Selling The Fortress To Save The Moat

These days it seems like every activist investor has set their sights on the once forbidden fruit inside a C-Corporations balance sheet called real estate. Until recently, most activist investors have always viewed brick-and-mortar as a somewhat cumbersome asset class, virtually illiquid but holding a place mat in the inner workings of corporate finance.

Activist generally aren’t astute when it comes to real estate as most of them scour the landscape in an effort to seek out companies in need of new management. The most tell-tell sign is when an activist sees shareholder dis-alignment – usually in the form of a low multiple – and the trader seeks to capitalize on the opportunity by shaking up the management team.

These days more and more activists are turning to real estate, the once unnoticed slice of the balance sheet that has the potential to unlock enormous shareholder value if monetized correctly.

Most corporations own some real estate, but many lease their properties and the one’s that do own the brick and mortar usually own it because it’s a small percentage of their Total Assets. For example, FedEx (FDX) leases most of its buildings, many owned by publicly-traded REITs like Monmouth Real Estate (MNR) or Realty Income (O).

However, many retailers and restaurant chains prefer owning real estate because it provides them with better control of their development processes while also serving as a piggy bank for future debt transactions that can serve as a source of collateral for future growth.

As many retail or restaurant chains evolve they usually don’t look to monetize the hard assets initially. They are often times cash rich so they list shares on an exchange and Mr. Market provides them with a steady flow of funds to build storefronts.

Take Shake Shack (SHAK) for example. The hamburger chain’s share price soared 119% on the first-day of trading, making it one of the strongest first-day IPO’s in quite some time. Mr. Market essentially gave Shake Shack an unlimited checkbook to go out and build dozens of locations across the globe.

As Shake Shack begins to mature it will look more like AutoZone (AZO), one of the largest auto parts chains in the U.S. The Memphis-based retailer owns around 50 percent of its 5,400 stores, yet the company is continuing to grow its footprint – adding 148 stores in the U.S., 40 stores in Mexico, 2 stores in Brazil and 11 hub stores in 2014.

Most retailers lease stores, but chains like AutoZone have opted to own them because they maintain better control over their development, but also because they can tap into the piggybank at a future date. But not today. AutoZone has returned 21.75 percent annualized since 2000 and 21.5 percent year-to-date.

But what happens when a company’s growth has slowed and it can unlock its vast real estate holdings?

That’s precisely what the activist investors are seeing as they are beginning to utilize the 50+ year-old (since 1960) tool in which companies that own at least 75 percent of their real estate (or 75 percent of income derived from real estate) can be converted to a Real Estate Investment Trust, or REIT.

Seritage (SER) is a new REIT that recently listed with 224 of its Sears Department Stores (11 are leased to other tenants) and Darden Restaurants Inc. (DRI) has proposed spinning off 430 of its more than 1,500 properties to form a REIT called Four Corners Property Trust Inc. These two mature chains are aging and beginning to suffer from declining traffic and lackluster expansion – some would argue the chains are in the later stages of brand evolution.

To spark the fading flame, activists are attempting to unlock the value of the brick and mortar by tapping into the highly coveted corporately owed real estate.

Recently, activist investor Tom Sandell sent a letter to Ethan Allen (ETH) suggesting that shares in the furniture retailer had “underperformed its peers…with 10-year underperformance versus its peers a staggering 119%”.  The activist investor went on to say that “capital (is) tied up in the Company’s vast portfolio of real estate assets (and) has been a drag on shareholder returns”. He went on to say,

“Sadly, the Company has still shown no indication that it intends to tap into the exceedingly robust market for both retail and industrial real estate properties in order to unlock this capital that has been trapped on its balance sheet.”

Ethan's Allen's real estate portfolio includes: 53 wholly-owned retail design centers; 17 retail design centers subject to ground leases; its corporate headquarters building and 18.0 acre campus; its 200 room Hotel and Conference Center; and its eight wholly-owned manufacturing facilities, as well as various ancillary properties. Sandell argues the real estate value is worth approximately $450 million, or about $16 per share.

Sandell’s argument is centered on the notion that Ethan Allen’s real estate portfolio (of $450 million) is around 50 percent of Ethan Allen’s market valuation (around $870 million). Sandell went on to explain.

…we believe based upon input from numerous finance and real estate experts that there are many interested parties and several ways to help the Company unlock this value, ranging from a series of sale-leaseback transactions to the creation of a tax-efficient REIT through an OpCo-PropCo structure.

Other well-known chains such as Bob Evans (BOBE), Cracker Barrel (CBRL), and Dillard’s (DDS) have been subject to activist exploration and while the hype has generated some buzz, the reality is that shifting the real estate off-balance sheet is not logical.

First, remember that the company will be moving its property off the balance sheet onto the income statement. The company will get the capital to reinvest into the business but it will also have a lease contract so it will be obligated to make monthly rent payments, including taxes, insurance, and maintenance. That doesn't apply to all companies however, especially the more bank dependent businesses where leasing can provide more breathing room to the balance sheet.

Secondly, the REIT will have to hire a management team to run the real estate operations and that is generally difficult given the fact that most of the properties will be leased to a one tenant concept. This can be an issue and is the conventional wisdom; however, the spin play is to create value and ultimately many of these companies will be merged into one another (if they survive).

That leads me to the third, and most important, issue for the new REIT-ailer. The new company, or spin-co, will have significant concentration within the portfolio. So in the case of Sears, there is a good chance that the company could run out of cash in the future and leases will have to be modified in the event of bankruptcy. When the sources of income decline drastically that ultimately leads to a dividend cut and of course, a sucker bet.

A better option is for the mature brand to monetize its real estate by selling properties to a REIT.

Last year, VEREIT (VER) acquired over 500 Red Lobster locations for around $1.5 billion and recently LifeTime Fitness, with a portfolio of 115 properties, sold a portfolio to buyers including Gramercy Property Trust (GPT), acquired ten stores. Instead of spinning off the properties into a REIT, these two companies were able to generate needed liquidity in the form of a sale/leaseback and return the capital more efficiently.

In summary, the wave of activism has increased within the retail and restaurant sector and while the glare of REIT gold may seem attractive to many, the aura is less appealing when compared to the life cycle of the business operation that ultimately is reflected in the underlying value of the company.

REIT spins have a powerful valuation creation motivation behind them.  Properly done, they can create value, and they will contribute to growing the Net Lease (free-standing) REIT sector.  All of the major NYSE Net Lease REITs (O, NNN, WPC, and VER) have came to their size through mergers and acquisitions (or M&A).   When compared to the volume of SpinCo deals in the Net-Lease space it's not hard to imagine Realty Income larger than the Mall gorilla, Simon Property Group (SPG).  Absent spins, the NNN space will always be more of an afterthought.  

There is a lot of real estate out there that "could" be in the REIT space, but won't because of tax issues.  Think Target, Home Depot, Lowe's, Kohl's, Safeway, Kroger, and even WalMart (the Mount Everest of Spins). 

It's true that real estate, owned by corporations, can provide meaningful financial muscle but the ultimate cost advantage for any business enterprise is to create sharper forms of differentiation first. In the words of Warren Buffett, “the products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors” and the companies that can withstand the relentless competition are better equipped to maintain financial flexibility , and not having to fire-sale the fortress.

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The author owns the following Net-Lease REITs: O, STAG, GPT, LXP, WPC, SRC. 

Brad Thomas is the Editor of the Forbes Real Estate Investor and writes for Forbes.com and Seeking Alpha. He is also a frequent guest on Fox Business and he is currently writing a book, Trump: It’s ALL Business, about U.S. presidential candidate Donald J. Trump.