News that Darden Restaurants will be spinning off some of its properties into a real estate investment trust has left investors and market experts wondering which restaurant or retailer could be next.
"More and more of these companies see a lot of value locked up in real estate assets that isn’t being realized when it’s part of the larger company," said Alexander Goldfarb, a managing director and senior REIT analyst at Sandler O’Neill Partners L.P. "There’s the old adage — PanAm should have sold the airline but kept the building," he quipped.
A big part of the appeal of a REIT spinoff is that real estate has seen record-high valuations in recent years. "Real estate prices in virtually all property types are at all-time highs," said Jim Sullivan, a managing director at Green Street Advisors, a real estate research and advisory firm in Newport Beach, Calif.
"A lot of corporate America controls a lot of real estate, and there’s a lot of motivation to figure out a way to extract value from those real estate holdings," Sullivan added.
Companies like Darden, which owns Olive Garden, Longhorn Steakhouse, and other restaurant chains, are betting that Wall Street will value the firm much higher as two entities than it currently does for a single combined company. "We appreciate the valuation differential between restaurant and real estate companies and are excited to create a new company," said Gene Lee, Darden’s chief executive, in a statement.
A REIT transaction also lowers a company’s tax bill since REITs aren’t required to pay federal taxes as long as they distribute at least 90% of their income to shareholders as dividends.
Darden is the latest chain to make this leap, but likely won’t be the last.
Earlier this year, Sears Holdings unveiled plans to spin off more than 200 of its Sears and Kmart properties into a REIT. It plans to sell the properties to the REIT and then lease the stores back, expecting to get $2.6 billion in proceeds from the sale.
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The strategy is particularly attractive for companies that are bleeding red ink and need cash to pay down debt or unlock shareholder value.
At Sears, the stock was dragged down by the company’s weak retail sales performance. "Sears’ brand had diminished and the operating business had diminished — and they realized the value was in the real estate," said Thomas Bohjalian, executive vice president and portfolio manager at Cohen & Steers.
In February, Hudson’s Bay Company, which owns the Saks Fifth Avenue and Lord & Taylor department stores, announced plans to form a $1.7 billion joint venture with mall REIT giant Simon Property Group involving 42 of its department stores.
In some cases, activist investors have been aggressively pressuring companies to spin off their real estate holdings. "A lot of investors think those are unproductive assets that you can monetize and return that capital either back to investors or back into the business," said Bohjalian.
Orange Capital LLC’s Daniel Lewis, for example, pushed casino operator Pinnacle Entertainment Inc. to take the plunge in 2014. "Based on our analysis, we believe a [REIT] transaction could result in an approximate 60%-90% increase in Pinnacle’s current share price to $35-$42 per share," said Lewis, in a letter to Pinnacle in July 2014.
By November, Pinnacle caved and agreed to form a REIT, although it’s been dragging its feet on proceeding. In March 2015, another REIT, Gaming and Leisure Properties Inc. , offered to buy Pinnacle’s real estate in a deal valued at $4.1 billion including debt. That offer is being reviewed.
Last week, Bob Evans Farms Inc., which owns and operates more than 500 restaurants, indicated on a conference call that it was looking at a possible REIT transaction either as a sale-leaseback to an existing REIT, or a REIT spinoff.
Others under the gun to make such a move, include fast food chain McDonald’s, retailer Macy’s, casino operator MGM Resorts International, department store Dillard’s, Target, Boyd Gaming, and Caesars Entertainment.
There are also unconventional sectors, such as fiber optic, telecom, utility and pipeline companies, that are putting assets into REITs. "These are companies in operating businesses that people don’t think of as real estate businesses, but where REITs have already been created in those sectors," said Sullivan. He sees more of these offbeat companies pursuing REIT transactions.
Still, there are risks associated with a REIT spinoff.
First, a company needs to factor in the future rental payments it will be forking over to the REIT. "These are companies that have never had to pay rent and now have to pay rent, and the business has to be able to absorb that cost," said Goldfarb.
This means it’s critical the company negotiates a fair rental rate with the REIT before the spinoff proceeds. But this can be tricky. If it demands uber-cheap rent, then the REIT’s financial viability is at risk, but if it pays exorbitant rent, then the operating company’s financial future could be in jeopardy.
Second, companies need to time REIT spinoffs when valuations are high to ensure the new REIT fully recognizes the value of the real estate assets. REITs are capital-intensive investments that rely on access to cheap capital and debt to survive and grow. Valuations tend to fall as interest rates rise — and the country is currently bracing for higher rates.
Concerns about higher rates have already rattled the REIT world. So far in 2015, the FTSE NAREIT All Equity REIT Index is down 2.7%, while the S&P 500 is up 4.1%. But experts believe those risks are already built into current REIT stock prices.
This article was republished with permission from TheStreet.