Gyrodyne - A Liquidation

Shares of Gyrodyne LLC (G-LLC) represent good value in the current market with shares available for purchase at $25.05 with a liquidation value of $31.24 with the potential for more. The company is in liquidation, thus providing its own ‘catalyst’ to realize value. The company intends to achieve liquidation by December 31, 2016, providing a 25% return with a margin of safety and a larger potential upside, especially from the Flowerfield property, if estimates turn out to be conservative.

Background:

Many value investors are familiar with the name Gyrodyne Company of America (GCA). In September 2013, GCA adopted a plan of liquidation. The company’s liquidation plan has a fairly complicated history and GCA as a whole has quite an interesting history as well. However, its history is largely irrelevant to the thesis. In order to not stray from the narrative, I will provide just a high level historical background.

Years ago, GCA owned a property which was taken by the state of NY under eminent domain. GCA was grossly underpaid for the property and chose to litigate. The courts came out in favor of GCA, which then received substantial payments from the state for additional consideration as well as for statutory interest. At the time of exercising its eminent domain rights, NY paid $26 million for the 245.5 acre property it “took”, whereas the court awarded an additional $98 million of consideration (this, total consideration of $125mm), $67 million in interest, and $1.5 million in costs and expenses.

GCA obtained a private letter ruling from the IRS allowing it to pay out amounts thus received to shareholders without incurring capital gains at the REIT level. Part of this dividend was paid in cash and part was paid in non-transferable interests in Gyrodyne Special Distribution, LLC (“GSD”), which held its properties. The transfer of properties by GCA to GSD resulted in the recognition of capital gain income (and thus REIT income) by GCA in 2013. In order to satisfy applicable REIT distribution requirements, Gyrodyne declared a second special dividend in December 2013. The second special dividend was paid in the form of nontransferable dividend notes (“DN”).

In order to finish the tax liquidation (which must be completed within the two year period from the adoption of the plan), the company undertook its latest transaction which combines all of GCA, GSD, DN into G-LLC. The merger to create G-LLC had to be delayed several times from an original date of August 14, 2014 to September 1, 2015, when it was finally consummated. The delay was caused by enough shareholders not responding to the vote proxy. G-LLC is now the only entity containing all of the properties to be liquidated.

Why is the opportunity available?

First, before the merger into G-LLC, the GSD and DN interests were non-transferable for almost one and a half years. Naturally, the merger into a liquid security gave holders of GSD and DN stakes an opportunity to sell. In fact, when the merger was completed, the trading level of G-LLC was pretty close to today’s announced liquidation value but soon dropped rapidly indicating significant selling. Second, all of this selling occurred in a fairly illiquid market. On an average day, anywhere from a few hundred to a few thousand shares of G-LLC may trade. The market cap is about $37 million and the free float is even smaller (due to large holders; Poplar Point, Tower View, and management together comprise about 21% of the outstanding shares without consideration of any other sub-5% holders), making it impossible for large buyers to take advantage of the situation.

Valuation:

Based on the latest 10-Q filed by G-LLC, the liquidation value per share is $31.24 per share, representing a 25% upside from today. Further, in the 10-Q, the company noted that the liquidation is “currently anticipated to be completed by December 31, 2016.”

The current properties of the company include (along with a description of each:

	Property	Description
1	Port Jefferson Professional Park in Port Jefferson Station, New York. (10 of 14 buildings owned by G-LLC)	On June 27, 2007, the Company acquired ten buildings in the Port Jefferson Professional Park in Port Jefferson Station, New York. The buildings were acquired for an aggregate purchase price of $8,850,000 or $225 per square foot. The buildings, located at 1-6, 8, 9 and 11 Medical Drive and 5380 Nesconset Highway in Port Jefferson Station, are situated on 5.16 acres with 39,329 square feet of rentable space. As of December 31, 2014, there were 15 tenants, comprising 14 leases; the difference reflects one long-term tenant under a month to month agreement. The annual base rent based on the rates in effect as of December 2014 is $743,000 which included month–to-month annualized base rent of $21,000 on approximately 800 square feet. The occupancy rate was 70% as of December 31, 2014.
2	Cortlandt Medical Center	On June 2, 2008, the Company acquired the Cortlandt Medical Center in Cortlandt Manor, New York. The property consists of five office buildings which are situated on 5.01 acres with 31,198 square feet of rentable space on the date of acquisition. The purchase price was $7 million or $231 per square foot. As of December 31, 2014, there were 15 tenants, comprising 15 leases. The annual base rent based on the rates in effect as of December 2014 is approximately $821,000. The property was 100% occupied as of December 31, 2014. Following certain capital improvements, the rentable square feet currently is 31,421 square feet. On August 29, 2008, the Company acquired a 1,600 square foot single-family residential dwelling located on 1.43 acres at 1987 Crompond Road, Cortlandt Manor, New York. The purchase price was $305,000. The Company was able to take advantage of a distressed sale by the seller. The property is located directly across the street from the Hudson Valley Hospital Center and adjoins the Cortlandt Medical Center. The property is zoned for medical office use by special permit and is potentially a future development site for expansion of the Cortlandt Medical Center. On May 20, 2010, the Company acquired the building located at 1989 Crompond Road, Cortlandt Manor, New York. The property consists of 2,450 square feet of rentable space on 1.6 acres. The purchase price for the property was approximately $720,000. This property is adjacent to the 1.43 acre property acquired by the Company in August 2008, and these two properties combined result in the Company owning approximately three acres directly across Crompond Road from the Hudson Valley Hospital Center in addition to the 5.01 acre Cortlandt Medical Center site. The property was 100% occupied as of December 31, 2014 by two tenants with a total annual base rent of $35,700.
3	Fairfax Medical Center	On March 31, 2009, the Company acquired the Fairfax Medical Center in Fairfax City, Virginia. The property consists of two office buildings which are situated on 3.5 acres with 57,621 square feet of rentable space at date of acquisition. The purchase price was $12,891,000 or $224 per square foot. As of December 31, 2014, there were 29 tenants, comprising 30 leases, renting space with an annual base rent of $1,463,000, based on the rates in effect as of December 2014. The occupancy rate as of December 31, 2014 was 93%.
4	Flowerfield	A 68 acre site, primarily zoned for light industry, and is located approximately 50 miles east of New York City on the north shore of Long Island. Flowerfield’s location places it in hydrological zone VII, one of the most liberal with respect to effluent discharge rates. The existing buildings are located in the hamlet of St. James, Township of Smithtown. The Flowerfield property is mostly undeveloped and is adjacent to the land that was taken by the state of NY under the 2005 eminent domain action. There is also about 130,426 square feet of rental space with an annual rent of $1,521,000.

