"These are trading sardines, not eating sardines…If I can buy assets at an 8 cap and sell at less than a 6, I will do it all day long." - William Kahane, CEO & President of American Realty Capital Trust
A couple weeks ago Realty Income Corp (O) announced it would be acquiring American Realty Capital Trust (ARCT). The takeout will be a stock transaction in which ARCT owners will receive shares of O in return for their ARCT shares. At the time of the announcement, the deal valued ARCT at $2.95 billion, which represented a 2% premium over the previous night's close. Although we understand the reason for the sale, as ARCT shareholders we are disappointed with the terms of the deal.
ARCT was formed in 2008 as a private REIT to invest in single tenant, triple net lease properties. The management team at American Realty Capital (ARC) set out to raise $1.5 billion in equity for ARCT through retail investor channels. Shares were sold to investors at either $10.00 if sold through a broker at a 7% commission, or $9.30 per share if offered through a fee-based advisor such as ourselves. Raising money for a private REIT was slow and difficult at first, but as time passed ARC was able to prove out their business plan by assembling a top notch single tenant, triple net lease portfolio that paid out a $0.70 annual dividend equivalent to a 7% or 7.5% yield depending on the investor's purchase price.
The fund closed in the summer of 2011 after it reached its goal of $1.5 billion in equity capital. Over the next several months the team at ARC finished building out the portfolio and subsequently hired Goldman Sachs to shop the portfolio around to potential buyers. In February of 2012 they announced that they would be listing the shares publicly on the NASDAQ. This move of going "full cycle" from inception to liquidity event in four years was unprecedented in an industry that is typically littered with conflicts of interest between fund managers and their investors. ARC set a new standard in the private REIT industry by waiving various fees and structuring their compensation to be well-aligned with shareholders. In March of 2012 ARCT began trading publicly at an initial listing price of $10 a share.
Leading up to this event, we explained our fundamental thesis for investing in ARCT. We made the argument that the ARCT portfolio consisted of newer, fully occupied properties with longer lease terms to a higher credit quality tenants versus other triple net lease REITs. ARC's management team made this same argument that ARCT would be offering a "better portfolio, stronger balance sheet, and discounted valuation" in the table below which was taken from the free writing prospectus.
The next table was also taken from the same free writing prospectus which shows ARCT's accomplishments to date as well as the management team's estimated enterprise value for the ARCT portfolio.
Six short months after listing on the NASDAQ, the announcement was made that ARCT would be sold to Realty Income in a deal that represented a very small premium to the current market price. Many analysts have argued that this transaction brings economies of scale and creates a better overall portfolio than either of the two portfolios in isolation. We agree that it is a great deal…if you are an O shareholder. From Realty Income's standpoint they are picking up a portfolio of fully occupied properties with better credits, longer lease terms and more attractive cap rates than their existing portfolio. Post-acquisition, O will immediately be able to increase their dividend yield since they are buying a portfolio of assets at a discount to what the market is currently assigning to the value of their portfolio. In our view this deal is clearly more accretive to O shareholders than ARCT shareholders.
From an ARCT shareholder's standpoint, all this deal offers is the potential benefits of ownership in a much larger company. Contrary to popular rhetoric, there is no diversification benefit from this deal as the same diversification could have been achieved by simply holding shares of both O and ARCT in a portfolio. The only real benefit is that Realty Income is able to borrow money at lower rates than ARCT (roughly 50 bps lower per a conversation with ARC's CIO at a recent conference). All else equal, the lower the company's cost of borrowing the more money flows to the bottom line, but we do not believe this factor alone is compelling enough for ARCT shareholders.
For years the management team at ARC has touted their portfolio as better, stronger, and cheaper than the competition, but now their tune has changed and they are singing the praises of their biggest competitor (as in this interview with Jim Cramer who is a big fan of this deal).
There is no denying the fact that the management team at ARC has made ARCT shareholders money. In fact, this investment has been one of the best performers in our client portfolios over the past year. They have done this by assembling a top notch portfolio of high quality assets one small deal at a time. By buying up individual properties that were off the radar of larger triple net lease companies like Realty Income they were able to negotiate very attractive purchase prices and leasing terms. As a result the whole is worth much more than the sum of the parts, which is why they are able to sell the portfolio to O today at a higher price than what they paid for it. But the fiduciary duty of ARCT's management team is for them to maximize long-term shareholder value. In our estimation, ARCT as it currently stands should command a higher premium than what is represented in the proposed transaction with Realty Income.
It appears that the management team at ARCT prefers the asset aggregation business to the asset management business. This sentiment was clearly stated by CEO William Kahane in the opening quote. It is our belief that it was only a matter of time before the market would have fully recognized and priced in the value of ARCT's high quality portfolio, pushing it to the same premium valuation commanded by Realty Income and offering shareholders another 30-35% in potential upside. How long would this have taken? No one can say for sure, but we can tell you that we would have been happy to clip a 6% current (7.5% on original purchase price) yield on our investment while we waited. For the time being we will continue to hold our ARCT shares and will revisit the position if/when the acquisition is finalized.
Additional disclosure: Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments or its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.