David Toti Comments: After Year Of Denials, Essex Justification For BRE Properties Deal Proves Elusive

December 23, 2013, SNL Financial

After Essex Property Trust Inc.’s CEO labored in a Dec. 19 conference call to explain the company’s proposed acquisition of BRE Properties Inc., skeptical analysts wondered whether the company is straying from its core strategy.

Mike Schall, Essex’s chief executive, has long and steadily maintained that Essex was wary of growing too large, and had no plans to make a bid for BRE Properties, its regional competitor. Those statements, which came as recently as a mid-November investor conference, made for an awkward pivot when Schall sought to argue during the call that bigger was, in fact, better.

Further complicating matters, he conceded, under persistent questioning, is that the deal is not accretive to NAV or growth rate and only mildly positive to FFO. Even so, he maintained that it is justified.

"Company size has both potential benefits and drawbacks," Schall said, citing greater efficiency in such areas as procurement and marketing, as well as a lower cost of capital stemming from a larger float and lower credit spreads on borrowing.

"The key question is whether the spread of acquisition yields over our cost of funds can increase by the same percentage as the share count, which expands 56% as a result of this transaction," he continued, adding that the company believes such an increase is achievable over time.

After one assurance that the benefits to the deal go beyond what Essex has underwritten, Andrew Rosivach, an analyst at Goldman Sachs, noted pointedly that the company has never emphasized the benefits of scale before. Schall countered that growth can be justified when it has the effect of removing a key competitor from the marketplace, adding, "We look at this transaction as a once-in-a-career type of opportunity."

David Toti, an analyst at Cantor Fitzgerald, said in an interview after the call that the deal is best viewed as a defensive move by Essex, in that it prevented another buyer from taking over BRE Properties’ assets.

"If you think about it, let’s say, hypothetically, a company is for sale, and you’re operating a business and that company is your biggest competitor in your market," Toti said. "Do you want another company to come in and take that competitor, and be bigger, or do you want to take it?"

Schall, he said, may have erred on the call in failing to characterize the deal as such a defensive gambit — particularly if BRE Properties, as its leadership maintained, has been exploring strategic options for more than a year. Otherwise, Toti said, "If it’s not NAV accretive, and it’s not FFO accretive — or barely FFO accretive — there’s clearly not a super-compelling return, at least in the short run."

Essex, he added, has traded at a premium to NAV in the past based partly on its strong markets, partly on its management team, and partly on its above-average returns, which were connected do management’s adherence to a specific strategy.

"That track record has earned the company a top-tier place in the REIT space in terms of investor favorites, and that’s why it’s always traded relatively rich," Toti said. "So the question here isn’t so much does the merger make sense, but does it make sense for Essex, in the context of why people have owned Essex in the past? The flipside to that argument is that everybody’s too obsessed with this small-and-nimble thing. Is it just a marketing device? Is the company really that much bigger, that it can’t move the needle? Not necessarily, but it’s the company that’s made the really big deal about staying small and nimble, not investors. You kind of have to believe what they say, and this is a reversal."

Still, Toti said, awkward explanations aside, many observers still like the deal — a reflection, in part, of the very real geographic overlap between the companies, and the potential for savings.

As of the close of trading on Dec. 19, both companies’ share prices were down, but not disastrously so in relation to other multifamily REITs.

"I think ultimately the messaging on the call was a bit off," Toti said, "and I think if they were just a bit more straightforward about the origins of this deal, I think everybody would be more pleased."