While bigger isn't always better, there are some cases where increased scale does confer real advantages. Both Realty Income (NYSE: O) and Kimco (NYSE: KIM) have recently inked deals to expand their portfolios via acquisition. And both should see material benefits from doing it. Here's why these two already large real estate investment trusts (REITs) are looking to get even bigger and why that's a good thing.
Net (lease) advantage
With around 6,600 properties, Realty Income was already one of the biggest players in the net lease space. Net lease REITs own properties, but their tenants are responsible for most of the ongoing costs of the assets. To some degree, with very low operating costs, Realty Income just sits back and collects rent. So the basic model is that the REIT makes the difference between its cost of capital and the rents it generates. And that's the important factor here.
So long as Realty Income can ink deals (be they portfolios or single properties) at a low cost, it can generate good returns. Its all-stock purchase of VEREIT (NYSE: VER) is expected to be 10% accretive to adjusted funds from operations (FFO) from day one as it expands the portfolio to more than 10,000 properties.
But there's a longer-term benefit here as well. For example, Realty Income has a better credit rating, so as VEREIT's debts roll over, the REIT will be able to reduce its interest costs. And, with a combined portfolio of more than 10,000 properties, Realty Income will have an unmatched scale in the net lease space, giving it the capacity to take on deals that peers couldn't even begin to consider.
On the cost side, although net lease costs are already low, Realty Income will be able to both reduce costs by eliminating redundant jobs and by spreading its costs over more properties.
That said, this isn't simply getting bigger for the sake of, well, getting bigger. Another benefit of this deal is that Realty Income will be spinning off an office REIT after the deal is consummated. Alone, it didn't really have enough office properties to do that, but with VEREIT's portfolio, it will. Net lease office space is generally more expensive to manage than other types, so Realty Income will be slimming down to areas (retail and industrial) likely to provide the best returns. So, in this case, bigger is also better because it affords Realty Income more flexibility to make adjustments to its portfolio. Execution will be key, but given the relatively simple business model here, Realty Income's deal to buy VEREIT looks like a winner.
More levers for growth
Kimco's deal to buy competitor Weingarten Realty (NYSE: WRI) has some of the same benefits, but they are slightly different. For example, managing a multi-tenant shopping center is a lot of work, so the synergies from economies of scale and the reduction of redundant corporate costs are even more important here. And the increased size of the portfolio, which will go from around 400 centers to more than 550, is probably less important than the diversity the deal provides within the portfolio.
Indeed, one of the core reasons for Kimco inking this deal is to increase its presence in higher-growth Sun Belt markets. So it isn't just more properties -- it's more properties in the right locations. That adds an additional avenue for one-off acquisitions and the higher rent growth that will come from operating the new properties over time.
On top of this are the redevelopment projects that both companies have. So this deal is a growth driver in many different ways, but location, location, location is the key.
It will be important to make sure that Kimco doesn't cut costs to the point where its business suffers, given the more active nature of operating strip malls. So execution risk is probably more notable here. But the deal will help to improve Kimco's balance sheet from day one because Weingarten's leverage metrics are better than Kimco's. So, in some ways, Kimco will be a safer investment after the deal than it was before it.
The bottom line
The real key to both of these deals is that they aren't about getting bigger for the sake of size. There are real advantages that will come from the increased scope afforded to each of these companies. Not all deals work out, so execution is vital, but it looks like the deals these REITs have inked will be winners for both the companies and their shareholders as they gain scale, increase diversification, and allow for strategic cost advantages. If you own Realty Income or Kimco, there's a reason to be upbeat today.