Roosting Chickens: The CWH Saga
Board: Real Estate Investment Trusts
As I often do, I am copying and pasting a fairly recent blog post that I wrote for SNL Financial's Block Party. It summarizes the battle for CWH, which has had a happy ending - and is one of the few successful hostile takeovers in REITdom. I haven't yet invested in it, and not sure I will do so. Corvex, Zell et al have their work cut out for them. Finally, some of my comments on externally-managed REITs may have value for some investors.
The boardrooms of Corvex Management LP and Related Cos were rife with high-fives two weeks ago when enough votes arrived to oust the board members of CommonWealth REIT (CWH). This much-watched takeover effort began early last year and, after more twists and turns than the story of Malaysia Airlines Flight 370, it’s now clear that the hunters have nabbed their prey. CWH’s long-suffering shareholders have finally found salvation.
This epic battle is interesting on a number of fronts. Hostile takeovers in REITdom are rare, for various reasons. Legal restrictions applicable to REITs, e.g., the “five or fewer rule,” provide daunting takeover obstacles and can serve to entrench management. And, until fairly recently, shareholder ownership of REITs has been widely dispersed, with many mom ‘n’ pop investors inclined not to disturb the status quo. Also, there have been very few successful hostile takeover precedents; the Public Storage – Shurgard contest in 2006 was one of the very few notable exceptions. Finally, demonstrably bad management teams are not common in REITville – so shareholders aren’t often highly motivated to “throw the bums out.”
So, what was it that resulted in the downfall of Barry and Adam Portnoy, and REIT Management and Research LLC (RMR), their management company, who have been the outside advisors to CWH in its various iterations for years? There were two key factors, either of which may not have been sufficient but in combination resulted in the insurgents’ victory.
First, we need to travel back in time. Prior to 1986, REITs were not allowed to perform many of the functions necessary to the efficient ownership and management of commercial properties, and so REITs would, in varying degrees, contract for these services from outside companies. When these companies are owned by the REIT’s directors and officers, numerous conflicts of interest are created, which enable a great deal of mischief. For example:
Fees payable to an outside advisor or management company, which controls the REIT, can be out of proportion to the value of such services, enriching the advisors at the expense of the shareholders. Even more important, fees might be calculated on the basis of the dollar value of the REIT’s assets – a clear conflict because that arrangement encourages growth for growth’s sake; new shares could be issued at prices highly dilutive to NAV merely to raise funds to acquire more assets at market prices (which generates more fees). And such structures provide no incentives for management to create value for shareholders. Finally, the outside management company or advisor might own very few shares of the REIT it manages, making stock performance a low priority for the management company or advisor.
But REIT world changed forever in1986, when the Tax Reform Act was passed by Congress; this milestone legislation empowered REIT organizations to internally manage themselves. Acquisitions, leasing, property management and all other business functions could be handled by REIT employees; restrictions remained in some property sectors, e.g., healthcare and hotels, but these were later largely eliminated by the REIT Modernization Act and RIDEA. The key benefit of this legislation is that it enabled REITs to eliminate the conflicts of interest that arise when using outside advisors and managers.
As a consequence, aside from mortgage REITs, the vast majority of today’s REITs are internally managed. Is this a good thing? Yes, of course. There is an argument that small-cap REITs can keep overhead costs lower by using an external advisor/manager, but in my view this minor advantage is more than offset by the numerous conflicts of interest inherent in an external structure. In addition, as noted in an excellent report issued by SNL Financial on March 28, “Post-CommonWealth, the Future for Externally Managed REITs is Unclear,” externally-managed REITs tend to trade at steeper discounts to NAV than other REITs. This often makes equity raises NAV-dilutive, destroying shareholder value. The SNL report lists only 18 equity REITs that are externally managed and advised, including five managed by RMR.
These REITs, including CWH, have not taken advantage of the 1986 legislation, and thus have not eliminated these conflicts; this ultimately became lethal to the Portnoys’ control of CWH. Shareholders just got fed up with these conflicts and how the Portnoys dealt with them (or refused to do so). And RMR received huge fees from CWH. Corvex and Related presented data showing that, from 2007 to 2013, fees paid to RMR rose 40%, even as CWH shares tumbled 68%. As my grandson Jake might say, “What’s with that?”
But perhaps the conflicts (and huge fees) at CWH, alone, might not have been the game-changer. We should also look at CWH’s performance relative to its peers in the office sector. A special report issued by Green Street Advisors on March 17 cited Bloomberg data showing that, for the 10- year period from February 25, 2013, when Corvex and Related made their intentions known, CWH had a cumulative total return of 14%, compared with a cumulative total return in the office sector averaging 170%. Even my mellow Golden Retrievers, Riley and Kacie, would have a problem with that.
But perhaps the key take-away for REIT investors is that the conflicts of interest and the horrible relative performance of CWH are two sides of the same ugly coin. Successful REITs create value, and they do so in many ways. They issue fresh equity at prices in excess of NAV, and use the proceeds, when appropriate, to acquire properties at, and sometimes below, market prices, and develop, at times, new properties at attractive profit margins. They upgrade and improve their existing properties. Except in those few property sectors where size is a real advantage, they remain small enough so that a few great acquisitions or developments can really boost per share value.
Furthermore, they recycle assets, and even consider buying in shares when they trade at significant NAV discounts. Many of them focus their business strategy on those geographical regions which they know well and where they can add value – “local sharpshooters” are attractive to REIT investors. They keep overhead and property management costs as low as possible. And they provide appropriate incentives in the form of stock options and stock grants to their key employees to align their interests with those of the shareholders. REITs that do these things consistently will see their shares perform quite well.
I haven’t been a CWH investor, nor even followed it closely, over the years, but it is my impression that CWH’s outside advisor had an attitude towards value destruction that might be similar to that of Alfred E. Newman – “What, me worry?” Indeed, CWH, in March 2013, pulled off a hugely NAV-dilutive offering of 34.5 million new shares at $19 per share, in response to the insurgents’ buyout proposal. Perhaps other externally-advised REITs are more sensitive to the conflicts of interest issue; I don’t follow them, so I cannot say. But investors should beware of these structures and their inherent conflicts. It took a long time but, at least in the case of RMR and CWH, the conflicted chickens have finally come home to roost.