Model Portfolio athompson:TPSNX

Meruelo Maddux Properties, Inc. (NASDAQ: MMPI) is a real estate company that I believe is substantially under-priced relative to the value of its real estate holdings. MMPI is trading at such a low price because the market is concerned about its solvency. While these concerns are not entirely groundless, I think it is likely that Meruelo Maddux will remain solvent, and all of the recent changes in this area have been positive.

Note: MMPI closed on September 17 at $0.99

Meruelo Maddux owns and develops residential, industrial, and commercial real estate in the Los Angeles metro area, primarily in downtown LA. As a development-oriented real estate company, Meruelo Maddux has a negative cash flow; the expenditures for development of its properties exceed its rental revenuewhich makes it difficult to value using commonly used metrics and ratios (such as price/earnings ratio).

Accordingly, I will analyze MMPI's value in terms of the price that shareholders effectively pay for the company's real estate holdings. I believe that Meruelo Maddux provides the opportunity to buy real estate for substantially less than it is actually worth. When you buy a share of MMPI, you are, in effect, buying a share of Meruelo Maddux's real estate holdings plus a share of the company's other assets). For this, you are paying the share price plus your share of Meruelo Maddux's debt. For simplicity, I'll analyze this in terms of the value of the entire company. Given its recent price of $1.24/share (September 8, 2008), MMPI has a market capitalization of $107 million. The company's total liabilities are $385 million. So you're paying a total of $492 million for the company's assets. You get Meruelo Maddux's real estate assets plus $23 million in other assets. Subtracting out the $23 million in other assets, you're paying $469 million for Meruelo Maddux's real estate assets. How much are those assets worth? $773 million according to Meruelo Maddux's balance sheet. So you're buying Los Angeles real estate at a 39 percent discount (if Meruelo Maddux's real estate is carried on the balance sheet at its actual value).

Is Meruelo Maddux's real estate carried on the balance sheet at the amount it's really worth? Well, the value of real estate is typically understated on balance sheets prepared in accordance with Generally Accepted Accounting Principles, particularly if the property was purchased a long time ago. Real estate is typically carried on the books at the original purchase price, less depreciation for buildings. But over the long term, well-maintained buildings generally appreciate rather than depreciate, and land also tends to appreciate. However, Los Angeles area real estate appreciated rapidly from 1997 to 2006. It seems reasonable to think that it became overvalued at some point and has not yet fallen back to fair value. So I will discount Meruelo Maddux's real estate holdings according to their acquisition date. For this, I will use estimates from the Global Insight/National City Bank Housing Valuation Analysis. For example, I will discount properties acquired this year by 11 percent, properties acquired in 2007 by 24 percent, and properties acquired in 2006 by 28 percent. I will assume that properties acquired in 2003 or earlier have appreciated. Using this method, I estimate the value of Meruelo Maddux's real estate holdings to be $716 million. Given this estimate, buying MMPI is equivalent to buying Los Angeles real estate at a 34 percent discount. I consider it reasonable to invest in real estate when you can acquire it at a discount of least 20 percent.

Of course, the most I have established so far is that if you want to invest in real estate, buying MMPI is an attractive way to do so. But you might well think that is a huge if. We hear about the real estate crisis everyday in the news. Surely real estate is just going to go down, down down! Even at a 34 percent discount, real estate is a bad investment. Well, a year or even six months ago, I was inclined to agree with this sentiment. However, real estate in Los Angeles has now fallen 25 percent from its peak. I believe Los Angeles real estate prices may be getting near fair value. Recall also that MMPI is trading at a 34 percent discount to the estimated fair value of its real estate holdings, not to their market value. This estimate assumes that Los Angeles real estate is still overvalued by about 5 percent. This estimate may not be exactly right, of course, but a 34 percent discount provides some margin of safety.

Moreover, there is another somewhat conservative element of my analysis. I treat properties as worth their purchase price (adjusted for appreciation or depreciation) plus the cost of improvements. However, the point of developing property is to increase its value. If all goes as planned, Meruelo Maddux's properties will be worth more than their cost once development is complete.

I also think that downtown Los Angeles is a relatively promising location. Downtown LA is undergoing a significant transformation, e.g., population grew 20 percent between 2005 and 2007. While I don't expect downtown LA to turn into Manhattan overnight, I do expect continued gradual renewal, partly because high gas prices provide an incentive to live closer to work. There are currently about 500,000 jobs downtown but only 30,000 residents. This is a much lower ratio of residents to jobs than other major West Coast cities. Downtown LA is also beginning to get the attributes, such as restaurants, entertainment venues, retail stores, and a major supermarket that make it desirable and feasible to live downtown.

Of course, a 34 percent discount and a promising location will mean nothing if Meruelo Maddux goes under. And given all the problems in the credit markets that we keep hearing about in the news, isn't that a probable outcome? That certainly seems to be what the stock market thinks. However, while it is a live possibility that Meruelo Maddux will go bankrupt, I think it is unlikely. For one thing, Meruelo Maddux has been able to roll over its maturing debt so far this year (at reasonably good interest rates for the most part). In the first two quarters of this year, seven of Meruelo Maddux's loans matured. In each case, the loan was either extended by the lender at the same interest rate or Meruelo Maddux was able to refinance the loan at the same interest rate. In another sign that the credit crisis isn't completely crippling Meruelo Maddux, the company was able to obtain an $84 million construction loan to complete a high-rise multifamily residential project. The terms of this loan are not particularly favorablethe interest rate is 12 percent. Still, it is encouraging that Meruelo Maddux was able to obtain a loan since financing is reportedly so hard to obtain nowadays.

There have been other favorable developments recently as well. In August, Meruelo Maddux received $14 million in a settlement of an eminent domain dispute with the Los Angeles Unified School District. (The total amount of the settlement was $50 million; the rest had already been received.) In August, Meruelo Maddux also sold another property for $35 million (for a profit of $14 million). I think it is likely that Meruelo Maddux will be able to obtain financing for some of its projects and that it will be able to sell non-core properties to fund the rest. Meruelo Maddux management has identified nineteen non-core properties for possible sale and has received written offers for eight of them.

Even in a “worst-case” scenario in which some of Meruelo Maddux’s properties were foreclosed on, this would not necessarily result in a loss to MMPI shareholders. Since Meruelo Maddux’s real estate holdings are worth $243 million more than shareholders effectively pay for them, there is a significant cushion to absorb some loss due to foreclosures or distressed sales. I should point out, however, that the continued revitalization of downtown LA is very important to Meruelo Maddux’s prospects. Meruelo Maddux’s success, and perhaps even its survival, depends on its ability to rent out luxury apartments in downtown LA at rents close to those currently achievable.

In sum, I think the market’s overreaction to credit crisis and to the fall in real estate prices has provided the opportunity to acquire valuable real estate at an attractive price by buying MMPI stock. It is certainly not without risk, but the upside is very attractive. I expect that the housing market will hit bottom and then begin the rebound within a year or two. There will most likely be an accompanying easing of the the credit crunch as well. Once that happens, I expect MMPI’s stock price to appreciate to the point where it no longer trades at a discount to the value of the real estate holdings. Since the real estate holdings are worth $716 million and there are other assets of $23 million, the total assets are worth $739 million. Subtracting out liabilities of $385 million leaves us with equity of $354 million. Since there are 86.4 million shares of MMPI stock, the price per share should reach $4.10.