Eliminating the RMR Discount

The five publicly-traded REITs that are managed by the RMR Group, Inc. (RMR), a Newton, Mass.-based property manager, have often traded at significant discounts to their peers. The discount has been attributed to the nature of the relationship between RMR and the REITs. RMR is an external REIT manager, which some claim raises potential conflicts of interest because the external manager can benefit at the expense of the managed REIT. For that reason, many analysts and investors prefer REITs that are internally managed, which they say better aligns the interests of management and shareholders.

This issue was brought to the fore in 2013 when two hedge funds, Corvex Management and Related Fund Management, acquired a combined 9.8% stake in the RMR-managed Commonwealth REIT, and offered to buy the remaining shares at a premium. RMR and its controlling shareholders, Adam and Barry Portnoy, mounted an aggressive defense to prevent the sale. Ultimately, the battle was resolved by a proxy vote in which RMR lost its management contract to a group led by Sam Zell in 2014.

As part of its attempt to appease the hedge funds, RMR proposed changes in its fee arrangement with Commonwealth, which were summarily rejected. It did, however, adopt those and other changes in its contracts with the remaining managed REITs. The changes included adding a provision to its REIT management fee whereby the fee would be equal to the lower of 0.5% of assets under management or 0.7% of the REITs market capitalization (including equity, preferred stock and debt) up to $250 million and 0.5% of market capitalization over $250 million. Previously, the management fee was based solely upon assets under management.

At the same time, RMR instituted an incentive management fee through which it would earn a percentage of the excess of a managed REIT’s total shareholder return over the return on its corresponding benchmark index. Under that arrangement, RMR has collected $426.4 million in incentive business management fees since 2016, including $155.9 million in 2018 and $120.0 million in 2019.

RMR Group, Inc. RMR is a holding company whose business is conducted substantially through its primary subsidiary, RMR Group, LLC (RMR LLC). RMR owns 52% of RMR LLC. The remaining 48% is owned by ABP Trust. Adam Portnoy, who is President and CEO of RMR, is the sole trustee of ABP Trust and owns a majority of its voting securities. (His father, Barry Portnoy, who was the founder of RMR, died in February 2018.)

ABP Trust owns a 51.5% economic interest in RMR’s common equity and has 92% effective voting control. It owns 90,564 of RMR’s Class A shares and 1.0 million of RMR’s 10-for-1 “supervoting” Class B-1 shares (which are convertible one-for-one into Class A shares). The Trust’s 15.0 million RMR LLC shares (which are paired with 15.0 million of RMR’s Class B-2 shares) are likewise convertible one-for-one into Class A shares). As of January 16, 2019, there were 15,229,687 Class A shares outstanding.

RMR, which was originally known as REIT Management & Research, currently manages four publicly-traded equity REITs and three managed operators (i.e. companies that operate properties owned by the REITs).

The four publicly-traded equity REITs are:

  1. Service Properties Trust (SVC), which until September 23, 2019 was known as Hospitality Properties Trust;
  2. Industrial Logistics Properties Trust (ILPT), which was formed in September 2017 when it received 226 industrial and logistics properties from Select Income REIT (also an RMR REIT). ILPT completed its IPO in January 2018;
  3. Office Properties Income Trust (OPI), formerly known as Government Properties Income Trust. In December 2018, a subsidiary of OPI merged with (the remaining properties held by) Select Income REIT; and
  4. Senior Housing Properties Trust (SNH), which manages senior living communities, medical office building and life sciences properties.

The three managed operators are:

  1. Sonesta International Hotels Corporation, now privately owned, which manages and franchises hotels, resorts and cruise ships, including hotels owned in the U.S. by SVC;
  2. TravelCenters of Americal LLC (TA), a publicly-traded operator, lessor and franchisor of a national chain of full service travel centers, many of which are owned by SVC; and
  3. Five Star Senior Living (FVE), a publicly-traded operator of senior living communities (independent living, assisted living and continuing care), most of which are owned by SNH.

