Some background might help to understand the motivations behind a proposal to merge the two real estate investment trusts.
Editor’s note: This is the second part of a two-part analysis of the proposed Pebblebrook-LaSalle merger. Part one examines the motivations of scale that are behind the plan.
The shared history of Pebblebrook Hotel Trust and LaSalle Hotel Properties offers some insights into a proposal on the table to merge the two real estate investment trusts, as well as the notion that scale creates value for investors.
LaSalle and Pebblebrook were both created by Jon Bortz. After a career in real estate at LaSalle Partners—now Jones Lang LaSalle—including the redevelopment of Washington’s Union Station, Bortz took over management of LaSalle Partners’ hotel investments on behalf of large institutional clients, largely pension funds. On 1 May 1998, some of those assets were contributed to a new public company upon the IPO of LaSalle Hotel Properties (LHO). Bortz served as LaSalle’s CEO until he retired on 13 September 2009. Mike Barnello took over as CEO of LaSalle in 2009, after serving as the company’s COO since its formation.
Bortz didn’t stay retired long. Within a month, an IPO prospectus for Pebblebrook was filed with the SEC, and Pebblebrook completed its IPO on 8 December 2009. It was led by Bortz as CEO and Ray Martz, a former VP of finance at LaSalle, as CFO. The companies had similar investment styles, preferring urban hotels, generally in coastal markets, and focusing largely on hotels that were not encumbered by long-term brand or management contracts.
Why scale can be good for investors
Scale doesn’t always create value, but under the right circumstances it can. Larger companies are often part of larger stock indexes, pushing more capital from index funds into larger capitalization stocks and raising market valuations.
In the case of Pebblebrook and LaSalle, dedicated real estate fund managers have to allocate capital between these two companies—and among all real estate stocks. But with one combined entity, investors who want exposure to those types of hotels and markets will have only one choice. All this tends to concentrate investment in larger companies with differentiated strategies, which tends to push up the valuation of those companies. And that improves large companies’ cost of capital and access to capital, giving them a competitive advantage in that they can grow their portfolios in a way that creates value for shareholders.
Cheaper, accessible capital creates a competitive advantage, allowing companies who have it to create value more easily. One proxy for the cost of capital is the implied cap rate of the company, basically the return investors in the stock are getting from the company’s net operating income.
I tend to look at net operating income after general and administrative expense, as companies are funding overhead out of NOI. If a company with an implied cap rate of 6.5% can buy an asset that yields 7.5%, the yield on its investment nets an excess 100 basis points of NOI on the incremental capital, all other things equal, and that excess return increases the return to all investors.
If two companies were attempting to purchase the same asset, the company with the lower cost of capital can get the same return while paying more—or a higher return for the same price—meaning it can succeed more often at buying high-return assets. While not quite as elusive as Holy Grail, this is what public companies are always attempting to do when they look to buy assets.
And when companies are undervalued by Wall Street, an inverse opportunity exists in which assets can be sold for a lower cap rate than that implied by the stock price. Pebblebrook demonstrated this strategy by unlocking the value of some of its assets by selling them over the last few years. It sold hotels, including its entire New York exposure—after unwinding its NYC joint venture—and a low-cash-flow parking garage in Boston, all at very low cap rates, essentially shrinking its balance sheet. This spread the remaining cash flow over a smaller asset base, but the cash flow declined proportionately less than the enterprise value, making the implied cap rate look even higher, and thus the stock price look even cheaper. In that way, Pebblebrook unlocked value that was not being captured in its stock price.
In my experience working with institutional investors over the last 30 years, I have found that what investors want most is a solid return on their investment with as little risk as possible. They take risk every day and want to be rewarded for that. That means investors want higher stock prices sooner with less chance that things go wrong. For real estate investors, a dividend is generally part of that calculus, but they will gladly trade off a lower yield for higher growth and the promise of a higher stock price.
Another issue on investors’ minds is the large number of hotel REITs, particularly those with similar business models. Investors would prefer to see fewer, larger hotel REITs, each with a differentiated strategy.
When a takeover offer comes along for a company that investors own, they want the highest price possible and the least execution risk. That translates to a general preference for a cash offer over an all-stock deal, because in a stock deal, the combined company has to perform well for value to be realized, while cash is worth its face value today. When assessing the risk of a stock deal, investors tend to focus on the business model, opportunities for synergies—in real estate, that usually means overhead savings but includes capital cost advantages and operating benefits—and on management’s track record for capital allocation and value creation.
Social issues—a nice way of saying who gets to run the combined company—often present barriers to otherwise logical business combinations. In Bortz’s second letter to LaSalle, he very politely referenced what might be conflicting interests of LaSalle’s management—that they would not be likely to remain at the combined company—when he wrote: “We recognize that aspects of our Proposal relating to management of the combined company create conflicts in your review process.” But ultimately, I believe the benefits of scale—in local hotel markets, with operators and in the capital markets—are the key drivers.
All these issues are likely to be on investors’ minds when evaluating the LaSalle/Pebblebrook transaction. And it is these issues that will likely be the focus of both company’s boards as they evaluate various alternatives.
After a 30-year career as a stock research analyst, David Loeb created Dirigo Consulting LLC, which advises on capital markets, strategy and communications issues. Clients have included REITS, brands, and private equity investors. He can be reached at firstname.lastname@example.org.
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