Lucrative Fees Behind Real Estate Management Spur Fights

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CommonWealth REIT (CWH) owns office buildings throughout the U.S., yet employs no one. Cole Credit Property Trust III Inc. (0283899D), which leases about a thousand stores around the country to retailers such as CVS, Lowe’s and Wal-Mart, also had no workers until a recent acquisition.

Instead, both real estate investment trusts have been run by outside managers who are paid to choose properties to buy and at what prices, and which ones to sell and when. That has raised criticism from some investors, who say a management company may make decisions for its own benefit -- decisions not necessarily right for REIT shareholders.

“It’s a good business if you can get it,” said Jim Sullivan, a managing director at Green Street Advisors Inc., a Newport Beach, California-based research company. “The adviser does well if the REIT gets bigger, but the shareholders may not be well-served by the REIT getting bigger.”

That conflict has been at the heart of two of the biggest REIT fights this year. CommonWealth, based in Newton, Massachusetts, is battling an attempt by its second-biggest investor to remove its board. Phoenix-based Cole Credit had to fend off a rival’s buyout offer after announcing plans to purchase the firm that oversaw its properties.

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CommonWealth -- and other REITs that share the same external manager -- are among the few publicly traded property trusts with the structure, Sullivan said. It’s a common setup among REITs not listed on stock exchanges, such as Cole.

Portfolio Size

The problem with using an outside manager is that the firm may buy low-quality properties -- or overpay for real estate -- to boost the REIT’s portfolio size and increase management fees, Sullivan said. The manager may be focused more on its own income than in building the best portfolio for investors, he said.

“If you have money to spend and it’s not your money, your decision-making might be different than if it was your own money,” he said.

Companies that manage REITs are generally paid fees based partly on properties they oversee. Some external managers also are paid commissions for acquisitions and for raising funds for the REIT. Cole Credit paid $46.4 million in property and asset management expenses to Cole Holdings Corp. in 2012, up 71 percent from the prior year as 349 properties were added to the REIT’s portfolio.

CommonWealth’s manager -- a company owned by President Adam Portnoy and his father, Barry -- was paid about $70 million for running the company and its properties last year. The manager doesn’t get fees from acquisitions, dispositions, leasing or financing, the REIT said on April 22.

‘Destroys’ Confidence

Corvex Management LP and Related Cos., which have a combined 9.2 percent stake in the REIT, argue the company is undervalued partly because CommonWealth’s external management reduces cash flow, decreases the company’s valuation multiple and “destroys investor confidence,” according to an April 18 letter from Keith Meister, Corvex’s founder, and Related Chief Executive Officer Jeff Blau.

The investors also claim that CommonWealth is being run for the benefit of the manager, Reit Management & Research LLC, or RMR.

“CommonWealth’s real estate assets trade at a substantial discount to fair value due to a misalignment of incentives between RMR and shareholders, and what in our view is plain mismanagement by the Portnoys and the trustees,” Meister and Blau wrote in their April 18 letter.

Perry Corp., which owns 5.5 percent of CommonWealth, also has criticized the management and supports the dissidents.

Lower Multiple

The day before Corvex and Related began their campaign, they said CommonWealth had a 5.4 multiple of share price to funds from operations, a measure of cash flow used by REITs -- lower than the 14 multiple for Piedmont Office Realty Trust Inc. (PDM), 13.3 for Parkway Properties Inc. and 13.1 for Highwoods Properties Inc. CommonWealth, which is selling suburban buildings and buying downtown properties, said its performance has been hurt by weak demand for suburban office space.

Bringing CommonWealth management in-house would be more expensive, boosting general and administrative costs and hurting shareholders, according to Adam Portnoy. He defends the payment of fees and denies that Reit Management & Research is putting its own interests above CommonWealth’s.

“If I was doing that, then why would I care about my investment-grade rating?” Portnoy said in a telephone interview. “If that was the case, why would I sell any assets? It makes no sense.”

Credit Ratings

The company has a Baa3 credit rating from Moody’s Investors Service, and BBB- from Standard & Poor’s, the lowest investment-grade ratings from both firms. CommonWealth has sold $1.5 billion of suburban office real estate since the beginning of 2008, and bought $3.7 billion of properties in central business districts, according to an April 22 investor presentation.

If CommonWealth weren’t a well-run REIT, it would have difficulty attracting investors, Portnoy said. “We’ve had no shortage of investors anxious and willing to invest in this company well before Corvex-Related showed up,” he said.

