Comstock Holding Companies (CHCI) – The living dead

Comstock is a distressed homebuilder that defaulted on most of its debt in 2009.  It allowed many properties to enter foreclosure while it worked with its unsecured lenders to re-negotiate/amend its debt.  Currently, the company is still in a precarious position.  It is effectively borrowing money at 20% (from insiders and private investors) while it tries to convert its inventory of land into cash.

Over the past few years, it has been unprofitable and has seen its revenues decline.  Since 2006, every year has been GAAP unprofitable except for 2011 (where the company was profitable because it won a lawsuit).  Comstock trades at a price to book ratio of 8.74 (higher if you take out capitalized interest).

Secured versus unsecured debt

(I could be wrong here.)  Here’s why Comstock’s debt didn’t kill the company even though it defaulted in 2009:

Secured debt is debt that is backed by something such as land and buildings.  Unsecured debt is a different story as it isn’t backed by collateral.  If the lender is unpaid, the lender can try to sue the company to get its money back.  Unfortunately for the lender, two things may happen:

  1. Usually the company isn’t paying its debt because it has practically no money left.  So, there is very little money for the unsecured lender to go after.
  2. The bankruptcy process is very expensive.  The lawyers and accountants have incentives to drag the process out so that they can collect more fees.  The professionals also get paid first before many of the other creditors.  This ensures that there is even less money for the unsecured lender to go after.

For this reason, Comstock’s unsecured lenders could push Comstock into bankruptcy but it would be a lose-lose scenario for both parties.  Instead they have tried to renegotiate the debt to recover what money they can.  What typically happens in bankruptcy is that the unsecured lenders get very little of their money back, so it does make some sense for the unsecured lenders.   Weirdly enough, Comstock has been able to get better terms on its unsecured debt since it is so close to bankruptcy.

The YE2009 10-K has a lot more detail on what happened.  Here is just a snippet:

On April 27, 2009, the Company received a notice of payment default from the lender. The notice of payment default indicated that the failure of the Company to make its quarterly interest payment within 30 days of March 30, 2009 would constitute an Event of Default under the Indenture. The Company has not cured the default. The Company did not make scheduled interest payments at June 30, 2009, September 30, 2009 or December 31, 2009.

On December 23, 2009, Stonehenge Funding, LC (“Stonehenge”), an entity wholly-owned by Christopher Clemente, the Chairman and Chief Executive Officer of the Company, completed the purchase of the senior unsecured note from JPMV in the current outstanding amount of approximately $9.0 million, plus accrued and unpaid interest. The purchase of the JPMV note also resulted in the transfer to Stonehenge of the warrant previously issued to JPMV for the purchase of 1.5 million shares of the Company’s Class A Common Stock. In connection with Stonehenge’s purchase of the JP Morgan debt from JPMV, Stonehenge and the Company entered into two separate subordination and standstill agreements for the benefit of the Company and its secured lenders, KeyBank and Guggenheim. The subordination agreements allow for Stonehenge and the Company to negotiate permanent modifications to the terms of the JP Morgan Debt and provide KeyBank and Guggenheim with assurances that the Company will not make any cash interest or principal payments to Stonehenge prior to the full repayment of loans to them in connection with the Company’s Eclipse and Penderbrook projects. See a related subsequent event disclosure at Note 18.

In regards to the JPMV (JP Morgan Ventures) debt, it was sold to the company’s CEO.  Subsequent restructuring of the debt has been favorable to Comstock as the company has been able to extend the maturity of the debt and reduce the interest rate.

Related party transactions

Comstock has a very large number of related party transactions.  There is some nepotism involved- the CEO’s brother, wife, and his wife’s parents are all mentioned in the 10-Ks over the years.  Many of the related party transactions seem fair or at least defensible.  However, there are some that bother me.  For example, the company is effectively borrowing money from insiders (and private investors) at 20%:

