Some REITs are repurchasing stock, but not all analysts agree with the move.

By Allen Kenney

Faced with a down market earlier this year, REITs began authorizing billions of dollars' worth of stock repurchases from shareholders. Approximately 50 REITs, including high-profile companies such as Simon Property Group (NYSE: SPG) had authorized buybacks by the end of August, according to REIT analysts at BMO Capital Markets who have been tracking this year's repurchase activity. Firms announced north of $1 billion in authorized incremental repurchases during the latter half of 2007's second quarter alone. At the end of August, outstanding buyback authorizations stood at 2.2 percent of REIT equity market capitalization.

Repurchase programs aren't just a passing fad, according to BMO analyst Paul Adornato. "So long as the economics of buybacks work, we will likely continue to see buyback activity," Adornato says. "The correction in REIT stock prices has created an opportunity for many REITs to repurchase their stock so that it is accretive to earnings."

However, even though shareholders have generally reacted favorably to such programs, it's not certain that buybacks are a wise move for every REIT navigating the ebbs and flows of the market.

Why Buy Back?

When a REIT authorizes a buyback program, the board of directors essentially gives management permission to buy the company's own stock back from the public. Basically, the company is granting license to invest in itself. Normally, such programs are limited to a specific amount of money and must be completed within a set timeframe. Whether the firm wants to use all of the money authorized for repurchases is up to that company, and many decline to actually use the entire authorized amount.

Adornato views buybacks in terms of capital structure efficiency. "All else being equal, the same gross amount of funds from operations (FFO) divided by fewer shares outstanding results in higher FFO per share."

Conventional wisdom is that REITs typically institute buybacks when they think that their assets have been undervalued on the open market, meaning that the current price of the stock falls short of the company's intrinsic value. Adornato says that the companies that stand to benefit the most from buybacks are those with stocks trading far below their estimated net asset value (NAV). For example, if a company thinks its NAV is $50 per share, then a price of $40 per share on the open market would mean that stock is available to the company at a 20 percent discount.

For Mike Kirby, director of research at Green Street Advisors, the current discrepancy between REITs' overall NAV and their share prices means that the buyback activity level this year has actually been "disappointingly low." In a September 2007 report, Kirby encouraged REIT managers to explore the "lucrative opportunities" available through buybacks, noting that the REIT market as a whole had been trading at an average discount of 15 percent in the prior three months.

"While it is frustrating for management teams hoping to implement growth strategies in an environment like this, there is a silver lining amidst the dark clouds: share buybacks, especially those funded with property sales, represent one of the most compelling investment alternatives a real estate company could ever hope to have," Kirby says.

Simon Property has made this case since revealing its repurchase plans in July. Simon Property's managers have authorized buybacks of up to $1 billion during the next two years. At the time of the announcement, analysts had pegged Simon's NAV as being somewhere between $100 and $130 per share, while shares were actually trading in the mid-$80 range. "It was a compelling proposition to buy back our own stock," says Les Morris, manager, corporate public relations for Simon Property. "In that sense you're buying back your own portfolio, and that would be a pretty good portfolio."

Credit Suisse analyst John Stewart upgraded his rating of Simon Property from "neutral" to "outperform" on the heels of the buyback announcement. At the time, Stewart pointed out that Simon Property was trading at a 21 percent discount on his estimation of the company's NAV. Stewart also projected that $200 million in repurchases, one-fifth of the amount authorized by Simon Property, could boost the company's earnings per share (EPS) by three cents.

A Strong Signal

A related benefit for repurchasers is that buybacks tend to drive up the company's stock price even beyond the effect of reducing the number of shows. Various studies by both academics and market analysts have found that markets generally react favorably to the announcement of a buyback program. Why that is the case appears to result from the perceived information gap between investors and company insiders.

A 2006 study devoted strictly to REITs by James Brau and Andrew Holmes of Brigham Young University found strong support for the "managerial signaling hypothesis"—the theory that a stock repurchase program informs outside investors that insiders believe their company is undervalued or ready to kick its performance up a notch. The signaling hypothesis posits that investors act on this information, driving up market demand and the price of the stock.

"Management wants to pass a strong message to the stock market: 'You misunderstand our story, and we will show you that we have enough confidence and conviction to buy our shares if you won't,'" RBC Capital Markets analyst Rich Moore wrote recently in a commentary on the buyback phenomenon.

Brau and Holmes' study looked at the nearly 200 stock repurchases made by individual REITs between 1982 and 1999, most of which occurred during the bubble in tech stocks of the late 1990s. Brau and Holmes concluded that, on average, REIT stock returns showed clear signs of underperformance prior to announcing a buyback. For instance, returns fell by 16 percent on average in the six months before the announcement, and the stock price was down 4 percent in the four weeks prior to initiating the buyback program. Also, the companies had an average market-to-book equity ratio of 1.9.

