SIR is an attractive value plus catalyst situation with 40% upside and little downside due to the combination of a deeply discounted valuation, low leverage, and quality assets.  It is a triple net lease REIT that is trading at a glaringly large discount to comps despite some very high quality assets, low leverage and a low dividend payout.  The discount exists because it is externally managed by a group called RMR that is not well regarded.  I think that’s about to change because SIR’s largest shareholder with a 44% stake, CommonWealth REIT (CWH), is in the process of being taken over by Sam Zell and a group led by activist investors.  CWH was also externally managed by RMR until the activists won a shareholder vote to throw out the entire board last month.   Sam Zell is obviously an aggressive money maker in the REIT space, and I think it’s highly probable that he’s going to “fix” the discount at SIR one way or another in order to create a couple of hundred million dollars of value for CWH.

Background

(There is an excellent VIC writeup from February by abra399 on CWH’s preferreds which gives a good overview of the proxy fight at CWH.  There is also an excellent write-up on SIR from June 2012 by fizz808 which is a great overview of SIR’s assets.)

SIR is one of 6 publicly traded REITs that are externally managed by REIT Management & Research (RMR) which is owned by the father and son duo of Barry and Adam Portnoy.  The Portnoy’s have a poor reputation for governance (based on sell side comments, opinions from proxy advisory firms, and press articles).  This issue took center stage during RMR’s lengthy fight with activist investors for control of Commonwealth REIT (CWH).  SIR was spun out of CWH in March 2012 because CWH needed to raise capital, which is why CWH has a 44% stake in SIR today.    

Without getting too much into the details of the fight at CWH, a team of activist investors with a 9.6% stake in CWH made up of Corvex, run by Icahn vet Keith Meister, and the real estate company Related, run by Jeff Blau, recently succeeded in leading a proxy fight to throw out the entire board of CWH.  On March 25^th, so about three weeks ago, CWH confirmed that 81% of the shareholders of CWH voted to remove the entire board.  You can read all about the saga here and about RMR’s track record with CWH.  The key point is that the activists argued that RMR was inept and unaccountable as an external manager because it had essentially no equity interest in CWH, and it got paid based on assets instead of performance.    As the link above shows, CWH raised a couple billion of equity over the last decade, did a few billion in acquisitions, and tanked the share price by 70%, all the while collecting hundreds of millions in fees.   

What happens now is Corvex and Related have a plan which includes installing new trustees and management, internalizing management of CWH, and improving the property management operations which they believe were neglected by RMR.  Corvex and Related have already proposed a slate of trustees as part of the consent solicitation to remove RMR’s board.  A special meeting to elect them is set for May 23^rd. 

Importantly, Sell Zell has agreed to become Chairman of CWH, and Zell’s colleague of 24 years, David Helfand, has agreed to become CEO.  Helfand was previously President and CEO of Equity Life Style Properties (ELS), a Zell REIT, and SVP/CIO of Equity Office Properties (formerly the largest office landlord before selling to Blackstone for $40bn). 

 As far as I am aware, Zell and Helfand have not talked about their plans for CWH’s stake in SIR, but I expect they will become more vocal in the next few weeks and months.  CWH owns 22m shares of SIR which are worth $660mm, or 22% of CWH’s market cap.  Based on where SIR should trade, I think there is an easy path for Zell to make $200mm+ for CWH which is 7%+ to its market cap, so not insignificant.  (CWH stopped consolidating SIR in mid-2013 when SIR raised equity and CWH’s ownership dropped from 56% to the current 44%.) 

Description

SIR is a triple net lease REIT with suburban office/industrial properties.  The average revenue weighted lease term is 10.8 years, in-line with other triple net lessors.   The distinguishing feature of SIR is its very high quality assets in Hawaii.  40% of NOI comes from large office/industrial land parcels outside of the CBD in Honolulu. 

 The Hawaii land is valuable due to land scarcity, desirable locations, and unusually favorably mark to market rent adjustments.  The land parcels have 20-30 year lease terms and many tenants own buildings on the land.  A portion (~56%) of the land is subject to a reset feature unique to Hawaii whereby rents are marked to market every 5-10 years.  The rent resets have been significant, at +30-50% in recent years.  14% of Hawaii revenue resets in 2014 at +25%.  2.8% resets in 2015, and none resets in 2016. These rent resets appear to be in consensus estimates. 

 SIR has been executing on a plan to grow the mainland portfolio through acquisitions.  It focuses on single tenant triple net lease suburban office and industrial properties that have minimum remaining lease terms of 7 years for office and 10 years for industrial.  They focus on properties that are strategic to the tenant, so for example, a corporate headquarters in a sale leaseback, or properties where tenants have invested significant capex.  As an example, SIR bought Baxter’s headquarters in a sale leaseback toward the end of last year. 

 One obvious concern: if the folks at RMR did such a bad job at CWH, haven’t they done a bad job here too?  The good news is that triple net leases are pretty hard to screw up because they are very long term leases, and there is little operational involvement.  For Hawaii, I don’t think there is much debate that the assets are very valuable and they have enjoyed strong rent increases.  For the mainland properties, it is hard to know for sure the quality of the properties SIR has acquired.  The cap rates SIR has been paying have been roughly in-line with the market at ~8%, so it does not appear that RMR has been doing anything obviously wrong.  The lease expirations are well staggered, so if there were a problem, it would likely take many years to manifest itself.

