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By Lawrence Raiman, Michael Mueller, Anthony Paolone, and Kevin Cohen
Illustration by George Schill
Going private anyone? REITs are delivering their second year in a row of negative total returns. (The first time that has happened since the mid-1970s). Underlying the REIT doldrums is the (arguably correct) view that the real estate cycle has moved into late innings. In reaction, many investors have stepped up the discussion about REIT leveraged buyouts and management-led buyouts. Several deals have already been announced (e.g., Sunstone, Berkshire Realty, and Walden Residential), and no less than a handful of other companies are rumored to be considering a management buyout or merger. Increased LBO activity, in most cases, would have a positive impact on share prices; the symbolism of cheap enterprise values and realities of private market buyers putting hard dollars to work, in theory, should serve as a catalyst for positive share price performance. Before jumping up and down, though, one needs to consider the corporate governance issues and the valuation issues pertaining to LBOs/MBOs for REITs.
We believe two key considerations are important when evaluating LBO prospects in REITland. First is the natural pricing conflict between private market buyers and public entities. With REITs only motivated to sell in the event of a fully priced deal, and buyers only motivated to step up in the event of a compelling discount to net asset value, a natural conflict exits that could preclude LBOs from ever happening. Over time, certain boards will have to come to grips with the fact that a "do nothing" strategy may not be in the best interests of shareholders. We say that because certain companies would likely trade down to even lower levels if they were to announce they are "off the block." At this point in the cycle for REITs, we believe the correct decision, in many cases, would be to sell the company even if pricing did not maximize shareholder value but instead enhanced it. The alternative of share prices trading down another 10 percent or more would be far worse.
Second is the issue that LBO valuation may not equal net asset value. Below, we review how private market buyers would account for a number of items, which would result in a haircut on Street expectations of NAV. The haircut would be associated with potentially higher cap rate assumptions, debt prepayment penalties and origination costs, and transaction fees. Taken together, these items could amount to between 5 to 10 percent of NAV and must be accounted for in any analysis of private market value.
Pricing Dilemma
How can a transaction be priced so that it’s acceptable to private market buyers and REIT shareholders? Looking out for the interests of shareholders is the REIT’s board of directors. The board safeguards shareholders against insufficiently priced deals or, in this case, an LBO that is priced below NAV. On the other hand, private market buyers may only be interested in sponsoring an LBO/MBO if pricing is opportunistic (i.e., below NAV). If REITs are only motivated to sell in the event of a fully priced deal, and buyers are only motivated to step up in the event of a compelling discount, can these deals happen?
As noted, a "do nothing" position could harm shareholders. Suppose a particular REIT, let’s call it REIT A, was either rumored or known to be exploring strategic alternatives, including an LBO. Let’s further suppose that REIT A’s stock price trades at a 20 percent discount to recently published NAV estimates. Let’s finally suppose that a private market buyer was willing to pay a 10 percent discount to NAV to effect an LBO. Holding to the strictest of guidelines, REIT A’s board of directors could decide to hold out for the last penny, in this case pricing at NAV, and spurn the LBO offer. Should the board of directors apprise shareholders of what’s transpired via a press release stating that the company was no longer interested in pursuing an LBO, REIT A’s stock would likely trade down even further.
Most shareholders we know are in no mood for more downside risk in these stocks. At this point, a good number of investors would be more than willing to part with their shares at reasonable (short of maximal) pricing. In real estate terminology that means shareholders would be willing to sell shares into a cash LBO at a reasonable (5 to 10 percent) discount to NAV.
Coming to Grips With NAV
More and more investors are coming to grips with the fact that the NAV calculations they arrived at, or the Street guided them toward, may not necessarily be the price at which LBOs could occur. We believe the buy-side is ahead of the sell-side and boards of directors on this issue.
