Merger deals are almost always hyped as great events by the companies involved. Sometimes that works out for investors, sometimes it doesn't. But the merger between Global Net Lease (GNL -0.14%) and Necessity Retail (RTL) has the potential to be a massive game changer for investors, and in a very positive way. Here's why.
Similar but different
Real estate investment trusts (REITs) Global Net Lease and Necessity Retail have some important things in common. For starters, they both use the net lease approach, which means that they own single-tenant properties where the tenants are responsible for most property-level operating costs. Across a large portfolio, the risk is very low with this approach, even though any single property is high-risk because it houses just one tenant. While neither REIT is exactly huge, they are each large enough to benefit from asset diversification.
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The next big similarity is that they are both externally managed by AR Global. Investors generally frown on external managers because such relationships can lead to conflicts of interest. The most common one is that management is open to taking on extra risks in an effort to beef up the fees it collects. Both of these REITs cut their dividends in 2020, ostensibly because of the effects of the coronavirus pandemic, but the dividends aren't back to pre-cut levels yet. So, it isn't unreasonable to think that too much risk was being taken.
The last big connection is that each of these REITs had a huge dividend yield. Even after the merger announcement, the yields are still above 10%. Absent the merger, the adjusted funds from operations (FFO) payout ratio for Global Net Lease is projected to be above 100% in 2023. Necessity REIT is projected to come in at 96%, which is better but still kind of high.
Getting better, fast
The merger, if finalized, will change the story here in a big way. First, the post-merger REIT plans to internalize its management. That's a good move from a corporate governance point of view, even though AR Global will still be a prominent player as it will own 17% of the new REIT. The key difference is that AR Global's interests should be more aligned with shareholders' going forward. A dissident shareholder has gotten involved in the merger process, as well, which increases the chances of a shareholder-friendly outcome.
The second big benefit is that the combined entity will be more diversified and larger. In fact, it will be the third largest globally diversified net lease REIT, with over 1,350 properties. Retail will make up around 50% of rents, with industrial at about 30% and office 20%. The average lease length will be a respectable, though not great, seven years. And just over half of the portfolio will be backed by investment-grade tenants. That's not a bad story and is, frankly, better than either one of the REITs alone.
And then there's the dividend, which will be reset to $1.42 per share per year. After the merger, the adjusted FFO payout ratio is expected to drop to 84%. That's a much more comfortable level that actually leaves some breathing room in case of adversity.
Don't jump just yet
At this point, investors are probably best off taking a wait-and-see attitude here for at least a couple of quarters after the deal is consummated. While the merger is being hyped as a great benefit for investors, there are a lot of moving parts and the REIT that comes out of the deal will look vastly different than either of the two companies today.
Still, investors who once shunned Global Net Lease and Necessity Retail should probably put the combined, externally managed entity on their watch lists. It looks like it wants to compete with some of the net lease industry's most trusted and respected companies. If this deal puts it in a position to do that, it could be worth owning.
