This is part 4 in a series on conflicts of interest in the REIT industry.
The corporate world is full of difficulties that distort efficient operations. There are two major difficulties that we would like to focus on. The first difficulty is that the interests of managers may not be aligned with the interest of the shareholders they are expected to serve. The second issue is one of information. Most theories in economics rely upon the assumption that "All actors have complete information." Unfortunately, we believe that is rarely the case. Many investors lack complete information. The lack of transparency in operations can be a hindrance to investing.
We believe that the second issue often causes the first. Specifically, we believe that if all shareholders knew precisely what was going on, management would be less inclined to design systems that would benefit them at the expense of the shareholder. To help shareholders find that information, we dig through the financial statements and flag several disclosures that investors should be concerned about. These conflicts do not indicate that a crime has been committed, or that management has actually worked against shareholder interest.
Many of these conflicts are very common in corporate America, and especially in the REIT industry. Some analysts use the term "conflict of interest" to denote cases where a conflict has resulted in a legal or illegal transfer of wealth from shareholders to management. This analysis is proactive rather than reactive. There are no accusations of wrong doing. Some investors do not mind these conflicts or think that they are inescapable. Because some of the companies we have analyzed have scored extremely well, we are certain the conflicts can be avoided. In our opinion, these conflicts of interests could be compared to the baby sitter having the key to the liquor cabinet. He or she may or may not have done anything wrong, but how does the babysitter having the key benefit you?
The general format of this report:
- Discussions of the companies
This report contains a chart that may be difficult to read without the description "How to read this chart." The explanation is part 1. To keep the analysis at a reasonable length, the description has not been restated. If you have not seen the directions in part one, please read them.
Below, you will see a chart showing several of the most common conflicts of interest, in shorthand, on the Y axis. Above the X-axis will be the ticker symbol for several REITs. This list is far from exhaustive.
Discussion of the companies
All of the companies would probably qualify for avoiding "equity based" conflict of interest if enough information was furnished to make a decision. When management is internal, the equity-based conflict is usually avoided. In this case, all five companies were internally managed.
NNN acquires, owns, invests in and develops properties that are leased primarily to retail tenants. The REIT generally uses net-leases, which means some of the operating costs can be passed onto the tenant. As a shareholder, that is attractive. Net-leases mean less volatility in costs to the REIT. When the REIT incurs the expense, they require reimbursement from the tenant.
They do have a conflict of interest in the dual role of CEO/Chairman, but to their credit they also have a "lead director" because of the dual role. I wouldn't consider it 100% mitigation, but it is better than nothing. Their overall picture looks fairly average in this group, but this REIT has fewer conflicts than most.
SRC primarily invests in and manages a portfolio of single-tenant real estate. The customers are generally in retail, service or distribution. Their single largest concentration, geographically, is in Texas. Over 12% of their rental income comes from Texas. The other states are all less than 7%.
The biggest concern from this review is the pending legal proceedings. Page 38 of the 10-K statement (linked above) outlines the case. SRC has attempted to settle the case by offering an undisclosed sum of money to the other party. The other party has agreed to attempt negotiations, though they are contingent upon court approval. SRC's management has stated that if the deal is approved by the courts the effect would not be materially adverse. In simple terms, management has said: "If this is approved by the courts, it won't be too bad for us. Don't expect a large loss." There is not sufficient information to know if that is true, but there does not appear to be any reason to doubt them.
PSB primarily owns and operates three kinds of commercial properties. They are multi-tenant flex, office and industrial parks. About one half of the rental income of the REIT comes from two states, California and Virginia. For each year from the start of 2009 through the end of 2013 the weighted average occupancy rate has been within a range of 89.4% to 90.9%. That may be an area that improves if we see a real economic recovery. A recovery of the financial markets is insufficient to improve occupancy rates, as evidenced in the last 5 years.
