Duke Realty: Prologis Acquisition Stuck In Valuation Dilemma (NYSE:DRE)

Prologis, Inc. (NYSE:PLD) proposed to acquire Duke Realty Corporation (NYSE:DRE) in an all-stock transaction, which was declined by the DRE’s board of directors. This was a revised proposal to a previous offer made on November 29th, 2021. The offer was rejected a second time because DRE’s board thought there wasn’t any substantial change in the revised offer.

Duke’s management believes that its shares are undervalued at $61.68 per share, based on the closing price on May 9th, 2022. However, the board of directors of Prologis doesn’t seem to agree to that, as they were offering a premium of almost 30 percent. I am hopeful that this acquisition will materialize (due to the strategic benefits and economic compulsion), and the two companies will arrive at a consensus over its valuation.

Overview of Duke Realty

Duke Realty is an industrial REIT that owns and operates over 150 million square feet across the 20 largest logistics markets in the United States. It has an outstanding development pipeline of 9.7 million square feet totaling $1.4 billion that is 84% pre-leased.

Over the years, Duke Realty has generated substantial returns to its shareholders. It is one of the few entities to surpass the return of S&P 500. Only during the past six months, this industrial REIT has generated negative returns, primarily due to the poor performance of the US equity market. S&P 500 recorded a more or less similar negative return over this period.

Synergies Between Prologis and Duke Realty

Prologis is one of the largest publicly traded REITs with a market capitalization of more than $90 billion. It is the global leader in logistics real estate with a focus on high-barrier, high-growth markets. Prologis controls a 1 billion square foot global network (spread over 19 countries) of warehouses and distribution centers, serving a diverse base of approximately 5,800 customers including retail and logistics giants such as Amazon.com, Inc. (AMZN), The Home Depot, Inc. (HD), and FedEx Corporation (FDX).

Duke Realty, on the other hand, has a market capitalization of more than $20 billion. The merged entity is expected to become the largest REIT, beating the current market leader American Tower Corporation (AMT). Though currently AMT has a market capitalization of $121 billion (i.e. more than the combined market value of PLD and DRE), the synergy effect due to this merger will, I expect, surpass that value. This enhanced scale, along with strategic and financial benefits, are primary drivers behind this acquisition.

A highly strategic and complementary combination is expected to derive higher growth, and a strong performance in terms of funds from operations (FFO). Historically, both PLD and DRE had sufficient FFO growth. Duke Reality recorded an FFO growth of 14 percent, 9 percent and 8 percent over the past one year, three years, and five years, respectively. Prologis, on the other hand, recorded an FFO growth of 9 percent, 11 percent and 10 percent over the past one year, three years, and five years, respectively.

Duke currently owns a 160 million square feet (including the pipeline) portfolio of industrial assets with a low average age and strong Environmental, Social, and Governance (ESG) position in 19 major U.S. logistics markets, some of which are in coastal areas covered by Prologis. Due to a considerable shift in ESG focused and ESG positive spending patterns, regulatory frameworks, employee expectations, and industry perception, REITs with strong ESG records are in a better position to attract more business and generate a higher FFO. This makes Duke Realty highly lucrative for Prologis.

Creating value through acquisitions is a historical forte of Prologis. After it bought DCT Industrial Trust Inc. and Liberty Properties Trust, Prologis has performed exceptionally well, and that materially benefited the shareholders of both entities. Prologis is trying to leverage these acquisitions in order to convince the board members and shareholders of DRE.

Digging Deeper into the Prologis Offer

On Nov. 29th, 2021, Prologis offered 0.465 of its shares in exchange for one equity share of Duke Realty. It represented a 20% premium over Duke’s closing price. On May 3rd, 2022, Prologis revised the offer with an exchange ratio of 0.466:1, which valued Duke Realty at 29 percent premium, valuing each DRE share at $61.68. As mentioned earlier, the revised offer was also rejected.

