Property
 

F E A T U R E S
 
Under The Microscope
The Minnows Still Beat the Sharks
The REIT industry has been consolidating for the last six years. Have investors benefited?

by Mike Kirby and Jon Fosheim

After a boom of initial public offerings in the mid-1990s, real estate investment trusts began consolidating. Thirty-six mergers and acquisitions involving equity REITs have been announced since 1996, totaling $70 billion. Have the deals panned out well for investors? In general, they haven’t. But, as we concluded in a series of three studies over the years, investors who bet on the smaller companies in M&A activity came out better than those who owned shares in the larger, acquiring companies.

This shouldn’t come as much of a surprise, since the investment performance of REIT mergers mirrors that of corporate America, though there are some differences (see sidebar “Are REITs Different?” on page 28). But as the merger trend has matured and we have amassed more data about its impact on investors, we find our earlier findings reinforced.

Much of our focus in sizing up this impact is directed at total returns realized by shareholders in the month—that is, 20 trading days—following the announcement of a merger. This type of analysis is commonly known as an “event study” and is frequently used by academics to study the impact of newsworthy events on share prices. It is also controversial, so it’s worth taking a moment to examine the methodology.

Detractors argue that a month is far too short a period for grading the effectiveness of a merger. After all, most mergers don’t close for four to six months after they’re announced, and many of the benefits may not show up for a year or more. This criticism has merit, and, in a perfect world, merger studies would be done over longer spans. But event studies over longer periods seldom convey much information, because numerous other events over time tend to drown out the long-term effects of the events being studied. Among REITs, for example, property-sector focus is such a strong determinant of total returns that it tends to overwhelm abnormal performance caused by mergers, and, until recently, it has been difficult to control for this variable. (The task should now be easier, thanks to the improved property-sector indices of the REIT trade association, the National Association of Real Estate Investment Trusts.)

Another criticism of the event study methodology for M&A transactions is that risk arbitrageurs typically short the shares of acquirers quickly after the deal is announced. While it’s probably true that arb trading puts pressure on the shares of acquiring companies immediately after announcement, it is very difficult to believe that this pressure continues to serve as a drag on the stock price 20 trading days later. Within days of the announcement, arbitrageurs have had a chance to take their positions (which, by the way, sometimes entail going long the acquirer), and any short-term trading imbalance they may have created should have been eliminated. If the arbitrageurs are truly to blame, someone would have already set up a money-management shop to take advantage of the “inefficiencies” they create.

Despite the drawbacks to event studies, they do provide meaningful information regarding the efficacy of M&A-based growth strategies. The market, after all, is an efficient information processor, particularly when it comes to significant transactions that command the attention of most of a company’s shareholders, potential shareholders, the business press, and industry analysts. Within a relatively short time after the announcement of a merger, management has had time to make its case, analysts have revisited valuation models and published reports, and investors have had time to vote thumbs up (by buying) or thumbs down (by selling). While the market’s reaction after one month is not a perfect predictor of long-term performance, it probably is right more often than not.

In effect, those who argue that a one-month reaction period is too short to provide a meaningful report card are arguing that, on average, investors don’t know what’s good for them. We don’t buy this.

Are REITs Different?
The poor performance of acquirers in the REIT sector is reflected throughout the U.S. corporate community. But there are differences, and REITs need not have the poor M&A track record found in corporate America. After all, common reasons cited for acquirers’ poor performance include at least a couple of explanations that may not be of much relevance to REITs—as well as some that are. Here are some of the most common explanations of why mergers have fared poorly in corporate America:

(1) “Empire building” causes a disconnect between the interests of management and shareholders.

(2) Diversification is a goal that is highly desirable to management but provides little or no benefit to shareholders.

(3) Many mergers are doomed to failure because of poor integration of people, systems, and other ingredients.

(4) Takeover premiums are so large in corporate America (40 to 50 percent, on average) that synergies have to be huge to compensate for them.

With regard to the first and second reasons, REIT managers are no different than most managers, and there is reason to believe that problems between managers and shareholders have resulted in disparate conclusions regarding the merits of certain mergers. Specifically, the high insider ownership (at a low tax basis) and geographic focus of numerous REITs have undoubtedly caused management teams to seek diversity for the sake of diversity. However, the fact that investors were previously able to buy shares in both the acquirer and the acquiree implies that diversification of this sort is worthless to them.

By contrast, the third and fourth reasons appear to be much bigger issues outside of the REIT arena than they are for REITs. The vast majority of the mergers in our study have been more akin to acquisitions of real estate portfolios than to mergers of equals. While there have been attempts to merge two management teams, the initial plan for most takeovers called for the acquiree’s senior management to quickly leave the scene. While this can create considerable transaction costs, this type of deal entails less risk of failure. In addition, the average takeover premium for REIT mergers is 10 percent, much smaller than what is found in corporate America, generally.

Here are our conclusions on the payoff in REIT mergers:

Acquirers Underperform—As we have found in the past, the shares of acquiring REITs underperform the Morgan Stanley REIT Index, or RMS, over the 20-trading-day period following deal announcement (see graph on page 30). This underperformance averages 3 percent, about the same as the negative impact felt within a couple days of announcement. This finding is statistically significant.