Residential REITs appear to be having much better occupancy rates, but many REITs explicitly state the percentage that were rented at the end of the year rather than the weighted average. Don't think those metrics are interchangeable. They are not even close to the same thing. It would be ideal to have both, but if only one is presented, PSB presented the right one.
One of their executives, Mr. Havner, was deemed not independent because he is the Chairman of the board, CEO and President of Public Storage. After reviewing the situation from pages 28 to 30 of the proxy statement, it does not appear to be a problem. The two companies are working in a positive relationship that appears to benefit the shareholders of both companies. If management compensation was tied to some derivative definition of "equity" this would be a red flag, but compensation is clearly spelled out. The controls to prevent conflicts of interest appear to be quite solid.
The company is legally in California, rather than Delaware. That may be another positive for shareholders. Delaware is famous for being "friendly to corporations." Somehow, being friendly to management at the expense of shareholders became "friendly to corporations."
DEI owns and operates high-quality office and multi-family properties. All of the properties are located in either Los Angeles County, California or Honolulu, Hawaii. In short, if you're buying shares in the company, ensure that you diversify your REIT holdings. We have no problem with the company concentrating operations as long as they make it clear, and DEI is very clear about their concentration of risk. The excessive concentration creates interesting short-term plays in the company stock as a way to place geographic bets. We are not advocating that strategy, but it could cause some increase in volatility of the stock.
Only 15% to 20% of executive compensation is guaranteed. Most of the annual bonuses are in the form of equity that vests over 3 years and is contingent upon the future stock price exceeding the price at grant. Transferring the equity is restricted for at least 2 years to mitigate the ability of executives to transfer risks away from themselves.
Some of the executives are allowed to use their secretaries for personal matters. Again, that doesn't seem like a big conflict of interest. To the extent that their use is allowing them to focus on company business, it shouldn't hurt returns.
Their performance may deviate significantly from their benchmark group. The benchmark group is primarily operating on the East Coast. There may be opportunities where the intrinsic value of the stock deviates from the market price because of trading that focuses on comparisons to a benchmark that is not entirely applicable or predictive.
ESRT deals in office and retail properties in Manhattan and the greater New York metropolitan area. They have a nice "definition" section at the start of their 10-K. It's always nice to have words defined before the conversation starts, and the term "Malkin Group" is very well defined. It is clearly designed so that the people and beneficiaries of that group would continue to be referenced in the agreement even if they modified their corporate structure.
Unfortunately, that great definition is wasted. Under the employment agreement, the agreement references "Mr. Malkin" specifically, rather than applying to the entire Malkin group. That comes into play again when some of the contracts entered into were not at arm's length. Specifically they are option contracts on properties owned by the Malkin group. That is the kind of conflict that should have been prevented by effective use of non-compete agreements. The phenomenal job the company did in defining the "Malkin Group" is strikingly at odds with their failure to use the term "Malkin Group" when it matters.
To ESRT's credit, a majority of the independent directors must approve the price and terms of the transactions that are not at arm's length. However, approving the price and terms is not the same thing as negotiating them. Only part of the conflict has been mitigated.
The section on golden parachutes goes on for pages. The highly simplified version is that initially there is a parachute only for the CEO. If there is a change in control, then everyone gets a parachute. How does that benefit the shareholders? The only shareholders benefiting from that arrangement are the ones working in management. Indeed, 25.1% of the voting power rests in the Malkin group. Don't expect the other shareholders to have much voice.
PSB has done a spectacular job of eliminating conflicts of interest. Management is stuck working in the best interest of the shareholders. DEI looks quite good as well. They are both options that I would consider researching further as potential investments.
In this group, ESRT appears to have the worst conflicts of interest. Relative to some of the other REITs we have covered, they are doing better. In some articles, they would have been the best. The lack of shareholder power represents a potential long term risk to the value of the equity. Improvements in the conflict of interest section are highly unlikely. The conflicts of interest are benefiting the largest shareholder and proxy votes are frequently passed in favor of management without adequate due diligence. It isn't all bad news though. The large position in the company's common stock does help to align the interests.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis.