Barbarians at the REIT

The famous book “Barbarians at the Gate[1]” describes the takeover of RJR Nabisco by the Private Equity powerhouse KKR. The rise of the takeover industry changed US business forever and made it much more efficient.

Until the 1980s US conglomerates were considered the crown jewel and the object of admiration for business school graduates. Managers like Jack Walsh the revered CEO of GE and Rand Ariskog CEO of ITT roamed the country with a fleet of private jets like Roman emperors.

The Reagan era was characterized by deregulation and allowing free market forces to operate uninterrupted. As a result companies were mismanaged, wasted valuable resources and were taken over, restructured or liquidated in what is now known as the "fourth" wave of merger and acquisitions, which marked the end of the great American conglomerate. The fear of being taken over forces management to ever improve and outperform for the benefit of its shareholders. Although takeover defense evolved dramatically with the invention of the notorious poison pill and staggered board mechanism, CEOs always look over their shoulders. It is relatively easy for an activist investor (such as Carl Icahn) to acquire a significant stake in a company, take a board seat, and pressure managements to improve.

Real Estate Investment Trusts (“REIT”) are different from the conglomerates of the past. A REIT is a very specific vehicle aimed at Real Estate investments. A REIT offers its investors significant tax benefits and is highly regulated by FINRA and the SEC. However, REITs have a unique structure (described below) that allows management to behave just like the notorious conglomerates’ kings before the takeover era, without real accountability for its stakeholders.

REITs are subject to the IRS’s “five or fewer” rule that prohibits five or fewer shareholders from owning 50% or more of a firm, combined with management imposed: (a) poison pill; (b) staggered board; (c) other defense tactics such as 25% of the shareholder required to summon a special meeting; along with (d) a favorable jurisdiction (Maryland) which offers a Business Combination statute that offers protection from hostile takeovers. This creates a major collective action problem. It is very expensive for a small investor to launch a full-blown activist campaign against an entrenched board. This problem increases in the smaller REITs in which major activists with substantial resources have no incentive to act. In the Public Non-Traded REITs, the problem is even worse, since an average investor tends to invest only a few thousands of dollars. With the collective action problem and the high cost of launching an activist campaign, proxy fights are a high barrier for shareholders which hold a relatively small stake in an underperforming REIT. Even if such shareholders wish to increase their stake, they cannot due to regulatory and specific REIT hurdles. As a result, managements are not held accountable for the distraction of value and mismanaging the REIT. Nothing apparent threatens its steady stream of income even at times of a significant destruction decrease in the NAV (unlike other businesses, REITs generally have steady income derived from rents paid).

The peculiar case of New York City REIT[2] (NYSE: NYC) If you managed a REIT which owned primarily office buildings in New York City, would you choose to list the REIT on the NYSE during the worst pandemic in US history? A pandemic that significantly decreased the value of real estate in NY specifically? Exactly! This simple logic, which seems to be almost universal did not apply to the management of New York City REIT which chose to list its shares on the NYC during August 2020. The math is simple[3]: Mark to market NAV value pre-listing: $890mm Current valuation: $111.3mm Average daily trading volume: $27.55

The only explanation one can find for New York City REIT listing on the NYSE during these unprecedented times of global pandemic, which affected NYC more than most cities in the world, is the fact that management of a publicly listed company generally is compensated much higher than non-listed companies. As mentioned above, New York City REIT’s management continues to get paid from the rents the REIT properties generate, despite of the tremendous destruction of value it caused. We were told that the REIT management ignored calls from its shareholders to postpone the listing.

Another good example can be found in the recent bid by activist investor Jonathan Litt against Apartment Investment & Management Co.’s which plans to split into two public entities[4] Mr. Litt is trying to call for a shareholders meeting to block the proposal. Litt’s firm, Land & Buildings Investment Management, said it owns roughly a 1.4% stake in the company. That creates a significant hurdle for him to call a meeting. Under the company’s bylaws, a special meeting can only be called with the support of investors representing at least 25% of all the votes that could be cast at the meeting. Even successful takeover bids such as CommonWealth REIT (in which two activist investors, Corvex Management LP and Related Fund Management LLC, succeeded in their fight to remove the company's entire board) took too long and proved extremely expensive. In this case, the activists accused managing trustees of excessive compensation and mismanagement that caused CommonWealth to trade below the value of its office-property portfolio[5]. While some argue that: “because REITs are required to pay out 90% of their taxable income as dividends (Boudry, 2011), the agency costs of free cash flow (Jensen, 1986), are thought to be less severe in REITs than in other public firms. REITs operate in a strict regulatory environment that in itself limits managerial entrenchment (Bianco, Ghosh, Sirmans, 2007; Bauer, Eichholtz, Kok, 2010)[6]”

I believe this is irrelevant because REIT trustees can unilaterally withhold such dividend payments. REITs routinely use excess shareholder provisions, under which voting rights and dividend payments are automatically suspended should a single shareholder's stake exceed some prescribed hurdle, typically 10%.

Furthermore, especially in Public Non-Listed REITs which reached its fundraising goal and closed the fund for new capital, management is practically immune to the wrath of the market (unlike publicly listed REITs). The fact that there are not many institutional investors operating in the Public Non-Listed REIT space (which is dominated by the non-sophisticated retail investor), makes it much more vulnerable for management abuse.

Regulators must re-think the REIT regulatory regime to empower shareholders to hold bad managements accountable for the destruction of value. Here are a few suggestions: (a) Reduce the threshold for calling shareholder meetings. (b) Prohibit staggered boards and poison pills (the REITs structure has enough hurdles) (c) Make sure shareholders who launch an activist campaign get compensated for the capital spent (similar to class action mechanism)

Shareholders’ activism in an efficient market would have ousted the NY REIT management and other rough trustees for significant destruction of value, and hold them accountable. Given the current regulatory regime, I fear there will be no change in site and what will make investors reluctant to enter this fantastic asset class.

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[1] Barbarians at the Gate: The Fall of RJR Nabisco is a 1989 book about the leveraged buyout (LBO) of RJR Nabisco, written by investigative journalists Bryan Burrough and John Helyar. The book is based upon a series of articles written by the authors for The Wall Street Journal [2] The author is the Managing Partner of West 4 Capital Advisors, an investment firm which inter-alia holds interest in New York City REIT [3] Sources: Bloomberg 11/18/20 and Yahoo Finance 03/29/21. [4] Source: Bloomberg, 9/22/20 [5] See “Corvex, Related Call for Earlier CommonWealth REIT Special Meeting” Wall Street Journal 3/25/2014 [6] “Shareholder Activism in REITs” David H. Downs , Miroslava Straska , and H. Gregory Waller