REIT Roll-Ups: How Much Is Your Platform Worth? by Sherry Cefali and Nick Tarditti of Duff & Phelps
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March 7, 2016 REIT Roll-ups: How Much is Your Platform Worth? by Sherry Cefali and Nick Tarditti of Duff & Phelps LOS ANGELES—In REIT roll-up transactions, the value of contribut- Under most external management agreements, the managers are paid a ed real estate assets is generally understood, as investors are usually base fee on assets under management. This means that the external man- comfortable with the well-established methodologies underlying real agers may be incentivized to build larger portfolios, even at the expense estate appraisals. The value of the platform or management company of quality or profits. Furthermore, a number of managers hold board is less straightforward, however, and often becomes an area of inordi- seats on multiple managed companies’ boards, resulting in further po- nate focus in roll-up transactions. So why is the management company tential conflicts of interest. As a result, even if an externally advised REIT a source of value and how is that value best determined? is successful in completing its IPO, we found that it will often trade at a discount to its internally managed peers.[4] This article is an update to our study performed in 2014 that explores management company valuations from the following per- Given the market’s preference for internally managed REITs, the path spectives: to achieving the highest returns for investors in a roll-up REIT IPO often includes converting to an internalized management company.[5] • Why it is important to convert to internal management prior To do this, the investors in the funds and the owners of the manage- to a REIT going public; ment company must agree on the valuation of the manager interest, • The reasons why a manager has value in a roll-up; and that often creates some of the most significant issues in the roll- • Historical trends regarding management company valuations up. in REIT roll-up and internalization transactions; • The use of a discounted cash flow analysis to value manage- What Value Should be Assigned to the ment companies; and, Management Company? • Factors that impact the values of management companies. So why does a management company actually have value and how is The Need to Convert to Internal Management that value best determined? Many private real estate entities operate as a series of limited life partnerships or LLCs, with an “external”[1] management company In the world of privately owned real estate investments, the overseeing each of them in exchange for an asset management fee manager has a contractual right to property and asset manage- and a carried interest participation in the ultimate profits of each ment fees, generally for the term of the fund. In the typical roll-up, entity (also known as a promote interest). Many of today’s note- the manager exchanges these contractual future rights, any carried worthy publicly traded REITs were formed as a result of roll-up interest, and (where applicable) its operating platform for shares transactions in which a series of these finite-life funds are reorga- or units of the newly formed REIT. After the roll-up transaction nized into a newly formed REIT at the closing of the IPO.[2] with the management company, the newly formed REIT will no longer incur fees payable to the manager for property manage- It can be very difficult to generate sufficient investor interest to go ment, asset management, and other services under the advisory public if an equity REIT[3] continues to use an external manager. agreement. Therefore, REITs are strongly advised to internalize their manage- ment company prior to, or concurrent with, their IPO. The number of REIT shares allocated to each partnership is typi- cally based on third-party appraisals of the real estate properties, ad- “REIT investors are generally very focused on making sure their in- justed for other assets and liabilities contributed to the REIT, such as terests are fully aligned with management’s interest when it comes mortgage debt and cash, to determine each partnership’s contributed to buying stock and pricing an IPO,” says Greg Wright, Co-head of net asset value (“NAV”). The number of REIT shares allocated to the Americas Real Estate Investment Banking for Bank of America Merrill management company is estimated using generally accepted valuation Lynch. “To achieve maximum investor demand and optimum pricing, methodologies, including an analysis of management company values we typically recommend REITs internalize management and be fully in REIT roll-up and internalization transactions, as well as a discount- integrated, self-managed and self-advised.” ed cash flow analysis. Manager Value as a % of Total Equity and Investment Capital* 12.0% % of Equity 10.0% % of Invested Captial 10.0% 8.0% 8.7% 7.9% 6.0% 7.1% 6.3% 6.0% 6.0% 5.9% 5.5% 4.0% 5.2% 6.0% 4.6% 4.5% 4.5% 4.3% 4.3% 4.2% 4.1% 3.8% 3.7% 3.4% 3.4% 3.2% 2.0% 3.2% 2.9% 2.7% 2.5% 2.5% 0.0% 0.9% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 *Excludes transactions where the external advisor was internalized with no fee Source: Duff & Phelps database of 48 internalization transactions compiled using publicly disclosed information and proprietary deal intelligence While the participants can use real estate ap- profitability or price paid for the management internalization transactions that occur each praisals to get comfortable with the relative company. However, the value received by the year, making it important to not focus on the value of contributed real estate assets, the management company can be determined if the data from any single year, which may be driv- value of the management company is much REIT disclosure documents include the number en by very few transactions. less transparent. of REIT shares or units the manager received as consideration in the transaction. In addition to The ratio of Manager Value relative to the “Investors easily understand that their prop- the consideration paid to the manager at clos- REIT’s Invested Capital is considered one of erties are valuable but tend to forget that ing, there may also be a contingent component the most important metrics, as it adjusts for internalized REIT management requires the if certain targets are achieved, as was the case the impact of varying amounts of debt within management entity giving up future prop- in the acquisition of the respective manage- REITs, and more closely approximates the ra- erty and asset management fees,” adds Peter ment companies by Cole Credit Property Trust tio of Manager Value to assets under manage- Linneman, CEO and founder of American Land III and by American Homes 4 Rent. While these ment (AUM). The ratio of Manager Value to Fund and KL Realty, chief economist of NAI “earn-out” payments may be difficult to quan- Invested Capital over the period analyzed[9] Global and current board member of Equity tify, they often represent a meaningful portion averaged 3.4%. CommonWealth REIT, Equity One and Atrium of the total price paid for the manager. European Real Estate Ltd. The ratio of Manager Value to Market Value There are three valuation ratios that are of Equity of the REIT is higher than the ratio Analyzing Other Management readily calculated based on the sale of oth- of Manager Value to Invested Capital. This is Company Transactions er management companies. The first is the due to the fact that Market Value of Equity One of the best ways to estimate the value of Manager Value relative to the REIT’s Market is net of debt (similar to NAV), whereas In- a management company is to analyze other Value of Equity[6]. The second is the Manag- vested Capital is calculated before subtract- REIT roll-up and internalization transactions. er Value relative to the REIT’s Invested Capi- ing out debt. The ratio of Manager Value to The market price paid for the management tal[7]. The final metric is the Manager Value Market Value of Equity of the REIT over the company (the “Manager Value,” also some- relative to the manager’s trailing 12 month period analyzed averaged 5.5%. times referred to as the “Internalization EBITDA[8]. Fee”) is analyzed relative to the management The trailing 12-month EBITDA multiples paid company’s profitability, as well as relative to As shown in the chart above, the price paid for management companies in REIT roll- the value of the REIT. for management companies relative to the up and internalization transactions ranged size of the REIT appears to fluctuate from from 2.9x to 14.0x, with a mean of 8.5x and Most of time, the manager is acquired just year to year based on the ratios of Manager a median of 7.9x. As shown in the chart on before, or concurrent with, the REIT going Value to the Market Value of Equity and In- the following page, over 40% of the EBITDA public. Therefore, there may not be any dis- vested Capital. This is primarily due to the multiples implied by the transactions analyzed closure requirements regarding the manager’s fact there are relatively few REIT roll-up and ranged from 6.0x to 8.0x trailing EBITDA. Manager Value to Manager EBITDA Multiples* 13% 13% Less than 6.0x 6.0x to 8.0x 21% 8.0x to 10.0x 10.0x to 12.0x 42% Greater than 12.0x 13% *The table above is based on 24 transactions where the manager EBITDA was disclosed or from proprietary deal intelligence.