The recent corporate governance failures in South Africa have shone a light on the role management play in running companies. We thought it an opportune time to highlight some of the key factors that we consider when assessing real estate management teams and their ability to add or detract value for shareholders.
In 2010 a well known UK-based listed shopping centre owner received a cash offer from one of the largest real estate investment trusts (REIT) in the world. The offer was priced at an 18% premium to the previous day’s closing share price, equating to a 15% premium to the company’s last published Net Asset Value (NAV) per share. Despite the company trading below its NAV, the board believed the offer significantly undervalued the business and, therefore, unanimously rejected the proposal before putting it to shareholders.
The company has since gone on to use dilutive equity raises to acquire assets while consistently trading at a discount to their NAV. To date, the company’s share price has never reached the price offered by the US landlord back in 2010 and is now priced at a 56% discount to NAV. Perhaps an even more sobering statistic is the contrast between the two companies’ performance since the offer. Had the Board recommended the offer and given shareholders the option to vote in favour of the deal, shareholders could have earned a total return of 159% to 31 August 2018 by using the cash received to acquire the US company shares. Instead, shareholders have received a total return (in USD) of -48%, equating to an annualised difference in performance of over 21% per year.
The 2011 film “Moneyball” starring Brad Pitt tells the true story of the Oakland Athletics baseball team. Heading into the 2002 American Major League Baseball season the team, faced with the impending departure of a few key players and unable to compete with the larger budgets of their competitors, decided to adopt an unorthodox strategy. With the help of a Harvard economics graduate, Paul DePodesta, Billy Beane the team manager (played by Pitt) used statistical analysis to select their team, a method now known in baseball as “Sabermetrics”. Their research found that baseball teams often overvalued specific player characteristics. By hiring undervalued and unpopular players and selling players overrated by other teams they could compete above their pay grade.
The method proved to be a success, enabling the Oakland A’s to put together a team that went on to win a Major League Baseball record-breaking 20 consecutive games in the 2002 season.
For real estate companies, Net Asset Value (NAV) can be a valuable tool to assist in capital allocation decisions much like Sabermetrics proved to baseball. Net asset value (NAV) is a measure of the market value of a company’s assets less the value of their debt. In the real estate world, if a company’s share price is trading in line with its NAV per share, it implies that the market is valuing the company’s portfolio at its current private market valuation. Consistently trading at a NAV discount can be an indication of the market’s view of management and the value that they are likely to detract from the value of the physical real estate.
By following a formula approach to capital allocation, a real estate company should really only consider accretive expansion (through acquisitions or development) if it is trading ahead of its NAV and its balance sheet is in line with management’s targets. Sun Communities, a US-based manufactured housing REIT, has used this strategy to good effect over the last few years by raising equity while trading at premiums to its NAV and using the proceeds to fund higher yielding external acquisitions and development. The company currently trades at an estimated 20% premium to NAV and in their most recent share offering raised $475 million of equity at an implied cap rate of 4.5%. The funds will be used to fund its previously announced external activity at a 5.5% nominal cap rate. The 5% share expansion priced at a 20% premium to NAV equates to a 1% accretion to their NAV per share.
If a company is trading below its NAV, a worthwhile strategy to consider is the sale of assets to reduce debt and/or buy back shares. This amounts to selling assets at full price and using the proceeds to buy back shares at a discount. A consideration for companies that consistently trade at a NAV discount is to be open to the idea of selling the company should a reasonable offer come along. This, however, is a bitter pill to swallow for most management teams as it usually means they will be without a job even if shareholders are better off for it.
Another critical factor to examine is the level of management ownership. Management teams that have a significant portion of their personal wealth tied up in the companies they manage tend to make capital allocation decisions which are more aligned with shareholders. By having skin in the game, management are forced to think like shareholders.
The last factor worth mentioning is the difference between internally managed real estate companies and externally managed ones. An externally managed real estate company generally outsources the complete management and day-to-day operations of their property portfolio to an external manager. Typically that external manager will earn both a property management fee as a % of total revenue as well as an annual management fee as a % of total asset value. Transaction fees are also routinely charged each time an asset is bought or sold. External managers are thus incentivised first and foremost to grow the absolute size of the company’s real estate portfolio in order to maximise the fees they earn. A ‘grow at all costs’ mentality creates risks for shareholders as the external manager may not consider the long-term growth prospects of the assets acquired. It is no surprise then that we prefer real estate companies to be internally managed thereby avoiding these types of conflicts of interest, creating accountability for the management of the company.
In closing, we believe that management teams that follow a disciplined approach to capital allocation, practice sound balance sheet management and own meaningful stakes in the companies they run, stand a better chance of providing superior returns to shareholders over time.
Real estate fundamentals overall remain healthy, mainly due to manageable supply levels relative to demand, with an improved economic growth outlook. Taking the estimated forward FAD (Funds Available for Distribution) yield of 4.73%, and medium-term growth prospects into account, listed real estate currently looks fairly valued on a risk-adjusted basis.
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Article written by Jonathan Kinnear, Investment Analyst at Catalyst Fund Managers
