What do high profile repudiations of REITs tell us about the future of the structure?
The decisions made by Macy’s/McDonald’s to reject REIT spin-offs are neither anomaly nor representative of a fundamental shift. In fact, their decisions have little to do with REITs or the REIT structure itself. REITs remain the most tax efficient means of owning large portfolios of similarly situated assets. Instead, the Macy’s/McDonald’s debate is much more about capital structure and finance than the appeal (or lack thereof) of REITs.
There is only one reason activist investors are pushing the REIT structure. They want to raise capital to buy back stock and thereby increase shareholder value. These investors seek the most efficient path to raising the most capital to accomplish their goals. Macy’s, McDonald’s and other similar retailers happen to control significant real estate portfolios that make attractive sell off targets. In many cases, it makes sense to try and further monetize these assets. This is no different than an industrial conglomerate that has a non-strategic division/subsidiary or a manufacturer with excess plants/equipment that could be sold off to return capital to investors.
Of course, Macy’s and McDonald’s could always simply borrow debt against their real estate portfolios. Here is where the REIT structure however — and the access to public markets it provides — has a strong advantage. In the current low interest rate environment where the cost of equity is relatively low, it is typically far more efficient to raise capital from thousands of REIT equity investors than it would be from a handful of large banks. Thus, if activists can force a REIT, they get access to a very large pool of cash.
Arguments Against a REIT Spin-off
But there are also very valid strategic reasons why McDonald’s and Macy’s would still not want to use a REIT – and in some cases those reasons are very similar to the reasons for not wanting to mortgage real estate through a bank.
1. Relinquishing ownership of real estate could have a negative impact on operations. Just as a bank mortgage constrains what a firm can do with its real estate, so too could an independent REIT. For McDonald’s it could mean losing some leverage over franchisees. For Macy’s it could mean re-directing precious operating capital to lease payments or subjecting needed capital improvements to landlord (REIT) approvals or further constraining which stores can be closed.
2. Rising interest rates (or the threat thereof) could greatly diminish the value of the real estate placed in a REIT. Corporate executives could reasonably conclude that the loss of control mentioned above is not worth a REIT public offering that could be hit hard by rising rates. As interest rates go up, the value of the REIT’s real estate is likely to go down. And while it is true that REIT values don’t always fall with a rise in interest rates, those REITs which are dependent upon so called triple–net retail leases are often very interest rate sensitive. In fact, fixed long term leases like those that would be found in a hypothetical McDonald’s/Macy’s REIT would be particularly vulnerable to changes in interest rates. In such a scenario, it’s not clear that shareholders would be better off over the long term. Sears is a good example of where it appears that investors are no better off with a REIT structure – and in fact may be worse off once transaction costs are factored in.
3. The operating company’s credit rating could be negatively affected – and therefore raise the cost of capital going forward. Recall that at its core, the decision to spin off real estate assets into a REIT is a FINANCING transaction. Think of it as a portfolio wide sale/leaseback transaction. After spinning out the REIT, the operating company (Opco) now has fewer unencumbered assets by which to bolster its perceived credit-worthiness. Of course, under the right circumstances, Opco would have just raised a big pot of capital to help ameliorate this problem. But if the Opco’s cash burn is high or rising rates bite into the amount raised from the REIT, then a credit rating hit or sickly stock price is distinctly possible.
Given these considerations and many more, executives have more than enough reasons to think twice about REITs – but that has always been the case prior to these two high profile rejections. There is nothing new about the decision process of electing to REIT or not to REIT. It’s just simply that that process can lead to different results depending upon the macroeconomic environment and the particular operating strategy of a given company. Sometimes the die turns up “REIT.” Other times it’s “NO REIT.” Right now given both the macro-and microeconomic circumstances, McDonald’s (especially) and Macy’s are probably well justified in resisting activists’ demands for a REIT.
But keep in mind, that reluctance says nothing about the intrinsic appeal of REITs as a strategy tool. In a different time, the answer may very well be exactly with the activists are proposing.