On the whole, management has provided a gross sales estimate of $45,450,000 and a net estimate (net of selling costs of 6%) of $42,723,000 in their liquidation analysis. Using the 2014 impairment (Jefferson) and sale analysis (Cortlandt and Fairfax) and assigning the difference (by subtracting those three properties from $45,450,000, it seems Management has valued the properties as shown below. Also summarized below are the original purchase prices, annualized rents (from the 2014 10-K) and per square foot metrics.

For income producing portion of the properties, management used cap rates of 7.5% to 9.5%. Given the nature and location of the properties, the cap rate does not appear unreasonable. (Note that two properties have a combination of leased and redevelopment space and occupancy at the other two locations is partial so if you took the current property level NOI and applied the cap rate, you wouldn’t get to Management’s estimates as other components are involved). The CBRE office market report for Long Island shows cap rates for B & C properties in Long Island to be within the range used by management. Also, the properties seem to be garnering rents per square feet in line with the local market area rents according to the report ($24-26 psf).

Further, in looking at the transaction activity for REITs that own medical offices, cap rates of 7.5% to 9.5% for Class B & C properties seem to be within the ball park.

Cortlandt and Fairfax were acquired during the recession and the current valuation appears not to be much different from the initial purchase which gives some comfort that the properties are perhaps not being aggressively valued. Jefferson was acquired at the peak of the market but has subsequently been written down in 2013 and 2014 by about 30%.

As to the Flowerfield property, management has used a market value approach. It’s notoriously difficult to value undeveloped land. But one data point does exist from the state of NY condemnation mentioned above. The final consideration determined by the court in that case was $125 million for 245.5 acres of this same property, which would equate to $0.509 million per acre. Applying this against 68 acres yields $34.6 million. Of course a significant discount to undeveloped land value is probably warranted as a large transaction similar to NY probably wouldn’t occur for all of the acreage. Given the location next to SUNY, it’s difficult to imagine this land would be totally worthless. I believe a 50% discount from the judgment amount is adequate to account for the market correction and illiquidity, giving a value of $17.31 million for the 68 acres. The rentable area of 130,426 square feet has the lowest annual rent per leased square foot at $17, which is quite low even in C markets. In the past few years, this property has produced NOI at 50% of base rental income. IF it were to be 100% leased at $17 psf, this NOI would be $1.109 million (130,426 * 17 * 50%). At a 10% cap rate on $1.109 million, the property would be valued at about $11.1 million equating to $85 psf in gross sale value. However, it’s going to be very difficult to be leased 100% prior to sale, and perhaps a discount of 50% to $42.5 psf is warranted, giving a value of $5.54 million. Adding the land and the rental pieces together, Flowerfield could total up to $22.85 million. Appraisal estimates used in GCA’s litigation with NY were in excess of this amount. However, those appraisals were made using a residential zoning scenario for the acreage and the company, according to the latest 10-Q, is planning to rezone prior to sale.

I am not suggesting that Flowefield will necessarily fetch $22.85 million, but the point is to only show that management’s implied valuation of $16.4 million is likely achievable given that the value under fairly conservative assumptions produce a number above management’s valuation.

It is also worth noting that valuations for the properties similar to those used in liquidation accounting were also used to issue the GSD dividend to take advantage of the IRS private letter ruling and it would be highly unlikely that management would significantly overestimate the real estate value in the dividend.

