What is holding back REIT consolidation?

COMMENT News that Ediston Property Investment Company’s board is considering a merger or sale has put the issue of REIT consolidation back in the spotlight. Ediston’s board said while it employs a capable investment manager and considers itself to be well-positioned, it, like many of its peers, remains of a size which might deter some potential investors”. As a large shareholder in Ediston, we concur with the board’s comments on the manager’s capability, and applaud their self-awareness around the size and liquidity of the vehicle. I too believe that despite 2021’s flurry of merger and acquisition activity, fuelled by cheap debt-backed private equity, there is scope for further consolidation in the listed property space. Last year brought us a handful of deals that prove the benefits of a strategic merger. LXi and Secure Income REITs agreed to combine on a NAV-for-NAV basis, creating a liquid, cost-efficient trust with £3.9bn of assets. As shareholders in Secure Income, we were pleased with the transaction given the stock had been trading at a 12% discount to NAV prior to the deal. Ironically, these two businesses were not even among the cohort of minnows at the bottom of the stock liquidity charts. The regulatory, reporting and investor relations requirements for listed companies have mushroomed over the years. Quite simply, the costs of running a listed property company with less than, say, £500m of assets are disproportionate. This is not necessarily the fault of management, but the boards of these businesses need to accept the reality that undersized companies do not achieve their primary objective of providing investors with liquid exposure to real estate within an efficiently managed structure. Building pressure Decluttering the REIT sector has been slow as deals usually involve a degree of self-sacrifice on behalf of board members. Mergers inevitably result in corporate governance’s answer to musical chairs, with only one chairmanship and one chief executive role available to the four potential ascendants. Reluctance to merge can also be attributed to the fact that many management teams do not, in my view, own enough shares in their own businesses. When looking for our “perfect” company, we always look for alignment in the form of a management team with hearty holdings of their own stock. Secure Income REIT’s leaders were good examples of this, and the outcome was beneficial for all of their shareholders. I am not the first to make the argument in favour of consolidation, yet I believe there are factors at play in 2023 which mean that pressure is mounting. The first of these is that recent price action in the listed real estate universe has been dominated by the perceived security of any given stock’s balance sheet. Companies with the greatest leverage and/or sensitivity to interest rates have suffered the greatest volatility – with generalist investors shunning the property sector and ignoring the fundamentals that underpin it. This means there are many REITs with strong fundamentals and yields (at least for the medium term) that now look extremely cheap, potentially making them attractive acquisition targets. Big investors, small REITs Another factor is M&A activity in the private wealth management sector, given that large wealth managers crowd the shareholder roster at most REITs. The desire for economies of scale is nothing new. But the acquisition-based creation of wealth management giants means these firms end up with significant stakes in very small REITs. Such holdings are increasingly liable to being seen as rounding errors that are taking up unnecessary time and resources. REIT boards and managers should be prepared to accept that even if they are merging their company for fair value, the big gain is liquidity and operating margin, both of which are likely to be substantially improved. In this way, they remain attractive holdings for wealth management’s new bevy of multi-billion behemoths. I am hopeful that the comments from Ediston’s chairman will be a wake-up call for the boards of many tiny REITs. Marcus Phayre-Mudge is a fund manager at TR Property Investment Trust Photo © TR Property