Real Estate Merger Makes Sense, Not a Moat

Earlier this year, we downgraded our moat assessments for industrial property landlords ProLogis Trust and AMB Property Corporation as stand-alone businesses to none from narrow. Recently, these firms merged, creating  ProLogis Inc. (PLD), a worldwide behemoth owning industrial property in markets that represent roughly 80% of the global economy. Still, the expected benefits of the merger are not sufficient enough for us to change our outlook on the newly combined firm's moat.

We look at a number of operating and financial metrics when assessing moats among landlords. We think landlords with competitive advantages should be able to post solid operating metrics across a complete real estate and economic cycle and generate returns on real estate assets that exceed their costs of capital. By our reckoning, industrial real estate investment trusts ProLogis and AMB Property failed in both areas as stand-alone companies.

The most common operating metrics we consider when assessing moats among landlords are re-leasing spreads and portfolio occupancy rates, which drive same-property net operating income (NOI).

Re-leasing spreads measure the change in rental rates on new versus expiring leases. In the last six years, both AMB and ProLogis experienced periods of rent roll-downs (negative re-leasing spreads), where the new rents were lower than the expiring rents, resulting in lower revenue.

< P>

This negative pressure on rents is unlikely to change in 2011. AMB recently has said that it estimates it is roughly 10% "overleased" (in-place rents on existing leases are 10% greater than current market rates) across its portfolio. We think ProLogis is in similar shape, if not slightly worse, given its recent relative performance.

Occupancy rates at stand-alone AMB and ProLogis also suffered recently, as tenants reduced their demand for industrial space in the wake of the financial crisis and a sharp decline in global commerce. The situation was magnified at ProLogis because it completed a slew of speculative development projects as demand cratered, resulting in high and persistent vacancies. But even ProLogis' adjusted occupancy rate, which excludes the negative effect of its poorly leased completed developments, fell meaningfully in the downturn.

< P>

Rental rates and occupancy are two main drivers of landlords' profitability. As rental rates and occupancy fall, so does revenue, and with a number of fixed operating costs, profits are squeezed. So it's no surprise that same-property NOI at stand-alone AMB and ProLogis was weak recently as well. Same-property NOI growth measures the change in profitability of a landlord's core group of properties. Because it excludes the impact of property acquisitions and dispositions, it is a close proxy for internal growth. While moaty landlords may have periods when same-property NOI falls, we would generally expect these periods to be limited in duration. Also, for moaty landlords with long-term leasing structures (including industrial landlords), we would expect any declines in same-property NOI to be minor. Conversely, ProLogis and AMB both suffered extended and meaningful declines in same-property NOI as stand-alone companies.

< P>

We forecast lease rates, occupancy, and same-property NOI to improve in the future as the global economy gets back on track. But we expect moaty landlords to produce consistent cash flow and operating performance throughout the real estate cycle, not just when the economy is humming. The meaningful declines in occupancy, lease rates, and same-property NOI in recent years suggest that AMB and ProLogis lacked moats as stand-alone entities, in our opinion.

Another measure we use to consider the competitive position of landlords is returns on real estate assets (ROREA), which measures the income a landlord generates from its property operations relative to the cost of its properties. The calculation also can provide insight into management's ability to create value over time by buying or developing assets effectively and efficiently. We define ROREA as:

ROREA = Net Operating Income/Gross Property, Plant and Equipment

We think moaty landlords should be able to earn returns that exceed their estimated costs of capital. Both AMB and ProLogis failed to accomplish this as stand-alone companies in the last five years.

< P>

Digging deeper into ROREA presents an even worse picture of these landlords' returns. An already meager ROREA for each firm is overstated for two reasons. First, both AMB and ProLogis have taken asset impairments during the last few years that have reduced the carrying values of properties and other assets on their books. ProLogis in particular took substantial write-downs, calling into question its business model and strategy.

< P>

Furthermore, ROREA in each case is overstated because we exclude the cost of land from the denominator. AMB and ProLogis historically have chosen to buy and hold land for future development. Over time, however, we have seen no meaningful ROREA benefit when that land has been developed, as returns still have lagged estimated weighted average costs of capital. The $700 million and $1.5 billion in land that AMB and ProLogis held on their balance sheets, respectively, at year-end 2010 represent incremental sunk capital that's earning no current income. A meaningful portion of this land was acquired during the peak of the last cycle. Some of it has been written down, but we still question whether the newly combined firm will earn an adequate return on these impaired land values going forward.

With greater variability in operating metrics throughout the real estate cycle and ROREAs that have trailed their estimated costs of capital, neither AMB nor ProLogis had a moat as a stand-alone entity, in our opinion. But does our moat assessment change following its recently closed merger? No. Even if we incorporate the expected cost savings as well as expectations for a robust medium-term recovery in operating and financial performance, ROREA for the combined firm would still trail our WACC estimate by a wide margin.

< P>

We like the strategic benefits of the merger between AMB and ProLogis--mainly, for being a single partner with a larger portfolio of property options in commerce hubs across the world--but we're skeptical that there are significant revenue synergies for the combined firm, and the merger does not change our moat assessment. While the firms clearly will be able to win more business combined than either would as a stand-alone entity, we're not convinced the combined firm will be able to win significantly more business than the separate firms would have won otherwise. Furthermore, we don't think the combined firm will have market concentrations significant enough to drive rental rates. For example, brokerage firm Grubb & Ellis estimated that the combined AMB-ProLogis would own just 5% of San Francisco's industrial space, and San Francisco is one of the top markets for each firm in terms of square feet owned. We do think bigger is better in this case, but not to the degree that the combined firm would achieve scale advantages that drive far superior financial performance.

Yet, even if we're wrong about that, sensitivity analysis shows that the incremental profitability required during the next five years to achieve ROREAs in line with our WACC estimate is substantial.

< P>

With little prospect of boosting financial performance enough in the near term to generate ROREA that exceeds WACC, we expect to maintain our no-moat assessment of the post-merger ProLogis for the foreseeable future.