An interview with Arkhouse Managing Partners Gavriel Kahane and Jon Blackwell

How do you create investment opportunities at Arkhouse?

JB: We are a boutique investment firm that is focused exclusively on real estate and our focus is on the dislocation of real estate values between the public and private markets. We screen all North American real estate companies and look for opportunities where the value dislocation is widest and where there are management, or governance and shareholder ownership dynamics that exist, that allow us to work with management to resolve the undervaluation by meeting private equity demand. An important criterion for us is identifying private buyers of assets that are interested in owning the assets of those companies. In an environment like this, where there is significant uncertainty, we tend to see those gaps in valuation being extremely wide and it’s a very opportune time for our strategy.

In 2021, Arkhouse targeted Columbia Property Trust and launched a $2.2-billion takeover bid as well as a proxy fight targeting a majority of the board. Were you satisfied with the outcome of that campaign?

GK: I would say we were very satisfied with the outcome. Proud that we shepherded shareholders to a premium exit on that office REIT. They were sitting languishing in the low teens per share, and it was our view, then, that there was private equity demand sufficient to give them – and us, in turn – a very big premium. And we did exactly that. We, as interested shareholders and private equity real estate investors, were able to recognize that dislocation, that the company had great assets. Public investors own real estate through the public markets in a different way, and in some cases, for different reasons than private equity investors do. That can create two very distinct pricing sets for even the same group of assets. Recognizing that, we raised the capital to privatize that company at that big premium, ultimately losing to PIMCO. But seeing a very big appreciation in the share price on behalf of our investors. Fast forward to today, it’s our view that the stock would be in an even more depressed place than it was prior to our engagement.

What other campaigns have you been focused on?

GK: The second campaign that we embarked upon was on behalf of shareholders at Preferred Apartment Communities (APTS). We had nominated a control slate in that case, as we had in the case of Columbia Property Trust, as a last-ditch effort to the extent the company disagreed with shareholders. It’s our hope that it never goes to a proxy fight. It didn’t need to in the case of Columbia Property Trust, nor did it in the case of APTS. In both cases, management did the right thing and moved to sell the company. We realized a very big premium disposition of the assets at APTS also at around $25 per share, compared to its low teens unimpacted share price before we approached the company.

JB: Over the last 18 months, we’ve been in a very different capital market and investment environment with drastically increasing interest rates, which is resetting both private and public values. One strength of our strategy is that we can be very nimble and adapt to that quickly changing environment and I think our pipeline would reflect that. One of our strengths is that we are matching buyers of assets in the context of the current market environment. Our plan of execution, approach and strategy has to evolve with that ever-changing capital market environment. Today, our pipeline is probably as deep as it’s ever been, but we also have to be very strategic and prudent to make sure that we are pursuing the right opportunities on behalf of shareholders of those companies and our investors.

According to DMI data, there was a 12% increase in the number of U.S. real estate companies to face activist demands in the first nine months of this year, compared to the same period in 2022. What do you feel is driving this increase?

JB: Two interesting dynamics that are at odds with one another. One, I would say, the uncertain market is creating those large dislocations in value, which I think is one of the sources for that increased activity. At the same time, with respect to a strategy like ours, that increased uncertainty actually makes it a bit more difficult for our private equity buyers to have conviction about buying certain assets at prices. I would say the general consensus in the market is that there’s probably more pain ahead in terms of real estate values. People, both in the public and private markets, are sitting on the sidelines watching where interest rates are going to settle, if we end up going into a recession or not – these big questions. Once there’s some more visibility on that, I would expect there to be increased activity in this space as a result of some of these large dislocations.

How have stalled return to office trends been impacting real estate activism?

GK: Work from home and return to office matter a lot in the long term, but I think that as a near or mid-term headwind for the office asset class they’re de minimis as compared to the capital markets and the availability of credit. We feel that the pain in the office market that is really expressing itself today is much more resulting from the excessive capital requirements to re-let space, the explosion in borrowing costs and the depletion of the availability of credit for that sector and asset class.

JB: In addition to the concerns about the availability and cost of financing, most large institutional owners of commercial real estate are over-allocated in their portfolios to office, and as a result, need to be net sellers of that category. So, in addition to the math not working particularly well, the supply/demand dynamics are completely off. People are still searching for the floor, and that uncertainty is making it a largely stalled category that is stuck and has negative prospects for the near term.

Merger proposals have proven to be the source of some of the most divisive activist battles over the last year, with some involving REITs. What do you feel are the primary concerns for activists when faced with such proposals?

GK: I don’t know that this is necessarily endemic to mergers, but any third party external manager that is able to take a big termination fee resulting from an acquisition is the beneficiary of the golden parachute. We’re concerned generally, for shareholders that go into these companies blindly, to the extent there’s proper disclosure, and investors understand that they are investing in a company with a conflict of interest – that’s their prerogative. In many cases, they can be buying in at values compelling enough to justify that conflict, but people should be going in with eyes wide open.

The second thing, with respect to mergers, is that it’s always a concern, from our perspective, when a merger creates diversification. Not because a real estate sponsor isn’t capable of being an expert, both in residential and commercial or net lease, and retail and industrial, but primarily, because the public market doesn’t like diversification, generally. Generally speaking, it’s equity in those pure play large scale REITs that perform better. Any merger that combines a bunch of different asset classes is likely to suffer some headwinds in becoming an exciting growth story to public investors generally.

How has market volatility impacted on activism in your area?

GK: We’ve gone through a wild pendulum swing, resulting from COVID and then a corrective stimulus and then a counter corrective rate hike. It’s been swinging the market wildly, which definitely creates opportunity to arbitrage dislocation. The problem becomes pinning down a capitalization that is achievable and executable. It is a real problem, when you buy an asset at a 4% or 5% capitalization rate, at a 20-multiple, with, at the time, accretive debt, but then the rate cap expires, or it’s floating. All of a sudden, your borrowing costs exceed your rate of return on the investment by 300 to 400 basis points. That very quickly puts you under water. That is pain that is felt across the market, in public and private markets alike. It’s somewhat of an exogenous factor that really sits above real estate as an asset class.

As investors continue to operate in an uncertain environment, what trends are you expecting as you look forward?

JB: Our institutional partners and investors are beginning to see light at the end of the tunnel, are being more constructive and are viewing the time to start being risk-on as getting closer and closer. For a strategy like ours, which is very transaction dependent and focused on collapsing that value dislocation by bringing a transaction to shareholders, I think opportunities like that in the upcoming season will have a nice tailwind. We’re very optimistic, both about the depth of our pipeline, but also them being great risk adjusted opportunities for our investors and shareholders. It’s positive news in a space that has otherwise been beaten down and depressed over the last couple of years. It is very sector specific. Not all sectors are going to be winners. The great news is there is tremendous capital still sitting on the sidelines, and that capital is earmarked to be invested in real estate. More and more investors are seeing the public markets as potential pipeline for their private real estate assets. I think that’s a trend that we will see unfold in more transactions as uncertainty fades away.