This is Perhaps the Most Egregious Example of Control Fraud This Far

Gretchen Morgenson of the New York Times relates to us the tale of CommonWealth REIT, which has a long history of aggressive acquisitions at excessive prices.

Their profits have suffered, and their share price has suffered.

In fact the only thing that seems to get a decent return on investment is the management company that the founders set up to conduct their operations.

They make lots of fees, and they get a fee for every misguided acquisition:

The annals of business history abound with stories of entrenched corporate executives building fortifications to maintain their plush status quo. But recent maneuvers by the board of the CommonWealth real estate investment trust put the company in a class by itself. CommonWealth REIT owns office buildings in and around major metropolitan areas in the United States. Founded in 1986 and based in Newton, Mass., CommonWealth, like many REITs, is not taxed on its income, which it distributes to shareholders. Its hefty payouts — 4.75 percent based on its share price of $21.04 — have made it a favorite among individual investors looking for income.

But CommonWealth, with $7.8 billion in buildings from Hoboken to San Diego, is unlike most other real estate investment trusts in one crucial way: its structure creates a significant conflict of interest. What sets CommonWealth apart is that it employs an outside management company, known as REIT Management and Research, to run the company’s operations and acquire properties. Many REITs were set up this way in the 1980s because they were small, but external managers are an anomaly among today’s much larger REITs.

To make matters more interesting, the outside management company is run by Barry M. Portnoy, CommonWealth’s founder, and his son Adam. Both father and son, moreover, serve on CommonWealth’s five-member board.

REIT Management and Research is paid an advisory fee based on the size of CommonWealth’s assets, rather than on how the investments perform. This is a stark incentive to simply expand the company through acquisitions and, in fact, since March 2010 CommonWealth has issued 88 million new shares to acquire new properties. The number of new shares is almost triple the stock outstanding before the sales. Such issuance dilutes existing shareholders’ stake because it increases the number of investors that share in the company’s income and payouts.

The incentive structure also encourages the management company to pay top dollar for properties. As noted in a recent report from Green Street Advisors, a research firm specializing in REIT analysis, “Selling equity and buying assets, without management rigorously asking ‘At what price?,’ can bleed shareholder value over the long term.”

Sure enough, since 2005, CommonWealth has underperformed the index of commercial office building REITs. In 2012, CommonWealth’s shares fell 7 percent. It cut its dividend last fall.

But because the assets have increased, the management company run by the Portnoys has been raking it in, earning $118 million in advisory fees in the last three years.

This might not be a concern if CommonWealth’s outside managers owned a sizable investment in its shares, aligning themselves with the company’s owners. They do not; the management firm’s executives and trustees on the board own 0.33 percent of CommonWealth stock.

The founders have adopted a series of increasingly extreme poison pills to stay in control.

Ms. Morgenson casts this as a shareholder rights fight, but I think that it is more than that.

This is management, who have almost no equity stake, are simply looting the company.