How To Value REITs With Questionable Alignment

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Includes: ARCT, EQC, GAIN, GLAD, GOOD, SIR, SNH, VER
by: Dane Bowler

The market fears externally managed companies and trades them at significantly lower earnings multiples. Such a discount is in many cases justified by the degree of misalignment between management and shareholders, but when this misalignment is only perceived and not practiced, the discount is an opportunity. In this article we will examine some of the REITs which are perceived to have the most misaligned management and analyze the extent of truth behind the perception. Below is a list of externally managed REITs:

Company (ticker)

External manager and/or parent company

Price/FFO or P/E pending REIT status

CommonWealth REIT (NYSE:CWH)

RMR

4.7

Select Income REIT (NYSE:SIR)

RMR

9.0

Senior Housing Properties Trust (NYSE:SNH)

RMR

13.1

Gladstone Commercial (NASDAQ:GOOD)

Gladstone Management Corporation

11.9

Gladstone Capital Corporation (NASDAQ:GLAD)

Gladstone Management Corporation

9.8

Gladstone Investment Corporation (NASDAQ:GAIN)

Gladstone Management Corporation

10.65

American Realty Capital Trust (NASDAQ:ARCT)

American Realty Capital

15.6*

American Realty Capital Properties (ARCP) American Realty Capital 17.4*

SNL US Equity REIT Index

n/a

15.2

Click to enlarge

*The reason for these elevated valuations is detailed later, and ARCT recently internalized management.

We will begin our examination with CommonWealth and its external manager RMR as it is both the most stigmatized (as evidenced by the extremity of its multiple) and serves as a nice template for an externally managed company. Included below is the pertinent portion of the newly updated (12/13/12) contract between CWH and REIT Management and Research LLC, Otherwise known as RMR.

Compensation

"The Management Fee for each full fiscal year shall equal the sum of (i) seven tenths of one percent (0.7%) of the Annual Average Invested Capital up to $250,000,000, plus (ii) one half of one percent (0.5%) of the Annual Average Invested Capital exceeding $250,000,000, plus (iii) one percent (1.0%) of the Annual Average Foreign Invested Capital. The Management Fee shall be prorated for any partial fiscal year of the Company during the term of this Agreement. (B) In addition, the Manager shall be paid an annual incentive fee (the "Incentive Fee") for each fiscal year of the Company, consisting of a number of shares of the Company's common shares of beneficial interest ("Common Shares") with an aggregate value equal to fifteen percent (15%) of the product of the weighted average Common Shares of the Company outstanding on a fully diluted basis during such fiscal year and (ii) the excess if any of FFO Per Share for such fiscal year over the FFO Per Share for the preceding fiscal year."

Essentially, the poor alignment with shareholders is derived from management fees being rooted primarily in invested capital. This incentivizes rampant growth through leverage and equity offerings with little regard to profitability or dilution. Some other contracts tie fees to revenue instead of invested capital, but the same problem results. Part of the contract above, in which incentive fees are based on FFO/share, may appear to promote alignment, but it actually favors volatility of earnings. For example, annual earnings alternating between $0.50/share and $0.00 per share would generate more fees than a constant $0.50/share. The very nature of this contract and that with most external managers directly undermines alignment.

The other point of note in the compensation agreement is that the overall amount of fees is not excessive. For the nine months ended 9/30/12 these fees totaled just over $32mm for CWH which is fairly comparable to the salaries plus stock based compensation of managers of an internally managed company of a similar size.

Since the fees are not excessive, we can conclude that being externally managed is harmful to a company's profitability if and only if it causes poor managerial decisions. This sort of thing can only be examined on a case by case basis.

The RMR managed companies

The failure to use available capital to redeem common stock with CommonWealth trading at absurdly low prices suggests that RMR has more loyalty to their compensation agreement than to shareholders. Enumeration of all the egregious acts of CWH's management here would be redundant as I already wrote extensively about this matter in a previous article. I believe that the extremely low valuation of CWH is, unfortunately, justified by poor managerial performance and therefore does not represent a solid opportunity.

As Select Income REIT is also managed by RMR under a similar contract, a similar conclusion could be intuited. However, in the March, 2012 spin-off in which SIR IPOed, it received the properties that were arguably the strongest portion of CWH. Furthermore, its FFO has been steadily increasing. While I remain apprehensive just by association, SIR definitely has potential.

Senior Housing Properties stands out as having one of the highest valuations of any externally matched company at 13.1, but it still remains cheap compared to its peers. It is the cheapest play on the senior housing market which looks very strong in the current environment. Much like SIR, it is performing well, but I am left wondering if it will follow in CommonWealth's footsteps.

