Saturday, December 12, 2009

Why new is better than old, when it comes to REIT ipo's.

Way back when, (September 23 2009) Tom Petruno of the LA times wrote about the troubles of starting up a new REIT as a blind pool offering (Real estate vulture Colony Capital set to launch REIT IPO and Why investors are balking at IPOs of new vulture mortgage funds).

Buying into such an offering is making a macro bet that there are good investments out there, and a micro bet the management team will be able to identify these investments, generally run the company in a way that keeps it going for the long term and attracts investor interest.

With the exception of Lodging REIT Pebblebrook trust (PEB) these blind pool IPO's have been externally managed. There have been a number of S-11's for internally managed Hotel REITs (and as of Dec 11 an Class A Office REIT), which involve industry veterans with star (not iStar) power. Investing in any of these equity REITs means taking a macro view on the recovery of their target property sector. Financial reits require less operating expertise, since their assets are passive by nature, and if they need active management you are doing it wrong. The key skill is to carve a good investment out of a (pre-existing) messy situation, or be able to avoid messy situations

External management has a benefit in that you know what the companies cost structure is going to be. Incentive fees are tricky, since if not properly structured they can lead to "moral hazard" due to an emphasis on short term income. In theory an internally managed company should be prone to less empire building, but they can have more subtle issues of excessive compensation and awards of stock options.

Incentive fee's and a business model based on financial leverage leads to trouble. The temptation to crank leverage as financing spreads (or gross yields on assets) decline is irresistible. And yet, a fixed management fee is an annuity to the manager. Which can create an incentive to grow the equity base of the company.

The upside to starting a company from scratch is that there are no "legacy" issues. Old debt maturities to refinance, formerly performing assets now non-performing, etc. Unless a REIT is into development, the very nature of the REIT model is that of accretive growth (via acquisitions) instead of internally generated growth (from re-investment and asset management). This is especially true for REITs owning passive financial assets, where there isn't much asset management to be done because you can't raise rents on a mortgage.

A brand new company with just cash is poised for a large amount of growth and corporate transformation relative to its initial state, compared to most public REITs which are just trying to stay alive and have no capital for growth. It is that combination of legacy issues and strangled capital that makes most existing REITs uninteresting. They trade an high multiple to their ability to generate FAD at the corporate REIT level.

This makes blind pool IPO's kind of fun, since they often trade at only a slight premium (or more often discount) to book value till the company shows signs of ramping up and gains some analyst coverage. As the company becomes fully invested, the dividend stream grow at the same time that the to Price/book multiple will increase to that of a stable proven company.

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