Tremont Advisors, a wholly-owned subsidiary of RMR and an SEC-registered investment adviser, manages the Tremont Mortgage Trust (TRMT). RMR Advisors LLC, also a wholly-owned subsidiary of RMR and an SEC registered investment advisor, provides investment advisory services to the RMR Real Estate Income Fund (RIF), a publicly-traded, closed-end investment company.

In 2018, RMR LLC and ABP Trust created the RMR Office Property Fund L.P. (OPF), a private open-end real estate fund. ABP Trust contributed 15 office properties valued at $206 million and RMR agreed to contribute $100 million to the fund. The two are limited partners of the fund, while a wholly-owned subsidiary of ABP Trust is the general partner. RMR provides OPF with administrative and property management services. OPF will focus on acquiring middle market multi-tenant urban infill and suburban office properties located in non-gateway cities across the U.S. It defines middle market properties as those with more than 50,000 square feet valued at less than $100 million. According to a 2018 article by Globe St., the fund has targeted $500 million of invested assets with expected leverage of 40%. The fund reportedly will offer limited partnership interests with targeted returns of 8% to 10% to private investors.

With 600 real estate professionals in more than 30 offices throughout the U.S., RMR has a nationwide capability to acquire and manage real estate of various types, including hotel, office, industrial, warehouse, retail, senior living and medical office properties. The managed REITs have no employees. RMR provides the personnel (typically the senior executives, including the CEO, COO and CFO) and services necessary for the managed REITs to operate. RMR’s asset and property management services are handled locally through the offices and most offices handle the full range of property types. Real estate portfolios are also managed functionally by specialist teams (e.g. industrial, office and retail).

The capabilities of the organization are therefore arguably more important than the senior executives appointed by RMR to each of the managed REITs. It is now typical for senior executives to have multiple responsibilities within RMR. For example, David Blackman, EVP, who is responsible for all office and industrial properties at RMR, also serves as President and CEO of OPI and TRMT. John Murray, EVP, who is responsible for all hotel and travel center properties and for all of RMR’s development, construction and design activities, also serves as President and CEO of SVC and ILPT. Jennifer Francis, SVP, who was recently appointed President and COO of SNH, is also responsible for asset management and leasing at all RMR managed properties.

Attempts to Address Conflicts of Interest. Since RMR serves as external manager of each of the managed REITs, its interests are perceived by many investors to be not in alignment with those of the managed REITs. RMR has tried to temper the potential conflicts in a couple of ways: At the end of 2013, it instituted the incentive business management fee which as already noted was based upon the relative total return performance of the individual shares of the managed REITs vs. certain benchmark indices. Thus, RMR would earn more when shareholders of the managed REITs received higher relative total returns.

Then, in conjunction with the IPO of RMR Group in 2016, the managed REITs received significant equity stakes in RMR, roughly half of which they distributed to their own shareholders. The remaining shares that they held were equivalent to 52.2% of the outstanding Class A shares or a 25.2% economic interest (assuming the conversion of all ABP Trust-held shares into Class A common). RMR asserted that this cross ownership aligns the interests of RMR with the managed REITs.

Revising the Incentive Management Fee. As noted, the incentive fee arrangement resulted in payments totaling $426.4 million from 2016 to early 2019 from the managed REITs to RMR. In July 2019, the managed REITs raised $297 million of through a secondary public offering of their RMR shares. One could argue that had the managed REITs not been required to pay the incentive management fees, they might not have had to sell their RMR shares. By selling those equity stakes, the cross ownership between RMR and the managed REITs has been eliminated and with it, so has the key argument supporting the assertion that the interests between RMR and the managed REITs are aligned.

I have other concerns about the incentive management fee, which remains in place. First of all, to my knowledge, the managed REITs do not disclose the actual calculations in each year that the fee has been assessed. Since the fee is based upon benchmark indices that are not readily available to an average investor (e.g. the SNL U.S. Healthcare REIT Index), the managed REITs should provide this disclosure preferably in the notes to their financial statements or at least in their quarterly financial supplements.

Second, it is questionable at best whether the incentive management fee is in the best interests of RMR and the managed REIT shareholders. In the forward looking statement admonitions to its financial statements, RMR warns with respect to the incentive business management fees that it has “only limited control over the total returns realized by shareholders of the management equity REITs and effectively no control over indexed total returns.” If that is the case, why should RMR receive this fee and what do managed REIT shareholders get in exchange for paying it? Does it enhance the managed REITs’ long-term total return performance?

