REITs: The Writing Is On The Wall

Includes: BX, O, VER, WPC
by: Rubicon Associates

I have been following the markets (as an institutional investor and as an individual) for more than two decades, and there is one observation or pattern that is consistently repeated: When a sector or a market is fully valued or over-valued, you will see institutional exit strategies employed. Put differently, the "smart" money sells into an over-valued market to realize the highest potential profits.

As well, you will notice that when the low hanging growth fruit (we'll call this organic growth) has been picked, merger activity will increase in order to grow further. This can be accomplished through cost cutting and eliminating overlapping positions and taking out physical costs depending on the sector. We'll call this "synergies."

We are currently seeing that in the REIT sector.

Taking a look at the "exit strategy" indicator, we expect that when there are high multiples (rich valuations) more firms will bring properties and REITs to market. The REIT universe (as calculated by BMO) currently trades at an 18x FFO multiple (18.4x forward). To put this in context, it is the highest since the financial crisis, as you would expect and approximately two turns lower than the 2005-2006 time frame (20.7x and 19.8x, respectively). While lower, the current economic environment doesn't make me think it should be at the same level, or for that matter, the level it is at.

Taking a look at the "exit strategy" indicator, we see the big daddy of them all: Blackstone's (NYSE:BX) proposed IPO of Brixmor (a large chunk of the old Centro Group). This is shaping up to be the biggest retail REIT IPO in decades.

A little background from the SEC S1 filing:

Brixmor is an internally-managed REIT that owns and operates the largest wholly-owned portfolio of grocery-anchored community and neighborhood shopping centers in the United States. Our IPO Portfolio is comprised of 522 shopping centers totaling approximately 87 million sq. ft. of GLA. 521 of these shopping centers are 100% owned. Our high quality national portfolio is well diversified by geography, tenancy and retail format, with more than 70% of our shopping centers anchored by market-leading grocers. Our four largest tenants by ABR are The Kroger Co. ("Kroger"), The TJX Companies, Inc. ("TJX Companies"), Publix Super Markets, Inc. ("Publix") and Wal-Mart Stores, Inc. ("Walmart").

As the retail sector trades at an 18x multiple currently with a mere 4.7% FFO growth estimate (versus a 19x and 7.5% growth estimate in the 2005-2006 "go go" years), one might infer -- as I have -- that Blackstone sees this as an opportune time to engage in risk transfer (prior to rising rates and multiple contraction).

Another indicator is the "exit strategy through merger" activity which is also a "growth through merger" strategy. This is one we have been seeing more of recently. Two top examples are American Realty Capital Properties, Inc.'s (ARCP) acquisition of the non-traded REIT American Realty Capital Trust IV ("ARCT IV") and W.P. Carey's (NYSE:WPC) $2.4B acquisition of the non-traded REIT Corporate Property Associates 16-Global Inc.

Let's go to the tapes:

American Realty focuses on the effect of the transaction on its business more than the rationale from ARCT IV's perspective. Its perspective is stated as such:

Attractive Return to ARCT IV Stockholders: Minimum total return of 31% to ARCT IV stockholders, including a full return of gross invested capital, a 22.5% share premium (assuming the guaranteed floor stock consideration value) and dividends paid since inception, assuming 100% stock election.

As W. P. Carey's President and CEO Trevor Bond stated:

"We are pleased to announce a merger transaction that we believe is beneficial to both W. P. Carey and CPA®:16 - Global investors. In addition to providing liquidity to CPA®:16 - Global investors, it will significantly increase W. P. Carey's asset base..."

Going a little further back, we see Realty Income (NYSE:O) becoming the exit strategy for American Realty Capital Trust (here):

Premium to Share Price and Asset Values This transaction enables the shareholders of American Realty Capital Trust to capitalize on the recent upward price movement of the shares of ARCT, and to achieve a premium valuation for their shares. Furthermore, ARCT's assets were acquired at an opportune time in the market. This transaction allows ARCT's shareholders to realize a premium over their purchase price.

In a low interest rate environment, we can also get a decent feel for a company's opinion of share prices. If you are buying a fully (over) priced asset, you want to use the cheapest capital you can. If the market is overvalued, a company's shares are cheap currency. Of the above referenced transactions, we see the following capital being used:

American Realty Capital Properties/American Realty Capital Trust IV:

American Realty Capital Properties offered 2.05 of its shares or $30 in cash for each share of the other REIT. The stock offer is worth about $31 per share.

This I found interesting as there is a cash component, but it is limited to 25% of the ARCT IV shares outstanding and has tax implications.

W.P. Carey/CPA 16:

Subject to the terms and conditions of the merger agreement, CPA®:16 - Global stockholders will receive shares of W. P. Carey common stock for their shares of CPA®:16

Realty Income/ARCT:

The acquisition will be financed by Realty Income directly issuing $1.9 billion of its common stock to American Realty Capital Trust shareholders

The REIT sector as a whole has seen decent returns over the last few years, but has slowed during 2013 and going forward, it should have a difficult time keeping up with the broader market due to a combination of valuation and the prospect of rising rates.

Bottom Line: The REIT sector as a whole appears fully valued given the economic outlook as well as the prospect of rising rates. Sector and security selection will be the driving force behind outperformance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.