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You Can't Control Company Mergers, But You Can Control What You Do About Them

Motley Fool - Thu Nov 2, 2023

The real estate investment trust (REIT) sector has been deeply out of favor since interest rates started to head higher. There are many reasons for this, but a major side effect is that growing via property acquisition has become more expensive. So perhaps it isn't all that surprising that Healthpeak(NYSE: PEAK) and Physicians Realty Trust(NYSE: DOC) have decided to join up in what is being called a merger of equals.

Although you can't control what's going on here, you can control what you do about it. But that doesn't really leave you many attractive options.

Earnings and a little more

On Oct. 30, both Healthpeak and Physicians Realty reported earnings. And in separate news releases issued on the same day, both announced that they had agreed to merge into one entity. Needless to say, this announcement overshadowed the earnings updates.

PEAK Market Cap Chart

PEAK Market Cap data by YCharts

These two companies hail from the healthcare niche of the REIT sector. Healthpeak was, at one point, among the largest companies in the space with a broadly diversified portfolio. After some missteps, it ultimately pared its portfolio down to mostly include just two property types, medical office and medical research facilities. It has a roughly $8.7 billion market cap. At one point, not too long ago, the company was twice that size.

With a market cap of roughly $2.6 billion, Physicians Realty is notably smaller. It has long focused on medical office assets. It prefers owning offices that are located on or near medical system campuses. These are locations that doctors often like to be in, given the proximity and connection with the nearby health system.

A big(ger) benefit for the combined REIT

Basically, all REITs have come under pressure of late as they try to manage rising interest rates. Higher rates on other investment vehicles (CDs, for instance) create more competition, which has led investors to shift away from stocks (which tend to be riskier). And, more to the point here, rising rates also make it more expensive to buy properties since debt is often a major funding source for REITs. Meanwhile, falling stock prices are a drag because they make it more costly to issue equity.

Thus, one of the biggest benefits of this pairing is that the company created will be larger. That should allow the merged entity easier access to capital markets for both selling stock and issuing debt. Of course, it helps a great deal that Healthpeak and Physicians Realty have roughly similar approaches and their portfolios will be fairly complementary to each other. The deal will lead to cost savings of as much as $60 million per year over time as the REITs integrate their operations.

The combined entity will be run by the CEO and CFO of Healthpeak, with the CEO of Physicians Realty staying on as "Vice Chair of the Board who will have an active role in strategy, relationships, and business development." In many ways, the deal creates the appearance that the larger Healthpeak, which will be the surviving entity, is buying Physicians Realty. Notably, Physicians Realty shareholders will get 0.674 of a newly issued Healthpeak common share for each share of Physicians Realty they own. Healthpeak noted that it has no intention of changing its dividend policy (which will have an adjusted funds from operations (FFO) payout ratio of around 80% after the merger is closed).

PEAK Chart

PEAK data by YCharts

Both REITs fell on the news

That's the backdrop for this reported merger of equals, but what should shareholders do from here? Normally, when two companies pair up, one pays a premium for the other, leading to one stock advancing, sometimes materially, on the news. That didn't happen here, as the shares of both REITs fell. Healthpeak dropped slightly more, but it is notable that there was no gain for Physicians Realty. That makes complete sense, however, because Physicians Realty shareholders aren't being paid a premium. The transaction effectively values Physicians Realty at about what it was trading at before the deal was announced, which is likely why this transaction was described as a merger of equals.

At this point, there's really only one thing that investors need to determine: Do you want to own the combined entity? For Physicians Realty shareholders, there is a slight dividend cut in the cards, which might lead some to look for alternative income options. However, Healthpeak's yield is 7.5%, which is lower than the 8.3% Physicians Realty is paying, but it is still fairly attractive. Given the benefits of scale, it might make sense to stick around and see how the deal plays out. But Physicians Realty shareholders are, in effect, losing from this merger of equals.

It's been announced, now what?

With the news of the merger between Healthpeak and Physicians Realty now out, all you can do is react. But the key is to understand what is happening so you make an educated decision. There's no premium involved, so investors don't have the luxury of cashing in by selling either stock. This means the big question is whether you want to own the company that is being created, which will benefit from larger scale. That's not a small issue given the interest rate pressures on the REIT sector.

The big negative here is that Physicians Realty shareholders will effectively experience a dividend cut, but the yields on both REITs are quite high, so it might be hard to find a replacement investment offering the same level of income.

Most will probably be better off riding this merger out and giving the company time to prove that this deal adds value. But whatever you do, don't sell and buy something else yielding north of 8% without doing enough due diligence. Buying stocks with high yields can involve taking on extra risks, and that's not something you want to rush into.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends Healthpeak Properties and Physicians Realty Trust. The Motley Fool has a disclosure policy.

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