External Management

As I mentioned, SIR is externally managed by RMR which gives it a taint because RMR is widely regarded as having misaligned incentives.   However, as a result of the fight over at CWH, SIR has implemented some meaningful changes to make it more shareholder-friendly in the last few months.  In December SIR adopted a new fee structure that started January 1, 2014.  It includes a base management fee tied to the lesser of historical property cost or SIR’s market cap plus debt.  Previously the fee was based on historical cost alone.  It also includes an incentive fee equal to 12% of the excess return vs the SNL REIT Index over a three-year period, paid in stock, and with 3-year vesting.   Previously the incentive payment was 15% of growth in FFO per share compared to the prior year.  RMR still gets a property management fee of 3.0% of rents.   RMR’s overall fees have been ~9% of NOI which is comparable to internally managed REITs, so RMR has not been fleecing SIR.

 The governance situation at SIR is similar to CWH, i.e. not great.  The executives of SIR are employees of RMR.  The CFO of SIR is also the CFO of CWH.  SIR has 5 trustees, Barry and Adam Portnoy (i.e. the owners of RMR), and three “Independent Trustees” who are also “independent” trustees of other RMR entities, Donna Fraiche (other RMR boards: FVE), William Lamkin (HPT, CWH) and Jeffrey Sommers (GOV, RIF, SNH).

 However, the governance situation is going to get slightly better.  The current SIR proxy has a proposal up for vote on May 2nd to de-stagger the board.  This amendment was approved and recommended by the board.  It requires 66% of the shareholders to approve it, but SIR thinks it will pass (they are supporting it after all, and CWH is 44% of the vote).  SIR currently has a staggered board with terms expiring for two trustees in 2014, for one in 2015, and for the final two in 2016.  If the vote passes, each director would be up for vote every year, but only after their current terms expire. 

 Hypothetically, if Zell wanted to replace the board today, it would take three years.  But, in the future, it should be possible to replace the entire board in a single year.  (Incidentally, I believe that one reason the activists went after CWH is that it was the only one of the six RMR entities that had a loophole allowing the entire board to be replaced at once.  CWH tried to close the loophole, but was unsuccessful.)  A remaining drawback for SIR’s governance is a bylaws provision that two of the five trustees have to be employees of RMR.   A majority of trustees always has to be “independent,” however.

 It is important to point out that although CWH owns 44% of SIR, it has no special representation rights (e.g. no board seat.) 

 I don’t want to minimize the challenges of replacing trustees.  The CWH example shows that RMR is willing to go to great lengths to set up procedural hurdles and to litigate in order to protect its trustees.  But, at the same time, the CWH example shows that it is possible.  And, SIR’s steps to de-stagger the board and appear more shareholder-friendly probably make it somewhat easier to replace the board at SIR. 

Valuation

SIR trades at 10.5x 2014 FFO/share and 10.0x 2015 vs the comparable group trades at 14x 2014 and 13x 2015.  I believe the discount is almost solely due to the RMR “taint.”  Moreover, SIR is less levered at 32% debt/capital vs peers at 47% (SIR’s debt/capital is 38% pro forma for the most recent acquisition in April).  The dividend yield is 6.5% vs peers at 5.5% despite a lower payout ratio at 79% vs peers at 90%.

SIR is relatively underfollowed with only 5 sell side analysts because it has a smallish float, and it is still a relatively new public company.  Management of SIR has indicated that they intend to increase leverage and the dividend payout ratio gradually overtime.

 I don’t think SIR’s valuation has reacted much, if at all, to the change of control at CWH.  SIR is up 13% YTD.  The REIT index is up 9%, and the triple net lease comp group is up 9%.  Also, while CWH’s shareholder list includes a lot savvy hedge funds, the shareholder list at SIR is much more plain vanilla.

Final Points

The obvious question is what is Zell’s team going to do with CWH’s SIR stake.  While I don’t know, they will certainly be asked these questions in the next few weeks and months as they take their seats at CWH, and that alone will be a partial catalyst for SIR.  I think it is pretty unlikely that they are going to dump the shares at the current price.  If I were Zell, I would publicly declare that I am dedicating a full time legal/strategy person to the task of replacing the board at SIR over three years, with a plan to internalize management in three years time.  I acknowledge the process would likely be arduous and costly because I assume RMR would throw up roadblocks like it did at CWH.  But, it is nevertheless worthwhile and a relatively easy way to create value for CWH shareholders.   Alternatively, I don’t think it would be crazy for CWH to offer to buy SIR in stock for stock deal. 

 Another question is whether RMR could screw SIR investors now that it surely knows SIR is in play.  I think the most obvious RMR countermeasure would be to raise a lot of equity at SIR in order to dilute CWH’s stake.  I don’t think RMR will do this because it would have to be done under the cover of statements that SIR has good acquisition opportunities.  But, management is on record saying exactly the opposite, i.e. that they are slowing the pace of property acquisitions because the pricing environment is too competitive.  Also, if SIR did undertake a big dilutive equity offering, I think the consequence would be to reduce the top end of upside case.  I don’t think it would necessarily destroy value from here. 

 Overall, I think SIR is a decent asset with a very cheap valuation and I think it is highly likely that Sam Zell and the new team at CWH are going to try to maximize the value of CWH’s stake.  I expect there should be some helpful commentary about their plans once the new board gets voted in at CWH next month, and I think SIR’s valuation could start to benefit.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time.