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Shares of CommonWealth REIT (CWH) have performed poorly over the last five years. Shareholders have seen the book value, net operating income, and owned square footage decline on a per share basis. At the same time, the manager of CommonWealth REIT, REIT Management and Research (RMR), has been able to increase the management fees it charges to CommonWealth REIT.

This is unusual in the fact that CWH pays an external manager to manage the REIT. Their partnership awards RMR for growing the real estate portfolio by paying a static fee of .5% on all properties purchased in addition to the regular management fees. We believe that this arrangement creates a conflict of interest because it puts an emphasis on growing the amount of properties owned by CWH instead of delivering value to its shareholders.

CommonWealth REIT is an office and industrial real estate investment trust, or REIT. The company reported ownership of $8.1 billion in properties based on the original purchase cost at the end of 2011. Although the company's real estate portfolio is in good shape, the shares trade at a discount of up to 73% to its peers. This figure is based on book value and other metrics. Recently, CommonWealth REIT spun off another REIT called Select Income REIT (SIR), and this is an added concern to us. This spinoff, which happened in early 2012, seems to be detrimental to the shareholders of CWH because it reduces the ability of CWH to pay dividends out of its own cash available for distribution, or CAD.

We have created the table below to illustrate the historical decline in value, on a per share basis, for CWH shareholders. Note that on a per share basis the FFO, book value, and NOI have declined an average of 20% from 2009 to 2011.

2009

2010

2011

Shares Outstanding in Thousands

55,965

72,138

83,721

FFO/Share

$5.37

$4.05

$3.69

Sq Ft./Share

1.11

0.91

0.86

Value of Real Estate Properties/Share

$112.97

$88.13

$86.53

NOI/Share

7.87

6.23

6.21

Equity Available/Common Share

39.44

36.30

33.01

Since 2009 CommonWealth has executed the following transactions:

  1. 2009: spin off of government properties into independent REIT (GOV)
  2. 2010: Issuance of 16 million shares (33% discount to book value), 4 for 1 reverse split
  3. 2011: Issuance of 11.45 million shares (also 33% discount to book value)
  4. 2012: Spin off of land lease and triple net leased properties from into independent REIT

We have created the following chart to demonstrate the disparity in valuations of various REITs and CommonWealth

Company

SYM.

share price as of 6/21/2012

Book value/ share

multiple to book value

Dividend yield

Total DIV as a % of EBITDA

% op & G&A/ revenue

Boston Properties

BXP

103.64

33.22

3.1

2.12%

28%

38 %

Cousins Properties

CUZ

7.22

4

1.8

2.49%

29%

44 %

Duke realty

DRE

14.11

7.61

1.8

4.82%

42%

Highwoods Properties

HIW

32.74

12.97

2.5

5.19%

48%

43 %

Kilroy realty

KRC

46.85

23.36

2.0

2.99%

41%

37 %

Liberty Properties

OLP

18.36

15.22

1.2

7.19%

54%

Mack Cali Realty

CLI

27.57

21.37

1.3

6.53%

39%

43 %

Vornado Realty

VNO

80.73

31.35

2.5

3.42%

33%

44 %

Averages

2.

4.34%

39%

42 %

CommonWealth

18.01

33.01

0.55

11.10%

33%

48 %

CWH Discount

-0.735

Note: The revenue and EBITDA percentages of CWH are seemingly normal, but, as the chart above shows, the dividend yield of is 150% higher than the peer average. The multiple to book value per share is 75% lower than the peer average. These are strong indicators of the investor sentiment.

Manager RMR

REIT Management and Research is the external manager of CWH. RMR is a separate company from CWH and receives about 3% of revenues for managing the properties. As mentioned earlier, RMR also receives the large static real estate fee on every property owned by CWH. This fee is determined by multiplying the original purchase price of the property by 50 basis points (.5%). The static fee equals about 3.5% of the total revenues for 2011. We figure that the static fee added about $42 million in operating costs to CWH in 2011. When CWH spins off a new REIT the new REIT is also managed by RMR. We calculate that the total compensation of RMR was 6.5% of the revenues of CommonWealth in 2011.

An area of concern for CWH and the REITs spun off from CWH may be the lower oversight of the various companies. CWH and the REITs spun off from CWH have intermingled boards of trustees. It is important to know that these boards of trustees perform the functions of a board of directors. Each board is comprised of five individuals, two managing trustees and three independent trustees. In each REIT in the CWH family, the two managing trustees are the senior managers of RMR, Barry and Adam Portnoy. The independent trustees serve on more than one of the boards, as evidenced by the following statement from the 10K of CWH: "All of our other Independent Trustees are members of one or more boards of trustees or directors of other companies managed by RMR."

The Recent Spin-Off of Select Income REIT

Select Income REIT SIR was spun off from CommonWealth in March of 2012. CWH deposited the triple net and land lease properties from its own portfolio to the portfolio of SIR. We believe that these were very high quality properties. CWH sold 9.2 million shares to the public and retained 22 million shares. Importantly, both companies are consolidated for GAAP accounting reasons on the financials.

