing non core properties to continue in the coming years as we remain sharply focused on unlocking value in our core regions where we have the greatest value creation opportunity.