REIT spinoffs create value

Share prices tend to jump when companies announce plans to return value to shareholders, either through special dividends, spinning off assets, or major strategic changes. But does it pay to invest in a strategy that waits for companies to make these moves?

Several companies over the past year have announced such plans. Many U.S. firms in particular expressed interest in either spinning off assets into a REIT or converting to a REIT. The resulting impact on share prices has been positive (see “Selection of REIT conversion and spinoff announcements,”).

For instance, document-storage company Iron Mountain planned to convert to a REIT last June, something analysts had been expecting ever since the firm launched a strategic review of its assets. The conversion still needs to be approved, but shares have been up 32% since the announcement. IRM needs to convince tax authorities it qualifies for REIT status using the argument that the storage fees it charges customers actually amount to rent.

Another service firm, Corrections Corporation of America, has seen its shares increase 30% since it announced plans to convert to a REIT. The company constructs and manages prisons for the U.S. government. Its competitor, The Geo Group, is up even more—82%. Both companies still need to obtain the requisite corporate and tax approvals. The difference in share performance is the result of analysts handicapping the odds of successful conversion.

Meanwhile, analysts are tracking the success of one non-traditional REIT—American Tower Corp., which owns 50,000 cell phone and broadcast towers globally. It completed its conversion in early 2012, and shares have been up 45%.

More than just tax benefits

Many planned REITs will likely succeed — it’s just a matter of timing. Companies will move quickly in obtaining board and shareholder approval, but some are stuck waiting for the appropriate private letter ruling from the IRS.

REITs avoid taxes by paying out 90% of taxable income as dividends. They must also have 75% of assets invested in real estate, and generate 75% of gross income from rents. While the impetus behind a REIT conversion is tax savings, it’s not the only benefit.

Firms are finding ways to create additional lift by spinning off a portion of their assets into a REIT. The strategy here is twofold: the spinoff usually creates value by eliminating a conglomerate discount on shares (so long as the parent company doesn’t retain a significant position in the assets); companies can play the spread between recent record-high REIT valuations and less impressive retail, media and service industry multiples.

For instance, in January 2013, CBS Corp. announced plans to convert its Outdoor division in the Americas into a REIT, with a targeted start date of 2014. The division handles outdoor advertising such as billboards. Lamar Advertising, a competitor to CBS, received a favourable tax ruling last fall in that billboards would be considered real property. The firm is currently pursuing plans for conversion.

Another such firm is Loblaw Companies. Shares have been up 21% since it announced plans in December to turn most of its real estate into a publicly listed REIT.

The major knock against the transaction is the company is determined to maintain majority control. So, what might have started as a good idea has become less attractive before it even got off the ground. It’s rare an investor would want to be a minority shareholder, especially when the majority owner can continue to sell assets into the REIT on its own terms. It’s practically begging to be taken advantage of.

But it might be deemed okay if the investment is highly attractive. For instance, minority shareholders might accept a deal at a significant discount to market values. They already expect a discount for being overexposed to a single tenant (Loblaw) that’s facing increasing competition from the aggressive expansion of Target and Walmart.

The HBC factor

With the surprise pop in Loblaw shares, attention has turned to The Hudson’s Bay Company — its real estate assets have been the object of speculation since the company became public. But is it worth investing in HBC to get a call option on a REIT spinout?

The timing is good—record-high REIT valuations make the proposition the most attractive in the last decade. With the company floating 20% of its shares in a public offering in November, a REIT spinout could be one way to leverage this.

Various sell-side estimates put the potential value at $3-to-$4 per share, or roughly a 20% to 25% increase from recent levels. But that’s using the Loblaw transaction as a template.

More value could exist if HBC decides to spin off majority control, similar to what Empire Co. did with Crombie REIT back in 2006.

Further, the same analysts who gave Loblaw an easy time by estimating cap rates of just 6% are implying HBC should require a cap rate in the 7.5% range. And consider that HBC would sell its owned properties—flagship locations that carry more of a premium to the average value of the portfolio—into the REIT. The same can’t be said for Loblaw.

Just evening out the cap rates would increase the spread that exists between HBC’s retail operations valued at 6x EV/EBITDA, and the value of real estate that might trade at 15x.

So while the underlying value is attractive, the real question is timing. We’re not fans of investing in the waiting game unless the fundamentals of the business are also showing growth. But once HBC has a few quarters as a public company under its belt, it might be worth taking a look at the call option on an industry trend that’s increasing in popularity.

Selection of REIT Conversion and Spinoff Announcements

Company	Transaction Type	Announcement Date	Announcement Price	Recent Price	Return
Corrections Corp of America	Conversion	5/1/2012	$28.94	$37.34	29%
Equinix Inc	Conversion	9/12/2012	$186.55	$210.15	13%
Lamar Advertising Co	Conversion	8/7/2012	$31.50	$44.39	41%
American Tower Corp	Conversion	5/18/2011	$52.16	$74.67	43%
The Geo Group Inc	Conversion	5/1/2012	$18.00	$32.73	82%
Iron Mountain Inc	Conversion	6/5/2012	$26.08	$34.62	33%
Cincinnati Bell Inc	Spin-out	5/3/2012	$3.56	$4.29	20%
CBS Corp-Class B	Spin-out	1/16/2013	$37.94	$42.84	13%
Loblaw Companies Ltd	Spin-out	12/5/2012	$33.60	$40.58	21%

Source: Accountability Research Corp.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.