While acquirers, on average, underperformed, not all did. Consistent with findings of mergers in corporate America, the shares of acquirers underperformed two-thirds of the time.

Acquirees Outperform—Shares of acquirees enjoy large run-ups upon deal announcement—gains that typically remain in place over the ensuing month. At the end of the 20-trading-day period, the weighted-average outperformance was 7.4 percent. Only 11 of the 36 acquirees in this study underperformed the RMS.

graphVirtually No Value Is Created—It is tempting to conclude that REIT mergers create value since acquirees rise in value by more than acquirers fall. This, however, ignores the fact that the acquirers in this group were slightly more than twice as large, on average, than the acquirees. After taking size into account, value creation was positive (roughly $500 million on $70 billion of deals), but tallied less than 1 percent of the aggregate purchase price. We find this conclusion puzzling; many of the studies of M&A in corporate America suggest that, even though acquirers normally underperform, a moderate amount of net value is typically created. The capitalized value of identified synergies (net of transaction costs) equates to 3.8 percent of the purchase price of the REIT mergers in this study, and it is surprising that these savings have not resulted in a similar amount of net value creation. Could it be that investors are so turned off by the perception that the surviving entity overpaid for these synergies that, out of fear that management might overpay again, they punish the shares, thereby roughly offset-ting the value of the synergies?

Large Takeover Premiums Result in Poor Performance—The acquirers who paid the largest premiums to the acquiree’s trading price before the announcement performed substantially worse than acquirers who paid modest premiums. Acquirers in the seven deals where the premium exceeded 20 percent turned in negative total returns averaging 5.1 percent; the nine acquirers who paid premiums of less than 5 percent generated negative total returns averaging only 1.3 percent.

Big “Synergy Gaps” Result in Poor Performance—The Synergy Gap is an analytical concept described by academic Mark Sirower in his book, The Synergy Trap: How Companies Lose the Acquisition Game. Applying the concept to our study, the capitalized value (at a multiple of 12) of synergies identified at the time of the merger equated, on average, to 5.5 percent of the total purchase price, although these savings were partly offset by transaction costs equal to 1.7 percent of the price. Thus, net synergies of 3.8 percent explain less than half of the 10.5 percent average premium over the acquiree’s prior total market capitalization. The remaining portion represents the Synergy Gap. In other words, less than half of the premium paid by acquirers is readily attributable to identified synergies, while most of the premium consists of “synergies to be named later.” (While this Synergy Gap analysis has always seemed to make sense, we were surprised by its strong predictive power.)

The size of the Synergy Gap is a good predictor of performance. Acquirers in the 11 deals with Synergy Gaps of more than 5 percent suffered negative total returns averaging 3.8 percent, while in the eight deals with positive Synergy Gaps (synergies explained the entire premium, and then some), the acquirers generated negative total returns of only 1.7 percent.

Larger Deals Have Fared Worse—Acquirers have done the worst—total returns down 3.9 percent—in the eight deals where the newly formed company’s market capitalization exceeded $7 billion. By contrast, acquirers underperformed by 0.6 percent on mergers that resulted in a company with market caps under $2 billion. In a similar vein, in the 17 deals where the acquiree had a market capitalization of more than $1 billion, acquirers generated total returns of minus 3.5 percent, but acquirers in the 19 transactions valued at less than $1 billion turned in negative returns of only 1.7 percent.

Long-Term Results Are a Mixed Bag—Of the 33 deals that have a one-year track record, 15 have outperformed the RMS, while 18 have underperformed it (see table on page 32). The average underperformance was 2.8 percent, but this figure is not statistically significant. Curiously, acquirers that outperformed actually outnumbered underperformers at the six-month point. The findings of the long-term study are inconclusive and highlight the difficulty of applying an event-study methodology over a longer period.

Based on a sampling of the more recent mergers, it is clear that property-sector influences have had a much stronger influence on results than any identifiable impact from the mergers. For example, a shopping center REIT that has outperformed RMS may well have underperformed its shopping-center peer group, and vice versa.

These latest findings won’t end the debate over real estate investment trust mergers. In fact, even though the $70 billion of REIT mergers that have occurred thus far have resulted in virtually no net value creation, we expect to see M&A activity continue at a pace consistent with the recent past.

So while it would be foolish to view all mergers as bad, the track record of REIT mergers to date warrants that investors bear in mind the following rules when it comes to M&A activities:

(1) Shares of acquisitive companies should trade at lower prices than they would if they weren’t on the prowl for takeovers.

(2) Conversely, shares of target companies deserve a pricing premium.

(3) And finally, acquiring companies generally don’t deserve the benefit of the doubt in light of the evidence that most underperform.

While this last point does not imply that acquir-ers should be judged guilty until proven innocent, we believe investors should increasingly frame the question: Since two-thirds of the deals don’t pan out, what makes this one so great?

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Mike Kirby and Jon Fosheim are co-founders and principals of Green Street Advisors, a Newport Beach, California-based research boutique that provides research to institutions on property-linked stocks. Barb Hoogland, a Green Street senior associate, performed the “real work” of gathering and analyzing the data in this report.

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