Corvex and Related sued CommonWealth on Feb. 27 in Maryland state court, alleging in part breaches of fiduciary duty, corporate waste and breach of contract, according to an April 1 regulatory filing by CommonWealth. Maryland state Judge Audrey J.S. Carrion said at a hearing today in Baltimore that she will rule next week on whether the dispute will continue in arbitration.

For Cole Credit, its plan to buy its external manager was called “outsized” and dilutive to shareholders by American Realty Capital Properties Inc. (ARCP), which made a a $6.7 billion buyout offer for the REIT. Cole Credit rejected the bid and completed the purchase April 5.

Cole Stock

Under terms of the deal, Cole Credit agreed to pay $20 million in cash and 10.7 million shares of its stock for Cole Holdings, according to a statement on March 6, when the transaction was announced. There are also contingent amounts, including 2.1 million shares of stock after the company is listed on the New York Stock Exchange.

American Realty, based in New York, is managed by ARC Properties Advisors LLC, part of American Realty Capital. American Realty Capital last year raised $2.6 billion, the most in the nontraded REIT industry, and competes with Cole Holdings, the next-biggest fundraiser, according to Cumming, Georgia-based Blue Vault Partners LLC, which tracks the industry.

Increase Earnings

Cole Credit, which owns single-tenant properties, said it bought Cole Holdings to increase its earnings and save money. It paid its management company, owned by REIT founder Christopher Cole, $43 million in property and asset management fees last year. The purchase may boost earnings by $30 million this year, Cole Credit said in an April 5 filing.

Marc Nemer, chief executive officer of the combined Cole, said in a telephone interview that Cole Credit was able to buy the entire Cole business, with its 350 employees, for an attractive price.

Taking over the management business, assuming Cole Credit raises $1.3 billion in the next year as it plans, would boost revenue by $90 million, according to a March 6 filing. Cole plans to become a publicly traded company on the NYSE in June.

Potential conflicts of interests involving external managers haven’t dissuaded investors, primarily individuals, from investing in nontraded REITs. Such firms have raised $82.5 billion in the past decade, according to Blue Vault. Last year, investors put $10.5 billion into such companies, the most since 2007, when the commercial-property market peaked.

Three REITs

Cole Holdings raised $1.28 billion last year for its REIT products, with an average investment of $36,000, according to the March 6 filing. In the 10 years through 2012, the company raised $8.1 billion from more than 155,000 investors, according to an April 16 filing. It’s raising money for three nontraded REITs it manages, according to its website: Cole Corporate Income Trust Inc., Cole Credit Property Trust IV Inc. and Cole Real Estate Income Strategy (Daily NAV) Inc.

Investors in nonlisted REITs are seeking the higher yields they usually provide, and want the firms to keep administrative costs low, according to Robert O’Brien, global leader of Deloitte Touche Tohmatsu Ltd.’s real estate group. Those buy-and-hold investors are more interested in steady dividends than share appreciation.

“That’s their greatest focus,” O’Brien said in a telephone interview. “They’re not looking for a huge uptick. They’re really looking at income.”

Higher Yield

The median yield for nontraded REITs in fundraising mode was 6.5 percent in the fourth quarter, according to Blue Vault. That’s higher than the average dividend yield for the Bloomberg REIT Index, composed of publicly traded property trusts, which was 3.7 percent in the fourth quarter and 3.3 percent at the close yesterday.

“There are many retail investors out there that are looking to invest in real estate primarily for yield reasons, and the nonlisted REITs provide that opportunity,” O’Brien said.

Nonlisted REITs’ higher yields come at a cost, said Sullivan of Green Street Advisors. Investors need exceptional performance from the manager because much of their initial investment is eaten up by fees, he said.

“The nontraded guys are where you find fees and fees,” Sullivan said.

Nonlisted REITs tend to be externally managed because the companies are too small and costs too high to maintain a high-quality management team in-house, O’Brien said.

Equity Stakes

Many investors in publicly traded REITs, meanwhile, prefer managers to have significant equity stakes in the companies to ensure their interests are aligned with those of shareholders. Sam Lieber, chief executive officer of Alpine Woods Capital Investors LLC, which manages the Alpine Funds, said he generally doesn’t invest in REITs with external managers.

“I would require a discount depending on the nature of the company and the assets and the higher yields to compensate for the fact that there is less alignment of economic interests -- or, potentially at least, less alignment of economic interests,” Lieber said in a telephone interview. “There are some management teams that have significant equity ownership stakes, but not enough.”

To contact the reporter on this story: Brian Louis in Chicago at blouis1@bloomberg.net

To contact the editor responsible for this story: Kara Wetzel at kwetzel@bloomberg.net

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