REITs are often looked at as asset or yield plays, but they are operating businesses. Management and the business strategy can matter as much as the NAV and bad management can cause tremendous amounts of damage. This article will discuss some techniques to spot and avoid bad management as well as how to go about finding good management.
Most of the market’s focus is put into the structural aspects of corporate governance.
- Internal versus external
- Number of board members
- Staggered or unstaggered board
- Poison pill
- Separation of chairman and CEO roles
While these aspects matter, the integrity of management matters far more. Perhaps the biggest misconception among REIT investors is that internal management is de-facto better than external. Following are some REIT management debacles, and each was internally managed.
SPG buyout of MAC
In March of 2015, Simon Property Group (SPG) announced its best and final offer to acquire Macerich (MAC) for $95.50 a share. Prior to Simon showing interest, Macerich was trading around $70 a share so this represented a big payout for shareholders. However, SPG already has a full management team that would have been more than capable of absorbing the extra properties. As such, I suspect Macerich management knew they would lose their jobs.
In the end, management rejected the offer and shareholders have suffered immensely. Rather than getting $95.50 a share, MAC is now worth less than $60.
Source: SNL Financial
The reason I believe management was self-interested in rejecting the deal rather than working on behalf of shareholders is that the pricing was so high. SPG was offering more than the properties were worth simply because the synergies available to SPG in becoming the dominant high-end mall player would have made up the difference. There was likely no other buyer who would have paid that much for MAC properties.
At a minimum, management could have allowed shareholders to vote on the deal. In my opinion, the hard block without shareholders getting a say cements the self-interest as their motive.
A similar misalignment is unfolding presently.
PEB buyout of LHO
This is a big premium to where LHO was trading before the offer, but more importantly, it represents a premium to the Blackstone offer which is coming in at $33.50 a share.
Similar to the MAC situation, LHO management would likely lose their jobs if they sell to PEB, but they may get to retain their jobs in some capacity with Blackstone. I can’t think of any other reason to take a $33.50 offer over a $35.57 offer. Unfortunately, shareholders are not given the choice. The vote on September 6 th will give shareholders a choice between the Blackstone deal or LHO going as a stand-alone. There is no option for shareholders to vote for the PEB deal which, in my opinion, is clearly superior.
One could argue that management has a responsibility to their employees in addition to their shareholders and in this regard PEB's offer would have been better again. As a hotel REIT, PEB is likely to maintain operations at each of the hotels, whereas PE firms like Blackstone are more likely to extract value however they can, which includes laying off employees to maximize short term profitability so as to re-sell the properties at maximized NOI.
Thus, I think it is clear that management was looking out for neither their shareholders nor the lower level employees. The choice to reject PEB seems to be entirely motivated by the C-Suite wanting to keep their jobs.
There are times when it is appropriate to reject a buyout offer, such as when the potential buyer is disreputable, or the value of the offer is insufficient. In both of these cases, the buyers have excellent reputations and the offers are quite generous.
Preventing harm to shareholders
There aren’t really any structural ways to prevent this kind of harm of shareholders. The only real way to prevent this is to invest with managers who have integrity; some sort of personal pride in ensuring their shareholders have the best possible outcome. There are 2 ways to discern the integrity of management.
- Meet with them in person enough that you can understand their character.
- Analysis of management actions
Investor conferences are a great way to get in the door and meet directly with management teams. We go to REITWEEK every year for this exact purpose. Other industries have their own conferences, some of which are free to attend.
That being said, meeting management may not be an option for small investors. Some management teams will not take meetings with shareholders below a certain threshold or individual shareholders without a company behind them. Fortunately, there are other means of assessing management that are available to everyone. It involves analyzing the decisions and these can be categorized as red, yellow or green flags.
Egregious pay packages are often an early warning sign that management is in the game for personal enrichment rather than performing on behalf of shareholders. Prior to the accounting scandal at VEREIT (VER), Nick Schorsch (CEO of ARCP) attempted to get the ARCP executives a $222mm pay package. These sorts of salary requests are rarely going to be associated with accounting scandals, but they are usually indicative of poor alignment. Executives at Northstar Realty Finance took enormous compensation followed by a massive payday in merging the company into what is now Colony Capital (CLNY). In both cases shareholders have lost a significant portion of their investment.
Current examples of excessive compensation that I view as warnings signs are:
- Sun Communities has over $91mm of G&A over the last 12 months with Gary Shiffman being the 4th highest paid REIT CEO in 2017 (data from SNL Financial). This compensation dwarfs that of its sector peers Equity Lifestyle and UMH Properties.
- I hate to say it because everyone loves her, but Debra Cafaro’s (VTR's CEO) salary is getting excessive. She was the highest paid REIT CEO in 2017, raking in $25.3mm. What makes this worse, in my opinion, is that it coincides with a period in which Ventas shareholders have not been rewarded. VTR has negative total return over the past 3 years and has significantly underperformed the REIT index.
- Macerich chalks up yet another red flag with its CEO, Arthur Coppola, pulling in $12.8mm after destroying a significant portion of shareholder value as discussed earlier.
