Creating Value for Public Shareholders Only a handful of REIT managements have strong franchise value and are adept at life in the public markets. Those that don't may be able to stay public for a while, but ultimately they will become takeover bait. by David Sherman

In general, unless a REIT management team has developed the full range of skills necessary to thrive and prosper in the public markets, including both above-average investment and capital-raising skills, we consider the company a potential candidate for consolidation. We do not expect the stock market to recover to the point at which an average REIT will have access to enough public equity to continue to grow its asset base for the foreseeable future. Internal growth will continue to be healthy for quite a while, but average companies with internal-growth-only stories will not get “public market shelf space” in a crowded sector.

While we can identify candidates for consolidation “on the numbers,” the actual order in which they fall (or don’t fall) will be much more a function of qualitative factors, the most important of which will be whether management is ready to admit that the broad bull REIT market is over.

On average, we expect companies to be cheap enough for consolidation once their stocks fall below 85% of net asset value. However, many factors will impact the actual discount for individual companies, including quality and “financeability” of the REIT’s assets, level of management entrenchment, debt structure and prepayment penalties, tax issues, and degree of board independence.

If we step back out of the weeds, the underlying theme of everything we are discussing is unlocking the value (and leverage capability) of the underlying real estate to create value for the public shareholders. There are certainly many alternatives available to REITs trading at a discount to NAV to realize some or all of that value without selling out. If a buyer can leverage the assets, there is no reason the REIT can’t leverage its own assets and either distribute the proceeds to the shareholders or use the proceeds to grow. Further, a REIT can sell assets outright or sell an interest in a pool of assets to a private real estate investor to generate cash to grow.

Some combination of these restructuring alternatives could create value for the shareholders by lowering the REIT’s overall cost of capital and, therefore, increasing its return on shareholders’ equity. However, for many REITs this will just prolong the agony and delay an inevitable sale of the company. We expect the environment to be competitive for several years. In this environment, capital will be limited and only those REITs that can consistently generate above-average returns on invested equity will be able to stand out from the pack and have access to public equity to grow. For those REITs that are fundamentally average managers of portfolios of property, any restructuring of the balance sheet will likely be a temporary fix. Short-term growth will be provided, but once the assets are leveraged, the REIT is likely to find itself out of capital and still trading poorly.

In short, in an equilibrium environment, we just don’t believe there is room in the stock market for 176 REITs with a total market capitalization smaller than Microsoft’s. That is not to say we think REIT management teams should not focus on finding the capital structure that maximizes returns to the stockholders. They should.

We are generally believers in leverage and think that the REIT group is significantly underleveraged. However, leverage alone will not keep a company independent. In the cold, cruel light of day, there are only a handful of REIT management teams that have strong franchise value and are adept at life in the public markets. Others will learn the skills and survive. Those that don’t may be able to stay public for a while, but ultimately they will become takeover bait.