Some time ago, when I was managing a fixed income and preferred portfolio for an insurer, my CIO told me something I often recall when looking at "value" investments:
Yield does not compensate for bad management.
I have been writing for over a year on Commonwealth REIT (CWH) (here and here) and have not been a fan of the REIT, its management or the opportunity available. My concerns with the REIT have been echoed by two activist investors - Corvex Management and Related Fund Management - and the REIT's share performance has been driven by their calling for management to resign.
Today the REIT announced changes that are steps in the right direction of focusing on the assets rather than management.
Commonwealth announced the following steps (release found here):
The base business management fees paid by CWH to RMR will be calculated on the basis of the lower of: (I) gross historical cost of CWH's real estate assets or (ii) CWH's total market capitalization. Market capitalization will include the market value of CWH's common shares, plus the liquidation preference of preferred shares and the principal amount of debt. (currently calculated at the annual rate of approximately 0.5% of the gross historical cost of CWH's real estate assets).The market value of CWH's common shares will be calculated based on the average shares outstanding multiplied by the average closing share price during the period in which the fees are earned. Accordingly, CWH's fees paid to RMR may decline when the market value of CWH's common shares declines.
Annual election of all Trustees. CWH's Trustees currently serve staggered, three year terms.
Accelerate the expiration of CWH's shareholders' rights plan (the "poison pill"), which currently expires on October 17, 2014, to a date soon after resolution of the pending disputes with Corvex/Related.
Essentially, ditch the poison pill, no more staggered board terms and a better alignment of management and shareholders.
Corvex and Related responded almost as one would expect (release here):
"Today's announcement is nothing more than hollow rhetoric and a desperate attempt to keep Barry Portnoy and his son Adam in control of CommonWealth. In particular, the "governance enhancements" lack substance and constitute mere window dressing by a rogue board that was removed from office over three months ago by the holders of more than 70% of the outstanding shares. Shareholders should note that these "to-be proposed" governance changes contain widespread caveats and would not even be considered, if ever, until after the arbitration is expected to be completed. It should also be noted that we consented to the dismissal of the damages claim to expedite the arbitration process. We remain confident that the arbitration panel will validate our prior consent solicitation at the end of next month's hearing."
Am I breaking ranks with the activists and saying the issues at CommonWealth are solved? Hardly. I think Robert Frost would have said:
These changes are decent, a start if not deep
But they have promises (to shareholders) to keep
and miles to go before they sleep.
Sigh, I guess now you know why I write on companies and markets and have not broken into the poetry scene. In any event, I believe that their announced changes are a good start. The question I have is why not implement them as soon as possible without waiting for the Related/Corvex arbitration to be finished. Should shareholders wait even longer?
Now recall a month ago when Moody's weighed in on the company's current performance and issues:
The negative outlook reflects the office REIT's weak operating performance, which is expected to persist for the intermediate term as it works to address a large number of challenged properties in its portfolio.
CWH's wholly-owned portfolio was a modest 85.8% occupied as of 2Q13 (excluding 70 very weak assets being held for sale) and it continues to contend with high capital costs in conjunction with its leasing activities. The REIT's operating performance remains impeded by a large number of non-core assets it has identified as challenged, with high vacancy and limited prospects for cash flow improvement.
Moody's notes that CWH has made good progress in executing its business plan to dispose of its weakest assets and accelerate its transition to becoming an office REIT focused on second tier CBD markets (CBD properties comprised 58% of wholly-owned NOI for 2Q13). The REIT sold 24 assets in the first half of 2013, with 70 remaining held for assets expected to be sold by year end.
Miles to go before they sleep.
If the company has begun taking the right governance steps, and continues to reposition their portfolio, is it time to get involved? In my opinion, no. Many, however, believe there is value in the REIT. A quick look at the REITs metrics versus peers Vornado Realty (VNO), Brandywine Realty (BDN), Boston Properties (BXP) and SL Green (SLG) will show us why:
Virtually all metrics are below the peer group and the yield is higher. Wait, didn't I just say no to buying the company. Yes I did. To quote my old CIO: Yield does not compensate for bad management. But what if management is getting better (the governance effect) and the portfolio is being realigned? I am still not ready to become an owner of the company.
But is there another way to get involved?
Let's look up the capital structure to the preferred stock and bonds.
The Commonwealth 5.75% (2042, callable in2017) is senior debt and yields 7.8%. You can get over 8% by investing in the preferred stock, but the senior debt offers an investor more downside protection given its level in the capital structure.
Commonwealth's debt has the following covenants:
- Debt / Adjusted Total Assets ≤ 60%,
- Secured (click to enlarge)Debt / Adjusted Total Assets ≤ 40%,
- Debt Service Coverage ≥ 1.5x, and
- Total Unencumbered Assets / Unsecured Debt ≥ 1.5x
These are "traditional" REIT debt covenants, with unconsolidated JVs excluded from total assets.
At the end of the most recent quarter, the company is well within their covenants and have headroom under them to conduct their business:
Given the covenants in the debt, if Related and Corvex were to take the company private (something I am not sure they could do given the financing needed), a bond holder is protected from a levered transaction.
Bottom Line: I am not ready to become an owner of the company through an investment in the equity, but the debt offers an interesting alternative and I would only now consider it as the company has floated better governance policies.