By Ben Strubel of Strubel Investment Management
There has been a lot of press lately over St. Joe’s (JOE), a Florida-based real estate development company. Two prominent investors have taken opposite sides of the stock. Leading the short case is hedgefund manager David Einhorn of Greenlight Capital, who contends that the JOE’s land in Florida is no more valuable than cheap rural or timber lands. The chief bull is Bruce Berkowitz of the Fairholme Fund, who believes that the land can be developed into much more valuable real estate. With super investors on either side, other investors are left with a dilemma. If you go long and Einhorn is right, you stand to lose a lot of money. If you go short and Berkowitz is right, you could lose a significant amount of money. Investors are essentially left with a coin flip.
But what if you could buy St. Joe at an Einhorn price and experience the upside that Berkowitz sees? Then if it turned out that the Einhorns of the world were right, you wouldn’t lose very much. If the Berkowitzes of the world turn out to be correct, you would have significant gains. It’s not a pipe dream—if you are willing to look in California instead of Florida. A different real estate development company, Tejon Ranch Co (TRC) in California, fits our “what if” scenario. TRC owns 270,000 acres of real estate primarily in Kern County, with a small amount in Los Angeles County. TRC’s stock price currently implies that its real estate holdings are not much more valuable than run-of-the-mill farm or ranch land despite the fact that much of the land has entitlements that allow development and some of it has been developed.
About Tejon Ranch (NYSE: TRC)
As stated above Tejon Ranch owns 270,000 acres of land in Kern and Los Angeles counties in California. The land is a mix of ranch land, rolling hills, mountains, and crop land. Interstate 5 cuts through a portion of the land, so 150,000 vehicles a day pass through Tejon Ranch. The company conducts ranching and farming operations, receives royalties from oil and gas drilling and water storage operations, and leases land to National Cement Company of California. A map of the land holdings is shown below.
(Source: company website)
History
Tejon Ranch was founded in 1912 and incorporated in 1936 in California. The company went public in 1973 and the stock moved to the NYSE in 1999. For much of its history, the owners did not pursue any commercial development of the land. Then in the 1980s, TRC announced that it would finally begin development. It wasn’t until 1999 that the first development took place.
The chart below shows TRC’s stock price over the past 32 years. Circled in red are two time periods where TRC reached almost $60 per share before plunging back down to lower prices.
The large jumps in price in the 1980s were due to a combination of the company’s announcement of development plans, rampant speculation, and extremely small float, which necessitated several trading halts during the run up. In the early 1990s, the California real estate market crashed and development of TRC was put on hold. Then in 1998 a new (and still current) CEO Robert A. Stine was named. Stine promptly replaced many of the company’s directors with ones more familiar with real estate development and began plans in earnest to develop the land. In 1999 the first development, what is now known as Tejon Industrial Complex, was started. With the 2008 real estate bust and recession, development has slowed and the stock price has once again fallen.
Future Developments
While the past of Tejon Ranch has been marked with a boom and bust stock price, incoherent or nonexistent development, and rampant speculation, we do not believe this will be the pattern in the future for several reasons.
1) As we mentioned in the previous section, the new CEO Robert Stine and the new board have committed themselves to developing the land commercially. The 1980s and 1990s waffling and refusal to sell off portions of the land is unlikely to repeat itself under the new management. Indeed, the company has been steadily selling off portions of the land , and development has been continuing steadily but for the current recession.
2) Third Avenue Fund Management, run by legendary value investor Martin Whitman, owns 26% of the company. One of Third Avenue’s fund managers, Michael Winer, is a member of Tejon Ranch’s board of directors. Thus shareholders have a powerful voice to encourage prudent and profitable development of the land. Value investors Michael F. Price and Royce and Associates also own small stakes.
3) A landmark environmental agreement was signed allowing three developments: Tejon Industrial Complex and Tejon Mountain Village are already entitled, and TRC is in the midst of the entitlement process for Centennial (a master planned town). It is extraordinarily unlikely that the company will turn back now and not develop the land.
In summary, Tejon Ranch’s relatively poor performance in the past was due to management’s inability to execute a coherent strategy to unlock value in TRC’s assets. With new management in place since 1999 and clear vision for development, we believe TRC will be a much more rewarding investment than it may have been in the past.
Valuation
It is important to realize that real estate and most real estate development companies are best valued by looking at the market value of their real estate holdings. Traditional valuation metrics and methods of evaluating other companies, such as price to sales or price to earnings, margins, return on assets, sales growth, etc., are all relatively meaningless when discussing real estate. The best way to value TRC is to look at the book value of the company. There is one problem with that method. Much of Tejon Ranch’s land is carried at historical cost, and the purchase of some of the land dates back to the 1800s. The company in its current form was incorporated in 1912. The current book value of the land is $118M, which is well below market prices. To properly value the company, we have to adjust the value of the land to reflect its worth at today’s prices.