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1. More conservative cap rate assumptions - Street calculations of NAV are dependent upon cap rate assumptions. In most cases, Street cap rates are reflective of prevailing market conditions. Specifically, most analysts calculate NAV as follows: office sector using cash-based cap rates between 8 and 9.5 percent; industrial sector using cash-based cap rates between 8.5 and 9.5 percent; regional mall sector using cash-based cap rates between 7.5 and 9 percent; community center sector using cash-based cap rates between 8.5 and 10 percent; and multifamily sector using cash-based cap rates between 8.25 and 9.5 percent.
On the other hand, private market buyers oftentimes incorporate higher cap rates in order to account for higher internal rate of return requirements and higher capital expenditure reserve assumptions. Recall that private market buyers generally seek 20 percent or more leveraged internal rates of return (IRRs) for their funds. This IRR can be broken down into two parts: an initial cash-on-cash return and future growth. In other words, private market buyers, in most cases, would price an LBO with a higher cap rate than Street expectations in order to achieve their requisite return hurdles (see tables below).
In the end, most LBO sponsors (particularly real estate opportunity funds) are in the market on a daily basis purchasing properties. In order to get them interested in an LBO, private buyers would need to purchase the REIT’s underlying assets below the levels they could achieve in the private market. That translates into more conservative assumptions regarding initial cash returns, future growth rates, and ultimately the resulting property level cap rates.
2. Debt fees and prepayment penalties - Any LBO valuation analysis must take into consideration any costs associated with the early retirement of debt. Recall that a large number of REITs have gone through the process of gaining corporate credit ratings and have issued unsecured public debt. These ratings carry certain stipulations on leverage. Also, most public note offerings contain certain debt covenants. Fixed charge coverage ratios, secured debt/total debt ratios, and debt/total asset ratios are three such debt covenants. As a consequence of this ratings process, many REITs have agreed to essentially restrain from the use of excessive leverage.
An LBO changes all that. By definition, an LBO is leveraged - usually to the tune of 75 to 80 percent in the real estate industry. In order to accommodate more leverage, public debt must be repaid and new mortgage debt must be issued in its place. This movement of capital is costly in two ways. First, most public debt carries prepayment penalties and make-whole provisions, which would have to be factored into the LBO valuation model. Second, secured debt in many cases carries origination fees, which also would have to be factored into the LBO valuation model. The combined total of debt prepayment penalties and new origination fees could amount to as much as 3 to 5 percent of transaction value, or 5 percent on a per share basis.
Not all REITs, however, have issued unsecured debt. To the extent that a REIT has remained a secured borrower, these costs would be circumvented, thereby saving money which could accrue to the benefit of all constituencies - both new buyers and existing shareholders.
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When all is said and done, the issues noted could cause private market buyers to ascribe a significant haircut to Street NAV calculations. As noted in the tables, we calculate that private market buyers could require a discount of 15 percent or more to NAV before getting interested in an LBO.
As shown in the table on page 74, we have depicted a scenario that is roughly equivalent to where the public REIT market now stands - with 50 percent leverage and Street expectations for a 9 percent cap rate. After entering this data into our model, we arrive at an initial cash-on-cash yield of 8.4 percent and an ending IRR of 11 percent, after assuming 3 percent unleveraged annual growth. This case essentially depicts where REITs are currently being priced - with dividend yields of 8.2 percent and expected total returns in the low teens.
In the table above, we have depicted what would be a very simplistic back of the envelope LBO calculation that employs 80 percent leverage (the maximum amount of leverage needed to really push the envelope) and an above-market cap rate of 10.25 percent instead of 9 percent. Additionally, we factor in associated deal and transaction costs. Under this scenario, we calculate an initial cash-on-cash return of 14.5 percent and an IRR of 20.3 percent. The table clearly shows that an LBO buyer with any more-conservative financing expectations (with respect to leverage below 80 percent or a more aggressive cap rate below 10.25 percent) would not be able to generate a 20 percent IRR. Hence, LBO buyers would need to be conservative on these points, incorporating higher leverage and higher multiples, and also take into account all transaction costs.