Activist Hedge Funds: Spun-Off Real Estate Isn’t Necessarily Gold

As activists urge more companies to follow Darden’s lead and sell their properties, someone should consider the value of the tenants.

Olive Garden and Red Lobster Locations Ahead of Darden Restaurants Inc. Earning Figures

Darden Restaurants Inc. Olive Garden signage is displayed outside of a location in Clarksville, Indiana, U.S., on Monday, June 22, 2015. Darden Restaurants Inc. is scheduled to release earnings figures on June 23. Photographer: Luke Sharrett/Bloomberg

Luke Sharett/Bloomberg

Darden Restaurants has been looking all the more appetizing to investors since Jeffrey Smith, CEO of the New York–based activist hedge fund firm Starboard Value, scored a big win last fall in his proxy battle with the Orlando, Florida–headquartered purveyor of chain restaurants such as LongHorn Steakhouse and the Olive Garden. Smith replaced all 12 of the company’s directors with his own slate and pushed the company into a major overhaul. Among Starboard’s primary demands — besides quipping about Olive Garden’s unsalted pasta water and unlimited breadsticks — was that Darden spin off the real estate that houses its restaurants.

It’s easy to see why investors believe there is hidden value in buildings and land. Interest rates remain low, as do capitalization rates, and real estate has bounced back in many markets — in some cases to historic highs. According to a report from investment bank Houlihan Lokey that ran in Activist Insight’s Activist Investing Annual Review 2015, activists’ push for companies to spin off real estate gained ground last year. More often than not, Houlihan Lokey found, the answer from target companies has been no. In fact, Darden was the first such campaign to make any headway.

Smith is now urging Macy’s to spin off its real estate, as he announced at Institutional Investor’s and CNBC’s annual Delivering Alpha conference last month. Thomas Sandell, CEO of hedge fund firm Sandell Asset Management in New York, is pressing home furnishings retailer Ethan Allen Interiors to unlock real estate assets that he believes the market is ignoring. Last year Sandell campaigned for a real estate spin-off at restaurant chain and food retailer Bob Evans Farms, an idea that began after the hedge fund firm received a number of unsolicited calls from real estate investment trusts (REITs) and private equity firms looking for access to new properties, according to people familiar with the fund. Larry Robbins, CEO of hedge fund firm Glenview Capital Management, wants fast-food giant McDonald’s to do the same.

There are a number of reasons executives have resisted the idea of turning real estate assets into separate companies that are in the business of, well, real estate. Houlihan Lokey reports that they’re often concerned with high transaction costs or with the lease expense in comparison to their cost of debt. They also contend that owning corporate real estate provides a certain amount of operating flexibility when the market for their core business is in decline.

Here’s another thing about real estate: Values can fluctuate according to use. Take Darden, which is selling leasebacks on 75 sites and creating a new real estate company that will hold 430 sites in a REIT and lease the properties back to the restaurant company. Although the real estate company can acquire additional properties that aren’t part of Darden, the value of the REIT will — at least for the next year or so — be heavily dependent on the value of Darden itself. Particularly at the beginning, a REIT spin-off is going to add value to a company only if the value is already there. Later, as the company acquires new properties, it becomes more of a real estate proposition, subject to all the vagaries of that market.

Activists, according to people familiar with the strategy, often take the position that a company’s management might be forced to pay more attention to operational efficiency when they have to pay rent. That will certainly be the case for Darden now, especially if the REIT market should happen to slip.

That’s why David Palmer, an analyst with RBC Capital Markets in New York, has called the Darden spin-off “a little bit of an experiment that everyone is watching.”

Darden, for its part, has started to turn around. Jeffrey Bernstein, an analyst with Barclays Capital in New York, said in a June 23 research report on the company that he has revised his share price target upward, to $80 (it was trading in the low to mid-70s as of early August, an all-time high). But whereas Bernstein likes the REIT, he doesn’t separate it from the rest of the package. “Industry fundamentals are improving, providing a favorable backdrop,” he wrote. “And specific to Darden, comps are once again outpacing the industry, cost-saving opportunities are large, and real estate monetization is being implemented.”

Palmer believes that if the REIT deal works well for Darden, it will be great for McDonald’s — but only if the colossus can improve its sales. “McDonald’s owns 55 percent of the land and the vast majority of buildings for its U.S. system,” says Palmer. But he calls sales trends “its most important value-creating lever.” According to McDonald’s most recent earnings statement, the company’s profits dropped 13 percent in the second quarter of 2015, and revenue dropped 10 percent, in part because of the strength of the U.S. dollar but also because younger customers are fleeing to fast-casual chains such as Chipotle Mexican Grill, which McDonald’s divested in late 2006, and Shake Shack, where the food is ostensibly of better quality.

Says Palmer: “The creation of a McDonald’s REIT would be far less popular among investors and franchisees, and perhaps less likely if the sales trends have not turned.”

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