Certain technical aspects of spin off, such as cash flow, cash available for distribution CAD, and net operating income, are important to examine. CWH may have jeopardized its ability to pay dividends solely from its own CAD after transferring so many of their high cash flow properties to SIR. An additional question was also raised by the actual price of the spin off. Our estimate was that the $975 million spinoff was completed at a cap rate of 8.99, which results in a discount of up to $265 million for SIR using a cap rate of 7. This was somewhat mitigated by the fact that CommonWealth kept 70.5% of the shares. Here are the ratios for the spinoff of SIR using various CAP Rates:

Background information on the Spin off of SIR

  • Value received by CWH for spinning off SIR:
  • $484 mm in shares,
  • $400 mm in cash,
  • Assumption of $50 mm in liabilities
  • Total compensation received by CWH for SIR: $934 mm
  • 2011 SIR NOI = $84 mm

Value of SIR Using Various Cap Rates

Cap Rate

Value

Discount

8

$ 1050 mm

$116 mm

7.5

$ 1119 mm

$185 mm

7

$ 1199

$265 mm

Since SIR was only encumbered with $227 million in debt, and has between $1 and 1.2 billion in properties, it is possible that SIR could leverage up by 80% or more. It is uncertain if management will issue more shares of SIR or sell the remaining portion owned by CWH. It is unknown if any increase in the portfolio at SIR will benefit CWH.

Our various projections for the consolidated companies, stand alone SIR, and CWH with and without dividend.

Quarterly Dividend Capability of CWH

Based on 1st quarter 2012

Consolidated SIR & CWH

SIR

CWH after Spin-off before Dividend

CWH After Spin-off with Dividend

Normalized FFO available for Common Wealth REIT common shareholders

75,954

20,428

55,526

55,526

Plus: lease value amortization from continuing operations

2,296

262

2,034

2,034

Plus: amortization of prepaid interest and debt discounts from continuing operations

746

0

746

746

Plus: distributions from investees

4,179

0

4,179

12,970

Plus: non-cash general and administrative expenses paid in common shares

281

0

281

281

Plus: minimum cash rent from direct financing lease

2,024

0

2,024

2,024

Plus: normalized FFO attributable to non controlling interest

1,062

0

1,062

1,062

Less: CAD attributable to non controlling interest

-988

0

-988

Less: average minimum rent from direct financing lease

-329

-329

Less: straight-line rent from continuing operations

-8,092

-773

-7,319

-7,319

Less: recurring capital expenditures

-26,842

-369

-26,473

-26,473

Less: Normalized FFO from investees

-5,367

-5,367

-5,367

CAD

$44,924

$19,548

$25,376

$35,484

CAD per share of CommonWealth

0.54

0.23

0.30

0.42

Overall, we question the spinoff of the properties because we cannot see that it was beneficial. Although we project a drop in the actual cash available for dividend for CWH, the company can also make the payment from cash on hand or borrowings.

Consolidated Portfolio Value Analysis

Regardless of the major turmoil in the real estate market in the last five years, the portfolio of CWH appears to be in good shape. We believe the current market value of the portfolio is near or above the average purchase price of the properties.

Their consolidated portfolio was acquired over the last 17 years. We created the following charts to demonstrate that, ultimately, we do not believe that the real estate value has changed.

Consolidated portfolio composition:

  1. 49 % large city office buildings
  2. 35% suburban office
  3. 16% industrial

The following chart gives a general idea of the performance of the different real estate sectors over the last 12 years. For your comparison, the following showcases property additions arranged by year of purchase. This chart is also slightly adjusted for price volatility by using a percentage discount, or premium, according to the time period it was purchased:

Acquisition years

Original purchase price in millions 3

Percentage discount or premium

Estimated current value in millions 4

1995- 2003

2744

+10%

3018

2004-2005

1122

-10%

1010

2006-2008

1069

-25%

802

2009-2011

2306

+3%

2375

Total

7241

7205

Note: This chart is not inclusive of lease liabilities and assets

Cap Rate Value of the Portfolios of CWH and SIR

We have also performed an analysis of the properties based on various CAP Rates and the Consolidated 2011 trailing NOI. We used NOI of $528mm + 45mm to adjust for the additional management fee of RMR. ($578 adjusted NOI).

Cap Rate

Value

8

7225 mm

7.75

7458 mm

7.5

7706 mm

This is a concurrent demonstration of the portfolio's value that is in line with the current book value.

Conclusion

We recommend investors avoid the shares of CWH at this time due to the uncertainty generated by the spinoff of SIR and the continuous decline in per share values. SIR is the second spinoff since 2009 and a recent one, GOV, did not seem to benefit the share holders. It appears that SIR, which carried little debt and all of the highest margin properties from CWH to its own portfolio, may become an acquisition vehicle.

The manager seems to be making decisions which are beneficial to the management company and detrimental to the shareholders. The management contract awards compensation for growing the portfolio but not as much for improving share value.

The portfolio is in good shape and could be worth more to an acquirer. We believe an insurance company or other entity could buy the company and reduce the preferred shares to create an attractive yield. An acquirer could also reduce the operating costs by about $50 million annually by replacing RMR.

Disclaimer: Individuals should consider the inherent risks before investing and this report should not be construed as advice tailored to an individual's investment criteria or objectives

Source: External Manager RMR Causes Concern At CommonWealth REIT