To value TRC we will use a sum-of-parts analysis. Tejon Ranch’s holdings can be broken down into six parts. The first two parts are land that will be permanently conserved and the conservation easement. The next parts are three existing and planned developments: Tejon Industrial Complex (TIC), Tejon Mountain Village (TMV), and Centennial. The final part is existing farm and ranch land not included in current development plans.
Dedicated Conservation Holdings (178,000 acres)
In 2008 Tejon Ranch negotiated a conservation agreement with Audubon California, the Endangered Habitats League, Natural Resources Defense Council, Planning and Conservation League, and the Sierra Club. Under the agreement 240,000 acres of the total 270,000 acres TRC owns will be set aside for possible conservation. Of this, TRC will set aside 178,000 acres for permanent conservation and make 62,000 acres available for optional conservation easements. In return the environmental groups agreed not to oppose any of the planned development of TRC’s remaining 30,000 acres. The 178,000 acres that will be permanently conserved consists of about 148,000 acres of mountainous areas and scrubland. The area has little to no infrastructure and its value as possible developable land was negligible. The remaining 30,000 acres will be open space in TMV and Centennial that will be conserved. In our valuation we have assigned this land no value under any scenario.
Conservation Easements (62,000 acres)
As part of the original conservation agreement, the California Wildlife Conservation Board (WCB) had an option to purchase the remaining 62,000 acres available for conservation at prevailing market prices. Late last year the WBC exercised their conservation options and purchased easements for the entire 62,000 acres for $15.8M. While this may seem cheap, reading the easement agreement reveals that TRC can continue activities on the land:
Tejon Ranch Co. will retain fee ownership of the 62,000 acres and continue to operate current revenue generating activities including farming, cattle grazing, filming, oil and gas and other mineral exploration and production on portions of the acreage. The conservation easements will preclude the Company from pursuing any long term development on the 62,000 acres. [emphasis added]
(Source: company press release)
To model the value of the fee ownership, we used a discounted cash flow model. A breakdown of the acreage and its uses along with prevailing rental rates are shown in the tables below.
We based rental rates on the prevailing rates published for Kern County by the California Association of Rural Appraisers and Farm Managers. For our low-end conservative estimate, we used the low end of the rate range given and assumed the scrubland was relatively worthless. For our higher estimate, we used the higher end of the rates given. We also assumed that Michener Ranch can be used recreationally and that the scrubland has some value. We believe the high end estimates are closer to the true value because many of the ranchlands on TRC are used for recreation, filming, and oil & gas exploration. Also TRC rents 55,000 acres in the northlands to a ranching operation and 195,000 acres in the southlands to another ranching operation implying some of the land we have labeled “scrubland” does have some value. (Note that under the conservation agreement ranching can continue.)
We constructed two discounted cash flow models: one using the low estimates and one using the high estimates. For each model we used an 11% discount rate and a 3% long-term growth rate to account for inflation. We assumed a short-term growth rate of 0% for five years due to current rental rate trends, which have been flat, and continued economic weakness.
On the low end we estimate the value of the existing operations on the 62,000 acres at approximately $47M. On the high end we estimate the value to be $72.7M.
Low Estimate: $62.8M ($47M + $15.8M)
High Estimate: $88.5M ($72.7M + $15.8M)
Tejon Industrial Complex (TIC) (1,450 acres)
Tejon Industrial Complex (TIC) is a 1,450-acre site at the north-south connection of Interstate 5 and Highway 99. TIC can reach 97% of California consumers within a one day truck turn. TIC is four hours from the port of Oakland and two hours from Long Beach and Los Angeles ports. TIC also sees 150,000 vehicles per day pass through Interstate 5. TIC has all entitlements needed and development has already commenced.
(Source: company website)
TIC is unique in that it is hard to find comparables to do a proper valuation. With real estate, location is everything and no other comparable parcels will be the exact distances from ports or major cities. Over the years the company has sold off portions of the property, so for our valuation we are going to assume that they can continue to develop and sell or lease property as they have in the past. The most recent transaction for TIC in 2008, valued the land at roughly $170,000 per acre. We will assume development and land sales take place over ten years and include a three-year lull until development continues. Again, we will use discount rates of 11% presently and 8% in the future. We also assumed a tax rate of 35% on land sales.
Low Estimate: $141M
High Estimate: $141M
Tejon Mountain Village (TMV) and Centennial
Placing a value on the acreage that will be developed into TMV and Centennial is also difficult. In researching comparable markets, we looked for small towns or resort communities outside of Los Angeles that are either similar to the planned TRC development in location, traveling distance, or size. Tejon Ranch lists several competing real estate markets in its 10K. Those markets are Santa Clarita Valley, Lancaster, Bakersfield, and Palmdale. We also added the markets in Big Bear City, Tehachapi/Bear Valley Springs, and Lake Arrowhead to our list of comparables. We then looked at what farmland or unimproved empty lots were selling for in those markets. We specifically excluded smaller lots in nicer, developed areas near population centers. Instead, we looked for large tracts (preferably 100+ acres) of empty undeveloped land on the outskirts of those areas.