Gladstone Management Corporation

Gladstone Management Corporation is the external management that runs Gladstone Commercial. Its compensation package, while not ideal, does a much better job of aligning management with shareholders. Below is the crucial portion:

Advisory Agreement

"The Advisory Agreement provides for an annual base management fee equal to 2% of our total stockholders' equity, less the recorded value of any preferred stock ("common stockholders' equity"), and an incentive fee based on funds from operations ("FFO"). For the three and nine months ended September 30, 2012, we recorded a base management fee of $0.4 million and $1.1 million, respectively, and for the three and nine months ended September 30, 2011, we recorded a base management fee of $0.4 million and $1.2 million, respectively. For purposes of calculating the incentive fee, FFO includes any realized capital gains and capital losses, less any distributions paid on preferred stock and senior common stock, but FFO does not include any unrealized capital gains or losses. The incentive fee rewards the Adviser if our quarterly FFO, before giving effect to any incentive fee ("pre-incentive fee FFO"), exceeds 1.75%, or 7% annualized (the "hurdle rate"), of total common stockholders' equity. The Adviser receives 100% of the amount of the pre-incentive fee FFO that exceeds the hurdle rate, but is less than 2.1875% of our common stockholders' equity. The Adviser also receives an incentive fee of 20% of the amount of our pre-incentive fee FFO that exceeds 2.1875% of common stockholders' equity. For the three and nine months ended September 30, 2012, we recorded an incentive fee of $0.9 million and $2.6 million, respectively, offset by a credit related to an unconditional, voluntary and irrevocable waiver issued by the Adviser of $0.5 million and $1.8 million, respectively, resulting in a net incentive fee for the three and nine months ended September 30, 2012, of $0.4 million and $0.8 million, respectively.""

The terms of this contract directly incentivize management to improve both shareholder equity and earnings per share. Perhaps the 20% of FFO beyond the hurdle is a bit excessive, but I would rather have well-paid management aligned with shareholders than the opposite. When this incentive fee becomes so high as to burden the company, management amazingly did the right thing and waived a portion of its fee as we will see in a continuation of the excerpt above:

"For the three and nine months ended September 30, 2011, we recorded an incentive fee of $0.9 million and $2.6 million, respectively, offset by a credit related to an unconditional and irrevocable voluntary waiver issued by the Adviser of $0.8 million and $1.8 million, respectively, resulting in a net incentive fee for the three and nine months ended September 30, 2011, of $0.1 million and $0.8 million, respectively. Our Board of Directors accepted the Adviser's offer to waive, on a quarterly basis, a portion of the incentive fee for the three and nine months ended September 30, 2012 and 2011, in order to support the current level of distributions to our stockholders. This waiver may not be recouped by the Adviser in the future."

The market's fear of external management holds GOOD at a P/FFO of only 11.9 and an impressive yield of 8.34% yet the capabilities and practiced alignment of management suggest a materially higher price. GOOD represents an excellent opportunity to catch the value and yield before the rest of the market realizes its strength. This company has never missed a dividend payment since its inception and steadily grows FFO/share.

GLAD and GAIN also post irrationally cheap valuations resultant from the markets seemingly unfounded fear.

American Realty Capital

ARC takes the game of raising capital to a whole new level with countless offerings summing to tens of billions of dollars raised. Most of these remain untraded, but it revolutionized the business once again with the way it executed the IPOs of ARCP and ARCT. While most companies hide their compensation packages, Nicholas Schorsch (Chairman and CEO) publicized his team's generous payment schedule with a broadly seen interview on Mad Money. He made it very clear to potential shareholders he was going to do everything in his power to raise the stock price as that was part of the terms of his compensation. This major payday was suggested to be part of the process of internalizing management at ARCT, so many investors expected ARCP was soon to follow. Rather than being seen as externally managed taboo, Schorsch successfully brought the publicly traded portion of his company into the favor of the market.

Having Recently paid for the expensive internalization, many ARCT shareholders felt cheated by the quick sale of the company to Realty Income. This merger was covered extensively in an article by fellow SA writer, Adam Aloisi, so I will not go into further detail here.

Conclusion

Many of those who are persuaded to invest in the capital raising efforts of companies such as these are left with unfavorable liquidity and hefty fee payments. Until the company matures and stabilizes in a freely traded exchange investors should be very cautious. Once this occurs, it can be an opportunity as long as we remain informed and trust the management.

CommonWealth and the other RMR companies are excellent values, but the deceptive behavior of management makes them too risky, even for my risk tolerant portfolio.

Gladstone Management Corporation structures its contracts in a way that promotes alignment, so we get the chance to buy a good company at a bad company's prices.

American Realty Capital is truly talented at raising capital and promoting its products, but such promotion leaves ARCT and ARCP fully priced and lacking of opportunity.

Disclosure: 2nd Market Capital and its affiliated accounts are long ARCP and GOOD. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.

Disclosure: I am long ARCP, GOOD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.