REITs, pubcos, and the tortoise and the hare

In the coming weeks and months we should watch carefully the announcements that pubcos make on whether to convert into a real estate investment trust (REIT) or not. These decisions will demonstrate whether the race to deliver shareholder value is currently being led by the short term hare or the long term tortoise.

We've already had Mitchells & Butlers' joint venture announcement regarding its property portfolio.

What, you might say, has this got to do with the average licensee or customer at the bar? Is this not another City game?

Over the last 20 years most pubs have changed from being the retail outlets for the brewer and a showcase for his products into one of the most active and dynamic property investment markets.

Pub owners have progressively received more fixed income, that is rent, rather than variable 'wet-led' income, for example, beer. The first part of this process in the 1990s saw brewing split from pub operations, and now in the 2000s we are seeing the split of pub ownership (propco) from pub operations (opco).

Investors in pub property seek total shareholder rates of return that are comparable with, or exceed, other property classes. This in turn puts pressure on yield (rent) and pub value. This has become the market that attracts investments from music impresarios or football managers, as they add pubs to their overall investment portfolios.

Their investment objectives are simple: what is my expected total return and over what period? In enhancing total return for pubs in such structures the pressure is always on one income source: rent.

Other sources of income are considered too volatile, even though attempts are being made to include wet income within the mix. The time horizons to realise returns on such investment are short and in such a dynamic sector as pub ownership occasionally very short.

Mechanisms for extracting value and returning capital to shareholders are under constant review by such investors: sale and leaseback, share buyback, leverage, etc. And now, of course, REITs offer a juicy tax advantage that allows the prospect to turn the value knob up a few notches and then exit.

This in turn puts more pressure on yield (rent) and thereby raises the fixed cost element or break-even point of the average pub. And the pressure is on the 'opco' (licensee to you and me) to effect a step change in performance too.

Most existing operators see many pitfalls in REITs and cannot determine what the appropriate economic distribution should be between different sources of income. But they feel it may be the only defence to unwelcome approaches in the future.

Yet when one takes the first step across this Rubicon, the value implications are likely to have a trickle down effect on all pub owners whether national, regional or individual freehouses.

Over time, the objectives of 'opco' may well become increasingly unhinged from the demands of 'propco'.

Furthermore, while the arithmetic of high rent and strong covenant may suggest one value for investors, the market may see flaws in such precarious structures - as the recent failure to sell Hilton Hotels at the target price or the collapse of London & Edinburgh Inns amply demonstrated.

Elsewhere in the market there exists a significant number of operators who remain vertically integrated and see more virtue in being so.

They invest continually in all parts of their business to exploit changing consumer behaviour and focus on delivering long term value to shareholders through brand and asset growth. And most have done so continually and successfully for many years.

The hares in the investment world see REITs as a new mechanism to out-box and out-run those tortoises that protect their freehold values under their shell. If the hare gains an advantage, the tortoise will have to up the pace of its operation to justify the new value or meet the rent.

But the hare may tire quickly of this pasture and is likely to find discomfort in the chilly winter of interest rate rises. Meanwhile, the tortoise will soldier on: steadily, efficiently, relentlessly and for the longer term. And I believe it will win in the end.

Jonathan Neame is chief executive of Shepherd Neame​