In fact, the incentive management fee has not worked well for managed REIT shareholders. For example, since the incentive fee was revised in 2013, SNH has paid $96.4 million (in 2017 and 2018) to RMR. However, the total return on SNH’s shares was negative 35% (-7.2% per annum) from the end of 2013 to October 3, 2019. By comparison, the S&P 500 has gained 59% (8.5% p.a.) and the Dow Jones U.S. REIT Index has gained 50% (7.3% p.a.). In December 2015, SNH shareholders did receive about one share of RMR for every 100 shares of SNH that they held in June 2015; but the distribution was not large enough to offset the weak performance of their SNH shares.

More importantly, the current incentive management fee formula does not address problems that are impacting the long-term health of the managed REITs. In SNH’s case, new construction has resulted in industry overcapacity that has put downward pressure on occupancy rates. The incentive fee formula should therefore promote initiatives by RMR that will improve the competitiveness of SNH’s properties, such as property upgrades, and raising tenant satisfaction. It might also reward RMR for achieving targets for key performance metrics, such as occupancy, average room rates and operating costs, and other objectives.

Properly designed, the incentive management fee formula (as well as the formula for the base fee) should provide steadier (and thus less volatile) income to RMR, as long as RMR is meeting its responsibilities. In theory, it should not reward RMR for better stock price performance that is not attributable to improved financial and operating performance; but it also should not penalize RMR for share price declines that are likewise not operating and financial performance-related.

The process of changing the incentive fee formula could begin by including a proposal for a shareholder vote at the upcoming 2020 annual meeting. The proposal would call upon the Trustees to revise the incentive management fee formula (and perhaps the formula for the base and property management fees, as well) by incorporating other metrics that would promote improved long-term operating and financial performance.

Converting RMR from an External to an Internal REIT Manager. A rewrite of the incentive fee formula could be avoided by RMR’s conversion to an internal REIT manager. Though simple in concept, however, this alternative might be tricky to implement. Shareholders of each of the managed REITs would swap their shares for RMR Group stock. RMR would then convert to a REIT. With the conversion, RMR would become an internally managed diversified REIT and the management contracts between RMR and the REITs would be eliminated.

The combination of RMR and the managed REITs (which I will refer to as the “RMR REIT Group” or “the Group” from here on) would result in tangible financial benefits. The combined managed REITs would get RMR’s $200 million or so in annual operating income. Since RMR would become a tax-exempt entity, it would also save most, if not all, of its annual income tax expense, which amounted to $29 million in 2018. In addition, RMR REIT Group would eliminate the public company costs associated with the five managed REITs and would likely realize additional cost savings by reducing or eliminating the organization and legal barriers that currently separate the five REITs.

On a combined basis, I estimate that the RMR REIT Group generated normalized funds from operations (FFO) of $1.56 billion in 2018. This will of course change in 2019 as a result of several factors, such as current year operating performance and specific developments at each of the managed REITs, including the reduction in rental income granted by SNH to its primary tenant, Five Star; the recent $2.4 billion acquisition by SVC of properties owned by Spirit MTA REIT; and other asset sales and purchases.

I also estimate that RMR and the managed REITs have a current combined equity market capitalization of $10.6 billion (including the Class B-1 and B-2 shares or RMR). Thus, the RMR REIT Group is valued at an implied 2018 normalized FFO multiple of 6.8 times. By comparison, the average 2018 adjusted FFO multiple of 15 diversified REITs is 15.6 times, suggesting that there may be considerable upside from closing the “RMR discount.”

To be sure, not all of the valuation gap may be due to the RMR discount. A couple of the managed REITs – SNH and OPI – face significant challenges in their businesses and are operating with relatively high debt levels. RMR is working to address these issues; but until it demonstrates meaningful progress on its objectives, some discount versus the peer group average will likely persist. Nevertheless, there still appears to be significant upside in such a conversion.