On March 14, 2013, Comstock Investors VII, L.C. (“Investors VII”), a subsidiary of the Company entered into subscription agreements (each a “Subscription Agreement”) with certain accredited investors (the “Purchasers,” and each a “Purchaser”), pursuant to which the Purchasers purchased membership interests (“Interests”) in Investors VII for an initial aggregate principal amount of $6,925 of an up to $7,000 capital raise (the “Private Placement”). Purchasers included unrelated third-party accredited investors along with members of the Company’s Board of Directors and the Chief Operating Officer, Chief Financial Officer and General Counsel of the Company. The Subscription Agreement provides that the Purchasers are entitled to a cumulative, compounded, preferred return of 20% per annum, compounded annually on their capital account balances. After six months, the Company has the right to repurchase the Interests of the Purchasers, provided that (i) all of the Purchasers’ Interests are acquired, (ii) the purchase is made in cash and (iii) the purchase price equals the Purchasers’ capital account plus an amount necessary to cause the preferred return to equal a cumulative cash on cash return equal to 20% per annum. The Private Placement provides capital related to the current and planned construction of the Company’s following projects: The Residences at Shady Grove in Rockville, Maryland consisting of 36 townhomes, The Hampshires project in Washington, D.C. consisting of 38 single family residences and 73 townhomes, and the Falls Grove project in Prince William County, Virginia consisting of 110 townhomes and 19 single family homes (collectively, the “Projects”). Proceeds of the Private Placement are to be utilized (i) to provide capital needed to complete the Projects in conjunction with project financing for the Projects, (ii) to reimburse the Company for prior expenditures incurred on behalf of the Projects, and (iii) for general corporate purposes of the Company.

This deal makes no sense from a tax perspective.  In the past, a similar deal was done for the Cascades rental apartment complex.  When the complex was sold, Comstock ultimately had to pay taxes on the profits (at roughly 38%).  By avoiding the equity, investors have left free money on the table and the structure of the financing forced Comstock shareholders to pay taxes that it otherwise would not pay.  The private placement raised $2.350M.  Comstock repaid the investors $2.944M(?) and paid $2.484M to the IRS.  Its cost of capital on a non-annualized basis is a whopping 131%.  On an annualized basis the figure is lower but still extremely high.  There is no way that Comstock is going to earn its cost of capital.

I can’t figure out how the private placement deals make any sense to shareholders.

The company rents office space from the CEO.  I believe that the rates charged are fair (roughly $29/sqft).  According to loopnet.com, most office space in Reston Virginia ranges from $19-30/sqft.  However, the company could have saved money by using cheaper office space.

Insider compensation

In 2012, $1.80M was spent on the CEO, CFO, and COO.  CHCI ended 2012 with a book value of $6.379M.  Money spent on the key officers was 28.2% of CHCI’s book value.
In 2011, $3.04M was spent on the CEO, CFO, and COO.  CHCI ended 2011 with a book value of $12.544M.  Money spent on the key officers was 24.2% of CHCI’s book value.  Morningstar has a nice summary of executive compensation.

For such a small company, the bloated overhead makes it harder for shareholders to make money.

Accounting

The company has NOLs that can save up to $45M in future taxes.  These NOLs are carried on the books at 0.  I don’t put much value on these NOLs since the company hasn’t been trying to use them effectively and hasn’t been profitable for several years.  Supposing that the company becomes profitable in the future, these NOLs might only be worth $25M or less if you factor in the net present value of the future savings.  CHCI’s market cap is roughly $56.10M, so I believe there is some margin of safety in case this company does become profitable.

I have no opinion on whether its land is carried on its book at a reasonable value.  There is some capitalized interest that inflates book value, though it doesn’t make much of a difference to the short thesis given the very high P/B ratio.

Bottom line

I think that the odds are stacked against this company returning to profitability.  The CEO does a lot of things that don’t make sense for shareholders.  Insiders are paid too much and the company’s cost of capital doesn’t make sense.  This is a badly-run homebuilder that is trading at a large premium to book value.

*Disclosure:  Short.

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3 thoughts on “Comstock Holding Companies (CHCI) – The living dead

  1. This is very interesting, but I’m somewhat confused as to one part of your post, specifically:

    “By avoiding the equity, investors have left free money on the table and the structure of the financing forced Comstock shareholders to pay taxes that it otherwise would not pay.”

    I’m not sure what you mean by leaving free money on the table, nor do I understand you mean by the unnecessary taxes.

    My interpretation was that you meant that the investors should have either bought Comstock common equity (thus not leaving any upside for existing investors) or Comstock debt (allowing the company to avoid paying taxes on interest expenses)?

    Is that interpretation correct?

    • They should have structured the deal in a more tax-efficient way. A private placement of stock would have been better for shareholders (as long as the company doesn’t violate the IRS’ NOL rules). Debt would have been better. Just any type of deal that lets Comstock use its NOLs.

  2. Pingback: Homebuilders revisited | Glenn Chan's Random Notes on Investing

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