In the 21-day window surrounding a buyback announcement, which included the 10 days prior and 10 days following, the stock price surged an average of more than 2 percent by the end of the period, according to the analysis.

"With the impact of other potential theories mitigated, the empirical tests clearly demonstrate that managerial signaling is a significant determinant of the stock price reaction to an open market share repurchase announcement," Brau and Holmes concluded.

Moore, however, asserts that the signaling effect has grown "less potent" over time from misuse. "Management teams often institute buybacks as a means to prop up a weak story or simply put in place buyback programs where few if any purchases are ever made," he says. "Companies who need to draw attention to changes, however, may derive some benefit."

A Wise Move?

Investors may clamor for a company following a buyback announcement, but that doesn't make repurchase programs a great idea for companies who are only looking for a quick bump in their stock price or other key valuation measures. In a 2005 analysis of stock repurchases, McKinsey and Company analysts Richard Dobbs and Werner Rehm argued that managers who use buybacks for purposes like inflating EPS are asking for trouble.

"Generally, markets have applauded such moves, making buybacks an alluring substitute if improvements in operational performance are elusive. Yet while the increases in EPS that many buybacks deliver help managers hit EPS-based compensation targets, boosting EPS in this way doesn't signify an increase in underlying performance or value," they wrote.

Such concerns should raise another issue for REITs considering a buyback: the impact of buybacks on their capitalization structure. If a firm chooses to finance stock repurchases by borrowing, it has increased its debt. If that firm chooses, instead, to use its available cash, it has less money on hand to finance its activities, including servicing its debt. Either way, the company has added risk.

"A buyback could be detrimental if it does not create a better capital structure," Adornato says. "This can occur if by repurchasing stock, the company's leverage becomes too high as a result of decreasing the outstanding equity base."

Jan Svec, a director at Fitch Ratings who covers REITs, expresses similar concerns.

"We view buybacks cautiously, as they typically result in reduced financial flexibility from increased debt and/or a reduction in cash on hand to service debt. This reduction in flexibility and smaller equity base provides less room for error during more difficult operating environments," she notes.

Duke Realty Corporation Chief Financial Officer Matt Cohoat agrees that REITs should look at the mid- to long-term effects of a buyback on capital structure and how that might impact future operations. Duke Realty has had a buyback authorization in place since 2005, and Cohoat says the company took great pains to make sure that the program wouldn't necessitate an immediate re-issuance of stock. Cohoat notes that REIT managers must ask themselves an important question before instituting a repurchase: "Do we think we can fund our business without this capital?"

The current market climate should give REITs evermore pause when considering more leverage, according to Moore. He points out that higher borrowing costs and tougher lending could make it difficult for leveraged REITs to make acquisitions. Consequently, REITs with less risk would be in a better position to take advantage of discounts in the market as struggling companies face the prospect of selling off assets.

A Healthier Alternative?

Besides the impact on capital structure, buybacks might not be the best move for companies if more lucrative opportunities are available elsewhere. For example, what if investing in development opportunities would likely provide better returns for the company? Similarly, acquisitions could present a better use of the cash.

"The key is for the company to determine that repurchasing its stock is the best investment for the company, considering all the other alternatives available, such as property acquisitions, development of new properties or other investments," Adornato says. "This, of course, is a more difficult determination to make."

When Duke Realty instituted its buyback program, Cohoat explains, the company was flush with $1 billion in cash following an asset sale, while also emerging from a difficult market situation. Repurchases made sense then, according to Cohoat, because the company lacked attractive acquisition targets and faced no imminent need to put the money into developing other projects.

"We had some good development opportunities, but we weren't sure how much development opportunity was in front of us," Cohoat recalls.

However, Duke Realty tabled its repurchase program in late 2006 when the company decided to go into "expansion mode," Cohoat says. Bucking the recent trend, Cohoat says the company has no current plans to rejuvenate it's buyback activity.

"The general expansion of our business now requires additional capital, rather than taking capital off the table," he says.

Mixed Opinions

In the end, there doesn't seem to be much consensus about the effect of buybacks. One thing is certain, though: experts agree that REITs should tread cautiously when considering a repurchase program. Moore, for instance, would rather see REITs limit their use of repurchases to only the most special of circumstances.

"We believe that management should worry about running its business and let investors set the share price according to the company's performance and investor asset allocation decisions," Moore says. "We encourage REIT management teams to avoid the temptation to buy back shares unless a very compelling reason can be identified. Good companies that continue to execute on well identified strategies gain nothing, in our opinion, from a stock buyback."

Adornato, however, offers a few simple guidelines for REITs to consider. "Other than avoiding excessive market volatility from repurchase activity, a company should be sure that a stock buyback is accretive to earnings, is the best investment alternative, and does not limit financial flexibility."