April 30, 2021

Breakingviews: U.S. REITs build solid deal with unusual blocks

by Breakingviews.

Mergers and acquisitions can be too fancy for their own good. Realty Income’s roughly $11 billion all-stock deal for rival real estate investment trust Vereit might appear to be guilty of this sin, with some financial engineering and a spinoff on the side. Better management, cost savings and separating office buildings make the deal a valuable idea.

The match is good strategically. Both firms rent out free-standing buildings to retailers like Walgreens and Dollar General, with long leases where the renter picks up property costs. And both have been relatively sheltered from the pandemic. Realty Income said in January only about 6% of fourth-quarter contractual rent hasn’t been paid by the likes of fitness clubs and movie theaters, while Vereit said in February about 2% hadn’t.

The details are also promising. The companies estimate some $50 million of cost savings, mainly from cutting back-office overhead. Both firms are REITs, which essentially means no tax bite. Capitalized on a multiple of 10, these are worth around $500 million.

That’s not as much as the premium, but there are other benefits. The larger firm should be able to refinance about $6 billion of Vereit’s debt on better terms. Even at the acquirer’s lower estimate of $110 million, that’s more than $1 billion in savings over the next decade.

Cost of capital is key, too. REITs grow earnings by buying buildings, and investors value them based on the yield their rents throw off relative to the interest they pay. With cheaper debt, acquisitions look more valuable. Plus Realty Income is using its highly-valued equity, which trades at over 2 times book value, more than a third higher than peers according to Refinitiv.

The second part of its deal includes spinning-off office rentals, a small chunk of the combined firm’s worth, which could make the deal messy. But with the rise of working from home, future demand for office space may be feeble over the long term. Separating the assets will give both firms a better chance to focus.

The biggest bonus, however, might come from Realty Income’s management. Over the past decade, the total return including dividends on its shares has been around 200%. That’s miles ahead of Vereit, which clocks in at less than 25% according to Refinitiv figures. Those are the blocks that make a successful deal.

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BREAKINGVIEWS

Reuters Breakingviews is the world’s leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.

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