On the basis of the proposed exchange ratio, Duke Realty shareholders would have owned 19% in the combined company. Now, this may seem to dilute the authority of Duke Realty’s shareholders. But, I don’t think it will be a major cause of concern. 65 percent of Duke Realty is held by 15 institutional investors that hold more than 50 percent of Prologis, too. So, in the combined company, these institutions will have their significant stakes.

If we talk about the largest stakeholders, Vanguard Group Inc., Cohen & Steers Inc., BlackRock Inc., State Street Corporation, and FMR Inc., together hold more than 50 percent in Duke Realty. These five firms hold more than 30 percent in Prologis. Thus, I believe that this acquisition deal just needs to get the nod of the Board of Duke Realty. This might have incentivised Prologis to go hostile. However, the big question remains, what will be an acceptable price for Duke’s board.

The Valuation Dilemma

Various analysts have come up with a valuation in excess of $65 per share. However, instead of enhancing the offer, Prologis is interested in building pressure through Duke’s shareholders. By making its offer public and issuing press statements regarding offering a huge premium to Duke’s shareholders, it seems that Prologis management is quite clear on Duke’s valuation. Considering the major merger and acquisition deals during the past two years, a 30 percent premium can be considered quite reasonable.

Brookfield Asset Management acquired its commercial real estate arm Brookfield Property Partners private for a premium of 14 percent. Kimco acquired Weingarten in cash and stock, at an 11 percent premium. Tremont Mortgage Trust merged into RMR Mortgage Trust at a premium of 6 percent. In another deal, VEREIT was acquired by Realty Income at 17 percent premium. Blackstone Real Estate Income Trust, Inc. acquired QTS Realty Trust in an all-cash transaction valued at a premium of 21 percent.

Among the healthcare REITs, New Senior shareholders were acquired by Ventas at a 31 percent premium. In a proposed merger into Healthcare Realty Trust Incorporated (HR), Healthcare Trust of America, Inc. (HTA) is valued around 16 to 18 percent premium. Retail Properties of America, Inc. merged into Kite Realty Group Trust where it was valued at 13 percent premium. Capstead Mortgage Corporation was acquired by Franklin BSP Realty Trust at a premium of 16 percent. PIMCO acquired Columbia Property for 16.6 percent premium.

Prologis management also believes that recent performance of Duke’s stock (which had fallen 19 percent in the time between Prologis made its initial offer and publicly disclosed that proposal) should make Duke’s shareholders more interested in the offer. Prologis’ shares performed relatively better, with a decline of almost 14 percent during the same period.

Moreover, both Prologis and Duke will face uncertainty over demand for warehousing spaces. There is a possibility that the rising interest rates might cool off demand for warehouse space. Under such circumstances, investors might be more interested in a merger deal since a larger merged entity will be in a better position to achieve higher occupancy and stronger FFO.

However, Duke’s Board also has reasons to expect either a higher value, or a mostly cash deal. Duke Realty is a strong player in industrial REIT, with a large average building size with above average lease terms. It has an attractive development pipeline and has been consistently generating significant FFO growth. Duke Reality is not under any kind of financial stress that may compel them to accept a bid if the DRE’s board members believe that the firm is being undervalued.

Conclusion

Prologis is targeting Duke Realty because it believes that the latter’s portfolio of high-quality, modern logistics assets located in the major US markets will complement the portfolio of Prologis. That might be the prime reason behind Prologis going hostile for Duke Realty. The board members of Duke Reality are aware of this. However, if DRE’s board members are able to convince shareholders that the deal is undervaluing them, Prologis may just have to up their offer to make it more attractive for Duke’s investors.

In my opinion, the acquisition will materialize. I don’t foresee a situation where Prologis loses interest in Duke Realty and tries to acquire some other competitor. I am hopeful that the valuation dilemma will be sorted out within a few months. Whether Prologis will be successful in its attempt of hostile takeover, or whether they will increase their bid value is yet to be seen. But, whatever the case may be, the ultimate beneficiaries will be the shareholders of Duke Realty. A 29 percent premium is anyways committed, even in the existing bid. A higher premium will further benefit Duke’s investors.