The most common yellow flag we see among REITs is growth for the sake of growth. The key to distinguishing good growth from bad growth is to measure the opportunity relative to the share price.
When companies have share-prices that exceed intrinsic value, it makes complete sense to issue equity and funnel it into acquisitions. Realty Income (O) has done this quite successfully; issuing fully valued shares to buy NNN properties in a fashion that is neutral to portfolio quality and immediately accretive to FFO/share. O seems to have one of the most shareholder friendly management teams. Unfortunately, most CEOs like to grow their companies and will often do so even when it does not make sense.
Ashford Hospitality Trust (AHT) trades at a truly massive discount to NAV and had cash stores amounting to more than a third of their market cap. The clear choice, in my opinion, was to do a share buyback, but it instead elected to buy more hotels at low cap rates. This decision is made worse by the fact that private hotels values are significantly above public hotel values.
W.P. Carey’s (WPC) latest M&A seems quite dilutive to me. It absorbed a related non-traded REIT using WPC equity that was at the time trading at a fairly low price. Further, the transaction resulted in declining AFFO/share.
Wheeler REIT (WHLR) issued high coupon preferreds at a staggering discount to liquidation preference to buy a shopping center at fair value. This was so obviously a bad decision that it swiftly resulted in Jon Wheeler losing his job as CEO. While new management and the activists at Wheeler are trying their best to right the ship, the damage has already been done. The preferreds will continue to be overwhelmingly burdensome.
Green flags are in many ways the opposite of red and yellow flags in that they involve management putting shareholder interests above their own. Generally, these fall into 2 categories:
- Voluntary pay cuts
- Shrinking the company to the benefit of shareholders.
We have seen voluntary C-Suite paycuts at each of:
- Executives at Gladstone Commercial (GOOD) voluntarily waived some of their compensation during a period where the dividend was not fully covered. This went a long way toward helping it fight through the tough times and its dividend is now securely covered by FFO.
- David Simon (SPG's CEO) chose to take reduced compensation in solidarity with shareholders as SPG declined. He still makes plenty of money, but the move shows that he cares about shareholder outcomes on a personal level.
- Executives at Farmland Partners (FPI) have reduced their compensation materially as the company works its way through the tough farming economy.
When REITs trade deeply below NAV, it is often accretive to sell properties to buy back stock. Most executives don’t want to do this, but some are willing to swallow their pride and do what is best for shareholders.
- Brixmor (BRX) has taken careful measure of shopping center prices and firmly believes the private prices are high relative to where the REITs trade. It has been a net seller, using the proceeds to by back stock and reinvest in its higher ROIC properties.
- Hersha Hospitality (HT) sold a large portion of its NYC hotel portfolio at low cap rates to finance a massive and ongoing share buyback in which over 20% of its outstanding shares have been redeemed.
- Farmland Partners is selling farms at profits to finance a buyback of roughly 15% of outstanding shares. This buyback is still in the early stages, so the accretion has yet to hit the bottom line.
- RLJ Lodging (RLJ) is selling assets to buy back up to $440mm of shares outstanding. Like Hersha, it is taking advantage of the dislocation between private and public pricing of hotels.
Opportunity in public misconception
The REIT market has a tendency to assess management through generalizations that do not always hold up. When the market believes management is bad, the stock price will suffer significantly which is appropriate when the market is correct. However, there are instances where certain companies suffer from blanket assessments that cause them to be incorrectly labeled as bad management. This creates a sizable opportunity in that a company with good management is priced like a company with bad management.
The most obvious historical example of this is Gladstone Commercial. Back when this was a $15.00 stock, people were terrified of GOOD’s management. They were bucketed as externally managed which in the eyes of many meant they simply could not be trusted. Today, GOOD is starting to get more respect and this is due to 2 things:
- They have done a phenomenal job with their public outreach. They made a point to set up meetings with as many institutions as they could reach to establish a loyal shareholder base.
- The stock price improved. It is amazing how much more highly people think of the stock AFTER it is up 30%+ to about $20.
The key with these things is to catch the stock at the point of maximal dislocation. The point in time when management is most feared; when there is the biggest gap between the actual quality of management and the public’s perception of management.
Right now, I think FPI is a similar opportunity to GOOD at $15. Unsubstantiated rumors are swirling and even those who like farmland as an asset class are saying they find FPI to be uninvestable.
I believe this is in sharp contrast to reality. FPI has hit none of the red flags and has 2 clear green flags in that management is voluntarily cutting their own pay and voluntarily shrinking the company to the benefit of shareholders. Additionally, officers' repeated open market purchases demonstrate they truly believe in the value of the stock and further align management with shareholders.
I think this a rare chance to buy a company with good management at the market price of a company with bad management. This is the point of maximal dislocation.
Disclosure: 2nd Market Capital and its affiliated accounts are long SPG, GOOD, FPI, BRX, RLJ, and HT. I am personally long SPG, GOOD, FPI, BRX, RLJ and HT. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article.Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.
Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.
Disclosure: I am/we are long SPG, GOOD, FPI, BRX, RLJ, HT. 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.
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