The big trend for restaurant companies recently is unlocking real estate value.
Darden Restaurants (NYSE: DRI) is the latest company to cave to the demands of activist investors, with the company looking to spin some of its real estate off into a real estate investment trust (REIT). The allure of this strategy is that it creates a more tax-efficient structure, since REITs don’t pay corporate-level taxes.
The Darden REIT move comes after activist investor Starboard Value effectively overthrew the Darden board of directors in 2014. And it’s a strategy that’s becoming common among activist investors. Don’t forget that Bob Evans (NYSE: BOBE), which has been facing pressure from Sandell Asset Management, is now exploring a REIT and potential sale-leaseback deal.
The big reason for a REIT formation is that there is an inherent dichotomy between the value of restaurant operations and the value of real estate. Thus, forming a REIT helps the market valuations become more in line.
Then there’s the fact that real estate valuations have rebounded nicely from their financial crisis lows. In 2013 and 2014 there were close to 10 activist campaigns to get a company to monetize its real estate. That’s well above the one campaign in each year from 2010 to 2012.
However, it’s not all peaches and cream. Many of these new REITs have their own disadvantages, especially when compared to larger, more established REITs.
The problem in Darden’s case is that its REIT will be composed of only Olive Garden restaurants. So the only customer for the REIT will be a restaurant that has seen declining traffic and revenue numbers. And being a single-tenant REIT, it may also trade at a discount to other REITs.
As far as Bob Evans goes, it’s not all bad news there. The big thesis at Bob Evans isn’t the REIT, but the fact that it might finally consider a spinoff of its BEF Foods division, something that Sandell Asset Management has been advocating for a number of years.
The worrisome thing about the restaurant REIT strategy is that it’s simply a Band-Aid. This is especially true if the company fails to address the issues of declining traffic and sales.
But the one company still on the block that could do a major REIT deal is McDonald’s (NYSE: MCD).
Will McDonald’s eventually explore a REIT? It is possible, but activist investor Pershing Square tried to pressure the company into such a move more than a decade ago. McDonald’s held its ground, and over the last 10 years its stock has outperformed the S&P 500 by more than threefold.
And while Darden is offering a solid 3.1% dividend yield, there are much better dividend plays. The McDonald’s dividend currently yields 3.5%, and the company has upped its annual dividend payment for 38 straight years.
Granted, the fast-food giant has fallen on hard times of late, but it’s working on righting the ship. This includes a vast turnaround initiative to refranchise upward of 3,500 stores in just over three years, which could help save $300 million in costs. A big part of this is transitioning toward a more franchise-friendly model in China, which remains a key growth market.
If you’re going to do a REIT spinoff, now is the time. Today’s market is affording REITs record multiples. But that might not be a recipe for long-term value creation. In many cases, it locks the tenant into long-term lease expenses that they would otherwise be able to avoid. It also forces restaurants to hold on to underperforming restaurants because of long-term lease contracts.
Ultimately, it’s restaurant specific as to whether a REIT formation will be a net positive or net negative. For Darden, I question the positivity. Rather, look for companies like McDonald’s that are doing more than just financial engineering to create shareholder value.
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