Finding Value in Small and Midsize REITs
- Feb 07, 2018
By Phil Owens
Small and midsize publicly traded REITs (defined as companies with $250 million to $1 billion in equity market capitalization) often have challenges attracting the attention of dedicated institutional investors. REIT management teams often get frustrated by the lack of interest from these highly desirable investors that have the influence and capital to validate a REIT’s strategic plans and support its ongoing growth initiatives.
Green Street’s Advisory group works with both investors and operators, and has found that the most common challenges investors encounter when evaluating smaller companies include a small equity float, high overhead, elevated cost of capital, less well-known geographic footprints and ineffective market communication strategies. While these are all valid considerations, investors should weigh both the positive and negative aspects of investing in smaller REITs, specifically as it relates to the potentially attractive return that smaller REITs can offer.
Weighing the challenges
One challenge most smaller REITs face is that they do not have a significant number of shares in the market. Their float (i.e. shares available to buy and sell in the market) isn’t as robust as those of a larger REIT. The concern many investors have is, ‘Why spend time and resources learning about a company that I can’t get a meaningful position in?’
Smaller companies also tend to operate at an overhead disadvantage. General & Administrative (G&A) expenses are essentially a “tax” on shareholders, so because larger companies have scale, the burden relative to the company’s size is lower. Furthermore, smaller companies often trade at discounts to underlying value relative to their larger peers. This leads to a higher cost of capital for the smaller companies, which may make it more difficult to compete.
Institutional investors may also be wary of tertiary market portfolios, and they are unlikely to take extra time to learn about them. Smaller companies often own portfolios that are located in less understood markets than the primary and gateway markets that tend to be the focus of larger REITs.
Finally, smaller companies often fail to communicate effectively with the market. Small REIT management teams should go above-and-beyond their larger REIT peers when it comes to investor communication efforts.
While smaller REITs face these real challenges, many people assume the smaller companies underperform the market and that they don’t offer as attractive of an investment opportunity as larger REITs. This is not necessarily the case.
Green Street analyzed five-year total relative REIT returns versus sector averages and found that larger REITs’ relative total returns are generally centered around sector averages. Small and mid-cap REITs’ relative total returns exhibit significantly higher variation by comparison. The smaller companies don’t systematically underperform, it’s just that their performance tends to be more volatile.
Outperformers vs. Underperformers
There are a few key principles that tend to differentiate the outperformers from the underperformers: franchise value, balance sheet management, corporate governance and overhead.
Positive franchise value, or the ability for a management team to add or detract value over time, can be reflected in the company’s performance track record. An important component of franchise value in the REIT space is management’s capital allocation acumen in terms of listening to signals from the market to grow or shrink their portfolio.
Balance sheet management is also critical, and needs to be a consideration beyond simply ensuring survival in a downturn. REITs that operate with lower leverage generally outperform those with more leverage. Over the last five years, as the market has been in an expansionary cycle, low leverage REITs have outperformed higher leverage REITs. Smaller REITs that operate with strained balance sheets often trade at discounts to their more appropriately levered peers and are unable to play offense during periods of market dislocation.
Corporate governance has become an increasingly hot topic in recent years. Over the past two decades, REIT corporate governance has improved meaningfully, but the industry still has strides to make. Corporate governance doesn’t seem so significant at first glance, but when issues arise that require management teams and boards to make critical decisions, the importance of corporate governance becomes a front-and-center area of focus. Issues relating to unattractive fee structures, generally misaligned incentives between management teams and shareholders, and knee-jerk rebuffed acquisition offers are just a few examples of ways investors have been burned by poor corporate governance. Best-in-class corporate governance is one of the easiest ways for smaller REITs to prove to shareholders that their voice is important and that they are being heard. Corporate governance is akin to a take-home test for REIT management teams—nobody should fail the take-home test.
It is not uncommon for larger REITs to operate with a G&A load that is 30 to 40 basis points as a percentage of asset value, while smaller REITs often operate at two to three times that. The overhead challenge for smaller REITs is often exacerbated when their shares are trading at a discount to asset value and therefore their cost of capital signal from the market is to shrink the company. As a smaller REIT, shrinking not only further increases the company’s overhead burden, but it also reduces the public float and may increase leverage. Entering joint ventures and strengthening investor messaging can be very effective strategies to consider when seeking capital for growth while working to reduce net asset value (NAV) discounts. Higher-than-average G&A without a story behind it can have a materially negative impact on value. That said, excess G&A that exists to support growth or compelling value-creating initiatives can be attractive.
Institutional investors don’t always pay attention to smaller companies, but they don’t completely ignore them either. Green Street’s analysis shows that the top 30 active U.S. REIT investors have made sizable bets on some small and midsize REITs. Some smaller players have taken proactive steps to attract large investors, giving them access to ample capital to thrive, but the majority still have work to do.