Potential upside beyond current valuation:

Valuations in liquidations often tend to be conservatively estimated. Managements are loathe to set up high expectations in liquidations and not meet them. It’s much easier to set up a lower expectations and then to beat them handily. This is particularly true when it comes to distributions or dividends. It is also safer for management to make conservative estimates and to surpass them than to make aggressive estimates and risk being blamed/sued for breach of fiduciary duty if the final distributions come out less than estimated.

As noted earlier, Flowerfield’s land and rental values taken together may somewhat exceed the Management valuation. This property has perhaps the most potential for generating. It is possible a higher value will be realized, but difficult to say exactly how much.

In the case of G-LLC, Management has a further incentive for a conservative bias. The company has a bonus plan in place to reward management for liquidating assets at a premium to appraisal value. The bonus pool is to be funded upon the sale of each of the Company’s properties with an initial amount equal to 5% of the specified appraised value of such properties, so long as the gross selling price of the property is equal to or greater than 100% of its appraised value. Additional funding of the bonus pool would occur on a property-by-property basis when the gross sales price of a property exceeds its appraised value as follows: 10% on the first 10% of appreciation, 15% on the next 10% of appreciation and 20% on appreciation greater than 20%. Furthermore, if a specified property is sold on or before a designated date specified in the plan, an additional amount equal to 2% of the gross selling price of such property also would be funded into the bonus pool.

In order for management to earn the additional 2%, the properties must be sold by the following dates:

Cortlandt Manor – December 31, 2014
Fairfax – December 31, 2014
Port Jefferson – December 31, 2015
Flowerfield – December 31, 2016

The delay of the merger (noted above) caused the deadlines on Cortlandt and Fairfax to be missed. During October 2015, GLLC signed two non-binding PSAs to sell two of the ten buildings in the Port Jefferson Professional Park with closing expected in December 2015. The sales prices in the contract exceed the appraised value. The Cortlandt, Fairfax, and Jefferson properties are expected to be sold by June 2016.

The bonus pool is distributable in the following proportions: 15% for the Chairman, 50% for the directors other than the chairman (10% for each of the other five directors) and 35% for the Company’s executives and employees.

The property-level appraisals in the plan were withheld under confidential treatment but total appraised gross value stated in the plan is: $45,050,000 compared to gross real estate proceeds stated in liquidation accounting foot note of $45,450,000. As a result, management is certainly incentivized to seek the highest values for the properties.

Further, the Company owns a 10.12% LP interest in the “Grove” partnership. The Grove owned a 3,700+ acre citrus grove located in Palm Beach County, FL, which was the subject of a plan for mixed-use development. The Grove’s lender (Prudential) commenced a foreclosure action against the partnership. The property was sold by the partnership, the lawsuit was dismissed, and the debt repaid. GLLC did not receive any distribution in connection with the sale. Under the agreement with the purchaser, the Grove may receive additional payments if some development benchmarks are achieved by the purchaser. G-LLC is not providing a fair value and marking the investment at 0. It’s very likely that this the Grove is in fact a doughnut. It’s a long-shot but if they get something for it, it may increase the return, but it’s impossible to guess if and how much. Just something to be aware of.

Risks - there are two main risks:

1.     Timing: The entire saga of the Gyrodyne liquidation has been going on for some time and there’s no guarantee that management will stick to its December 31, 2016 guidance. This is not a capital risk as such, only a timing risk which may reduce annualized return. The only way this becomes a capital risk is if the liquidation takes so long that we go through the next major real estate correction. Currently, this possibility of the liquidation taking THAT long seems remote.

2.     Development: This risk relates to Flowerfield and Cortlandt undeveloped spaces. Management has indicated that perhaps pursuing zoning or developing projects at these properties will increase the ultimate liquidation value of the properties. A development project may require an investment of capital. If the returns on these projects are positive, the liquidation value and return could be enhanced but so would be the time required. It’s impossible to know which way management will take (although, indications are that zone-and-sell will be the preferred route) and how that would affect the return, given the time required.

Given the downside protection provided by the estimated liquidation value, the timing risk and potential additional upside (from 0% to 20%) is best seen in a sensitivity chart shown below. If distributions are made as properties are sold, the realized returns will be higher than those presented here as they assume one final distribution at the end of the period.                                 

	Final Distribution Value
	0%	+ 5%	+ 10%	+ 15%	+ 20%
Years	31.24	32.80	34.36	35.93	37.49
1.0	24.7%	30.9%	37.2%	43.4%	49.7%
1.5	15.9%	19.7%	23.5%	27.2%	30.8%
2.0	11.7%	14.4%	17.1%	19.8%	22.3%
2.5	9.2%	11.4%	13.5%	15.5%	17.5%
3.0	7.6%	9.4%	11.1%	12.8%	14.4%

As of this writing, the 10-year treasury trades at 2.25% and the S&P 500 index trades at 5% earnings yield on a trailing basis. Given the relative safety of this investment, I believe it provides a good risk-adjusted return on a relative and absolute basis compared to alternatives available in the market.

Please note:

Under NO circumstances should any content or communication here be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. PLEASE do your own due diligence prior to investing.

Disclosure: Long GYRO