MGM Sitting on Real Estate Jackpot

It's exploring a REIT conversion to unlock its land's value.
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The Bellagio casino on the Las Vegas Strip is one of the swankiest resorts in the world. It's being valued by the stock market, however, as if it were a run-of-the-mill motel.

While the Bellagio's owner,

MGM Mirage

(MGM) - Get Report

, has seen its stock price double since September, some real estate-minded investors still believe the company's valuation is too low.

Now, sources familiar with the gaming market say that MGM is exploring the spinoff of some of its assets to create the first major gaming real estate investment trust, or REIT, to unlock some of the company's real estate value.

Casino operators have traditionally traded at discounted multiples to pure-play resort and hotel owners. This frustrates investors, however, because MGM owns high-quality hotels whose true market value might be lost to Wall Street. More than 80% of MGM's profits come from lucrative Las Vegas Strip properties like the Bellagio, Mandalay Bay, MGM Grand and the Mirage.

Mark Capasso, a managing director of Cushman and Wakefield who conducts property-level valuations of Las Vegas casinos and hotels, says that these discounts arise because gaming is looked at as a riskier investment than hotels.

"The underlying revenue associated with gaming-company stocks tends to be a lot more up and down," he says. As well, gaming companies also have more legislative and regulatory risks.

But this disconnect signals only hidden value for some investors.

"They need to find a way of evidencing the real estate value inherent in MGM, because it makes no sense for that real estate to be trading at 12 times EBITDA (earnings before interest, taxes, depreciation and amortization)," says one buy-side source, who owns MGM.

"You can't even buy a fleabag hotel anywhere (on the private market) for less than a 14 times-EBITDA multiple," says the source, who comes from a background in real estate securities but now invests across the spectrum. His firm prevents his being quoted in the press.

By splitting the gaming operations into one company and the property operations into a REIT, the hope is that MGM's parts would be worth more than the whole.

"If they can figure out how to structure it, it's worth investigating further to unlock value," says Joe Fath, a gaming analyst with T. Rowe Price, which owns MGM shares.

MGM didn't return calls for comment about a possible real estate spinoff or REIT conversion.

In a recent

Wall Street Journal

interview, MGM President Jim Murren was quoted as saying that investment bankers have "bombarded" him with examples of real estate-spinoff transactions, which he called "thought-provoking."

Any spinoff of MGM assets poses tax issues and regulatory concerns, but a REIT conversion could very well occur.

"I don't think it is necessarily as complicated as everyone thinks it will be," says one veteran real estate investment banker. The banker points to the fact that

Station Casinos

(STN) - Get Report

contemplated the structure in the late 1990s and even filed a S-11 on the matter, in conjunction with

Crescent Real Estate's

(CEI) - Get Report

proposed acquisition of the company at the time. (That deal later fell through, and Station recently received a management-led buyout offer.)

"Station managed to get through all these hurdles back in the '90s, and if anything, the REIT regulations have gotten more flexible," the banker says.

The main economic value of a REIT conversion is that REITs don't pay corporate taxes.

However, the conversion to a REIT could trigger a huge upfront tax on the sale of the properties, which would hurt MGM shareholders, according to a recent research note from Goldman Sachs analyst Steven Kent.

Over the past six months, the multiple spread between casino and hotel owners is shrinking.

Ever since billionaire Kirk Kerkorian announced his $55-per-share tender offer for 15 million shares in late November, MGM stock has soared. The stock now trades around $70.

At that price, MGM's enterprise value trades at 12.5 times its estimated 2007 EBITDA. In comparison,

Host Hotels

(HST) - Get Report

, at $26, trades at 12.6 times forward EBITDA.

Marriott

(MAR) - Get Report

, which owns no assets but receives lucrative management contracts for hotels, trades at $48, 14-times EBITDA.

In real estate terms, MGM's 12.5-times multiple implies it is trading at about an 8% cap rate, or initial rate of return. (The higher the cap rate, the lower the portfolio price.)

Average hotel portfolios are currently trading in the 7%-8% cap-rate range on in-place fundamentals, says Michael Fishbin, national director of hospitality and leisure services for Ernst & Young. Some of the highest-quality hotel assets in New York City are trading at cap rates of 5% and below, according to Cushman & Wakefield.

The highest price target from Wall Street analysts on MGM is $82, by UBS analyst Robin Farley. She values the Las Vegas assets at a 10-11 times 2007 EBITDA, which equates to 9%-10% cap rates.

But even this price target may be too low. The fact that Station Casinos' management is trying to take the company private and Kerkorian offered to buy a substantial chunk of MGM signals that Las Vegas real estate is mispriced on the public market, bulls say.

Kerkorian and Station's management "all see enormous hidden value in the companies they own," says Paul Kanavos, CEO of Flag Luxury Properties, a resort developer that owns developable land on the Las Vegas Strip directly across from MGM's City Center project.

Kanavos owns stock in MGM and calls it a tremendous value right now.

"The cash flow of hotels and casinos in Vegas have become very stable now," he says, adding that he expects casino multiples to eventually gravitate toward 15 to 18 times multiples over the next few years.

Kanavos' comfort in owning MGM is based on where quality hotels are trading on the private market. He says his firm was recently offered a 4% cap-rate price for the Ritz Carlton South Beach hotel in Miami. Given this offer, MGM's stock at 12.5-times EBITDA, or an 8% cap rate, only reinforces his belief that MGM is a steal.