We found that prices ranged from approximately $50,000 per acre for land in more out-of-the-way areas to up to $300,000+ per acre for land in nicer areas or closer to the center of populated areas. The average for all comparable acreage was approximately $150,000.
Tejon Mountain Village (TMV) (5,334 acres)
Tejon Mountain Village is a planned resort community to be built in the Tehachapi Mountains off Interstate 5 in Kern County. Plans include 3,450 home sites, golf courses, hotels, equestrian facilities, and a publicly accessible commercial center with 160,000 square feet of retail space. TMV will span approximately 26,668 acres, but only 5,334 acres will be developed. The rest will remain as open space.
(Source: company website)
To value the developable acreage, we assumed that development and/or sales of land will not begin for another three years. We also assumed that development will take place over twenty years. We used a discount rate of 11% for the first three years to reflect the current depressed real estate environment. We used a discount rate of 8% for the remaining twenty years. We used a value of $50,000 per acre for or low end valuation and $200,000 per acre for the higher end. Again, we assumed a 35% tax rate on land sales.
Low Estimate: $62M
High Estimate: $248M
Centennial (approximately 5,967 acres)
Centennial is a planned town to be built in Los Angeles County north of Highway 138 and east of Interstate 5, approximately 60 miles north of Los Angeles and 45 miles south of Bakersfield. Plans for the community include 23,000 homes and all the corresponding community and business development necessary to support a town of that size.
(Source: company website)
To value the developable acreage, we assumed that development and/or sales of land will not begin for three years. We also assumed that development will take place over twenty years as per the timeline published by Tejon Ranch. We modeled land sales taking place in equal installments over each of the twenty years for simplicity’s sake. We used a discount rate of 11% for the first three years of no development. We used a discount rate of only 8% for the next twenty years. At the low end of our valuation range we estimated the land to be worth $100,000 per acre and at the high end $200,000 per acre. A 35% tax rate on land sales was assumed
Low Estimate: $139M
High Estimate: $278M
Existing Farm and Ranch Lands (approximately 17,249 acres)
Tejon Ranch has plans to develop approximately 12,751 acres of the 30,000 acres not covered under any conservation agreement. That leaves approximately 17,249 acres of farm and ranch land with no development plans. Tejon Ranch currently farms a mix of crops on 5,138 acres. For valuation purposes we assumed the rest of the land, 12,111 acres, is ranchland. We valued the farmland at $8,500 per acre and the ranchland at $225 per acre, which is the midpoint of the value for crop and range land in Kern County. This gives us a value of $46M for the existing farming and ranching operations.
Low Estimate: $46M
High Estimate: $46M
Modeling Development Costs and Other Income Generating Activities
We chose not to directly model any development costs or include any other income-producing activities other than farming or ranching. In our view the additional expenses for the development of the land and corporate overhead are offset by additional income received. TRC receives income from oil & gas production royalties and cement, sand, and rock royalties mainly from National Cement Company. The company also has recreational ranching operations and receives income from filming rights.
Furthermore, for comparables we chose undeveloped land in large tracts that would need improvement, such as adding utilities service or roads in an attempt to account for this cost.
TRC also receives income for water rights, which is included on the balance sheet as “Water assets.” We chose to value these as recorded. We also included the equity value in several joint ventures related to the development of the land at book value.
Tejon Ranch’s Balance Sheet Adjusted to Today’s Value
We have provided valuations under three scenarios. Explanations for each scenario are included after the balance sheets shown below.
Our first scenario is a worst-case scenario. In this scenario, we assume that TMV and Centennial fail or are never built. We assign a value of zero to both communities. We still include TIC, since it is currently being developed and except for a lull during the recession, development has continued to be steady. We also assign a value of zero to all of Tejon’s joint ventures, a majority of which are related to the development of their land. Instead, we value all of Tejon’s land, except for TIC, at current market prices for range or cropland. Under this scenario we estimate TRC to have a value of approximately $26 per share.
For our conservative estimate, we used the low range values for all the land prices. Under this scenario we estimate TRC to be worth approximately $31 per share.
For our high end estimate we used the high range values for all the land prices. Under this scenario we estimate TRC to be worth approximately $49 or more per share.
Summary
While some of the assumptions used, specifically in the high estimate scenario, might be considered aggressive, they do lead to a valuation that TRC has traded at in the past. If the real estate market improves (and it has after every past real estate bubble) and development goes ahead, we do not believe it is unreasonable to assume that TRC will reach a valuation close to our high estimate. Also, should TMV or Centennial be a success, lots sales in the later stages of development should be sold at prices significantly higher than our assumptions, although our assumptions of land values in the beginning stages of development may be on the high side.
What we like about this particular investment is the strong downside protection. The stock is currently trading at a level that implies TRC’s land is no more valuable than run-of-the-mill farm or ranch land. If the bearish thesis is correct, investors likely stand to lose very little other than opportunity cost. If, however, development is a success, the price should appreciate significantly.
Disclosure: Long TRC
