RMR Group (NASDAQ:RMR) is a $1.4B market cap REIT management company with $33B in AUM. It trades at 15x base fee earnings (net of cash) derived from 20-year evergreen contracts. The founding family continues to control the entity and owns just over 50%, and RMR pays a dividend in excess of 3%. There’s additional upside if underlying REIT performance improves as they’ll collect higher management fees (which are pegged as a percentage of the lower of cost or market cap) and incentive fees. I think that given the highly recurring nature of its base fee earnings and possibility for further upside from incentive fees, RMR is worth 25x earnings which would result in a fair value of around $65, more than 40% upside from current levels.
Reason the Opportunity Exists:
It’s difficult to figure out exactly why RMR trades at the multiple it does today, but here’s my best guess:
- RMR was initially distributed to the REITs and most of these shares were quickly distributed to REIT shareholders. On July 1, 2019, the remaining ~8M shares (of 16M float) that were not distributed by the REITs were sold in a secondary offering to investors at a price of $40.
- Underlying REIT performance has been problematic as of late. Notably:
- SNH’s largest tenant (and another RMR-managed entity) FVE had the dreaded “going concern” disclosure, which seemed to have trickled through and caused a dividend cut.
- OPI performed similarly poorly in its past life as GOV, and addressed its problems by merging with its sister REIT, SIR, on top of a dividend cut.
- TRMT underwent a dilutive equity raise at $5 on May 21, 2019, significantly below its IPO price of $20 on September 18, 2017.
- The share structure and financials can be confusing.
- The company is a controlled company (by the founding family, the Portnoys).
Normally the share structure isn’t all that important, but this one is a bit unique. There are 31.2M total shares outstanding. 15M of non-traded Class B shares are owned by the founding family (the Portnoys) via a trust. There’s 16.2M of publicly traded Class A shares, of which the Portnoys own another 1.1M of. Thus the Portnoys own 16.1M shares in total or 51.6% of the business. A word of caution: data sources (including Yahoo) sometimes get really confused and list inconsistent market caps ($1.4B, which implies the 31.2M share figure) and share counts (15.2M, which implies a $700M market cap).
RMR has 20-year evergreen contracts with each of its 5 underlying REITs. This came into being after Sam Zell went activist on Equity Commonwealth and successfully wrested the management contract away from RMR. Now it’s very, very difficult to pull the same stunt and remove RMR as the REIT manager. Even if you have cause, it’s a 10-year term until the REIT can get out of the management contract.
These are the terms of the management contracts:
- 0.5% fee on assets (the lower of historical cost of AUM of total market capitalization)* managed REIT, excluding the first $250M which has a 0.7% fee: 70%
- 0.6% fee on revenues of the real estate operating companies: 15%
- Property management fees for the managed REITs including 3.0% of gross rents collected from tenants and a 5.0% construction supervision fee for any construction, renovation, or repair activities: 15%.
*Note: It’s important to understand here that “total market capitalization” is more like enterprise value and is defined as equity plus debt plus preferred shares.
Benefits of Closing Gap Between Market Capitalization and Cost
Right now, RMR’s REITs are collectively have a market capitalization that’s lower than cost by $7B. With management fees at 0.5% on the lower of market capitalization or cost, RMR is shot $35M in base management fees. Management commented on its 3Q:19 call that all of this $35M falls into cash flows. RMR has roughly 31M shares outstanding, so a recovery to cost would result in more than $1 of incremental operating income per share.
Moreover, because underlying REIT performance has been wanting, incentive fees are also low. For 2019, they’re expecting just $4M from one of their REITs (Service Properties Trust). However, if the underlying REIT’s economic prospects improve, there’s a significant chance that RMR will be receive higher incentive fees. The incentive fee is structured as a 3-year performance period vs. a relevant benchmark with no high-water mark. I’ve always struggled a bit with figuring out a good way to pull SNL index data in a cost-effective method, but at the current valuation any incentive fee can be viewed as a bonus rather than a necessity.
Virtually Non-Existent Capital Needs
RMR is a service business, and spent an average of $700K on capex per year over the past 3 years. This is relative to operating income of $200M in 2019. In addition, RMR’s EBITDA margins hover between 50% and 60%. This is a high quality business where it takes little capital to grow, while downturns can be readily managed via lower compensation costs.
Adam Portnoy is son of the founder who unfortunately passed away in 2018. He makes $4M a year, which is very small relative to his 16.1M in share holdings which are worth north of $700M. Moreover, his compensation is more or less in line with the other two EVPs (one is higher at $4.6M while the other is lower at $3.3M).
The big concern is underlying REIT performance. For example, RMR has stated that SNH may have to divest up to $900M in assets, which would result in a reduction of roughly $4.5M in base management fees (or $0.14/share).
The best part remains the valuation. RMR trades at $45/share but roughly $12/share of net cash so the effective price you’re paying is actually around $33. RMR’s earnings next year should be roughly around $2.20/share, so the P/E net of cash is right around 15x. Perhaps you can argue that given Portnoy owns more than half there should be some discount both on the multiple and in the net cash. On the other hand the $2.20/share earnings stream is as predictable as they come and can almost be considered a bond-surrogate, not to mention that there’s further incremental upside if the incentive fees come in, which they eventually should given that they reset on a 3-year rolling basis. The way I view this, it’s a buy on the base recurring earnings, and becomes a strong buy if any incentive fees start coming in. I think a 25x multiple is reasonable, putting fair value in the high $60s.
As a rule of thumb sanity check, investment managers which receive higher incentive fees tend to be worth 2.5%-7.5% EV/AUM (hat tip: this awesome blog post on asset managers by Wexboy). Alternatives that charge incentive fees typically are closer to 7.5%. $65/share on 31M shares puts us $2B, or $1.6B net of cash. On $33B of AUM, that’s basically precisely on the midpoint of 5%. On $26B, which is the actual fee-paying AUM (due to book value exceeding market capitalization), it’s 6%.