Activist Investors Disrupting REIT-dom

The upsurge of activist and private equity investors fishing in the REIT sector has sparked an explosion of potential transactions.

The latest deal, announced yesterday, is an $8 billion sale of BioMed Realty (BMR) to Blackstone Group (BX), the biggest private equity real estate investor in the US. BioMed has been trading at a substantial discount for most of the year and the San Diego-based REIT’s high-quality life science portfolio became a compelling target for the highly active buyer.

Blackstone had just closed on a similar REIT privatization deal with another San Diego-based REIT, Excel Trust (EXL). Similar to the BioMed deal, Excel had been trading at a discount and Blackstone seized the opportunity by taking advantage of the lack of shareholder demand for the small-cap REIT.

Historically REITs have traded within a reasonably predictable band, mostly above their Net Asset Value (or NAV); however, more recently REITs are posting less-than-stellar results, becoming prime targets for cash rich private equity buyers like Blackstone.

Another more hostile group of deal makers forcing REIT control are activist investors.

Unlike private equity buyers, activists are forcing change by targeting companies that are under-valued, hoping to unlock value through disruptive activities.

Recently Land & Buildings Investment Management LLC, an activist investor, targeted New York REIT (NYRT) for concerns over corporate governance that has hurt the REIT’s share price. While most New York Office REITs have traded in-line, NYRT’s share price has languished as Land & Buildings Jonathan Litt explained, the REIT "has consistently traded at a significant discount to the value of its trophy Manhattan office buildings," which the firm believes is roughly $14 per share (according to Litt).

On October 1^st NYRT addressed Litt’s concerns by announcing that the company had engaged investment banker, Eastdil Secured, to advise the REIT on strategic transactions at the asset or entity level.

Litt is no rookie at bullying under-valued companies. His firm has been a proponent of forcing MGM into a REIT conversion or to possibly sell assets. In addition, he has taken aim at Pennsyvania Real Estate Investment Trust and Associates Estates Realty Corp., the latter he successfully orchestrated a $2.5 billion sell to Brookfield. Jeffrey Friedman, chairman and chief executive officer at Associated Estates, said in a news release,

After analyzing the company's strategy, assets and other opportunities, including running a process involving a number of qualified potential buyers, the board unanimously determined that this transaction is the best course of action to maximize shareholder value.

It’s not just real estate companies that are under activist watch, a number of C-Corporations are also being pressured to unlock value through spinning off REIT-eligible assets. Similar to the private equity buyers like Blackstone that are pursuing under-valued REITs, activists are also on the prowl for underperforming companies that own portfolios of real estate.

By broadening the IRS’ definition of real estate last summer, activists have encouraged a broad spectrum of companies to monetize their assets, stirring the pot for a frenzy of new deals.

In a recent Forbes.com article I referenced a few possible REIT spins including Ethan Allen (ETH), Bob Evans (BOBE), Cracker Barrel (CBRL), Dillard’s (DDS), and McDonald’s (MCD), all being viewed through the REIT lens by activist investors (or suggestivists as some are called).

More recently 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. By dividing the real estate into a property company, Darden aims to monetize the sites to payoff around $1 billion in debt.

As a result of activist pressure Bob Evans said that it would pursue a sale-leaseback transaction for approximately $200 million worth of its restaurants. According to SNL Financial the proposed deal was announced after pressure from activist Sandell. The transaction is expected to close in the second half of 2016 and generate net proceeds of $165 million to $170 million. These proceeds, plus $85 million to $90 million expected from the sale-leaseback of the company's headquarters and certain industrial properties, will be used for stock buybacks and debt repayment.”

Hit The Brakes Cowboy

The REIT vehicle, as it was structured in 1960, provides valuable alignment for individual investors to gain access to the wide world of real estate. With a growing number of REIT IPOs, REIT Listings, and REIT Spins it seems logical that the growing universe of high-dividend paying stocks would benefit investors.

But it seems that some investors, mainly the market timers, are looking to capitalize on the REIT sector by turning a quick buck. As my mother used to say, “give him a rope and he thinks he’s a cowboy.”

Now that the IRS has given the REIT sector more rope to expand the playing field it seems that some of the “quick buck” players are forcing the IRS to put the brakes on certain extreme transactions.

Notably the IRS is worried about companies that are disguising taxable transactions as spin-offs to avoid paying taxes. Think about it, practically any company that owns real estate could spin their brick and mortar into a REIT to defer paying Uncle Sam. Innocent investors would be left holding the bag when the musical chairs are over.

Sears and Darden could have been the catalysts that sparked the IRS query.

Regardless, the IRS has recently issued IRS Notice 2015-59 and Rev. Proc. 2015-43. The IRS releases did not actually propose any changes to existing law, but rather announced that absent “unique and compelling circumstances” the IRS ordinarily will not issue comfort in the form of a private letter ruling with respect to a proposed tax-deferred spin-off under Section 355 of the Internal Revenue Code if real property owned by either the distributing corporation or the distributed corporation serves as the basis for a REIT election by either of the two corporations.

One of the rules for a tax-free spin-off is that the spin-off must be involved in an active trade or business. Being a Landlord and collecting rent is not an active trade business. The real gray area that the IRS is examining is how much of an operating company does the REIT need to be.

I side with the IRS. Many of the new and proposed deals are being orchestrated by activists and are not aligned with individual investor interests. Instead, they are structured as “quick buck” opportunities with relatively no alignment of interest with regard to shareholders.

It’s my belief that the U.S. REIT sector is extremely healthy and part of the success of this industry has been the fact that the laws were crafted to protect the investor and provide a meaningful path for wealth compounding. The historical performance of the 56 year-old industry is proof in the pudding and for any long-term investor; REITs offer compelling diversification, transparency, and liquidity attributes  that are precisely the ingredients for the REIT recipe: sleeping well at night.

Source: SNL Financial

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.