Yet, implementation of the conversion would also require the following:

  1. Adam Portnoy and ABP Trust would have to agree to a reduction in their 51.5% economic interest in RMR. According to my estimates, the current equity market value of their holdings are equivalent to about 7.9% of the combined total equity market capitalization of RMR and the managed REITs. Similarly, Mr. Portnoy and ABP Trust would almost certainly have to reduce their voting control of RMR from 92%. Institutional shareholders would likely press them to eliminate the super voting interest on the Class B-1 shares.
  2. Despite the lower economic interest, my estimates suggest that under the current combined dividend payouts of RMR and the manage REITs, ABP Trust would still receive about the same annual distribution – $62 million – with a 7.9% economic interest in RMR REIT Group that it received in 2018 from RMR, Inc., RMR LLC and its holdings of equity interests in the managed REITs.
  3. RMR would have to obtain a very high participation rate from the shareholders of each of the managed REITs in order to complete the consolidation. Under most state laws, RMR would need to get the participation of at least 90% of outstanding shares in order to complete a merger. A 2013 exception to Delaware law allows a short-form merger under certain conditions if the acquirer obtains more than 50% of the outstanding shares through a tender offer, but RMR and its managed REITs are governed by Maryland law.
  4. Managed REIT shareholders would have to be willing to swap their shares of sector-specific REITs for a broadly diversified REIT. They would also have to agree that the shares of RMR that they receive in the swap represent fair value for their REIT shares.
  5. RMR could conceivably accept less than 90% of each of the managed REITs and allow them to remain as separate entities, with publicly-traded minority shareholder interests. On the positive side, this might make it easier to value the consolidated diversified REIT. However, it would also require that RMR continue to incur the cost of maintaining five publicly-traded entities. RMR would also not get the substantially greater financial flexibility that would come from merging all of the managed REITs.
  6. RMR should be able to continue to operate the managed operators – Five Star Senior Living, TravelCenters of America and Sonesta International Hotels Corporation – without running afoul of the REIT rules. In a consolidation, it would own 8.5% of TravelCenters, 38% of Five Star and an unknown portion of Sonesta. At the sale time, the revenues that the managed operators generate for RMR would be less than 1% of the RMR REIT Group.
  7. The creation of the RMR REIT Group would require a revamping of the managed REITs’ bank credit agreements, probably consolidating them into a single larger credit agreement. On the other hand, I believe that it would not require the consent of the managed REITs’ bondholders. All of the senior unsecured note issues – at least, those that I have reviewed – have minimal covenants and none has a change of control provision. Even though they probably do not have a say, bondholders should welcome the merger because it would improve the Group’s financial flexibility and provide a greater asset pool to support their claims.

If the obstacles can be overcome, there would be significant potential benefits from a merger of RMR with its managed REITs.

  1. The RMR REIT Group would likely have an equity market capitalization in excess of $10 billion, which would be more attractive to institutional investors.
  2. The additional $200 million in operating income would provide better coverage for the Group’s interest expense and better support for the dividend.
  3. The elmination of RMR’s management contracts and the associated fees would simplify the analysis. Some might argue that this simplification would be offset to some extent by the greater diversity of the Group’s property portfolio, but I believe that this is a good tradeoff for investors and one that could lead to a higher valuation for the Group over time.
  4. The additional $200 million of support for the Group’s outstanding debt combind with the improved financial flexibility should almost certainly result in improved ratings from the credit rating agencies (or at the very least, make future downgrades less likely). Improved credit ratings should help the Group reduce its debt costs (or keep them low).
  5. If investors do not push for a merger, they must still act to change the incentive management fee formula, since RMR’s claim that its interests are aligned with the managed REITs has now been effectively voided by the REITs’ sale of their RMR shares earlier this year. Failure to do so could allow this “misalignment” of interests to persist, which could widen the RMR discount over time. Furthermore, by retaining the incentive management fee formula as presently constituted, the REITs could face significant payouts in the future that are unrelated to improvements in their financial performance or competitive positions. This could drain their financial resources at an inopportune time, just as the incentive management fee payouts did in 2017 and 2018.

October 20, 2019 (from a report initially published on October 9, 2019).

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246
admin@larkresearch.com

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