Morgan Stanley: A 'McREIT' Could Be Worth $107 Per Share

• John Glass of Morgan Stanley argued in a note that shares of McDonald's Corporation (NYSE: MCD) could be worth $103 to $107 per share under a REIT structure.
• Glass noted that investor focus on retail/restaurant REIT conversions "seems to be increasing."
• Glass added that spinning McDonald's real estate holdings into an REIT structure "does not create as much value" as would be expected.

Shares of Macy's, Inc. (NYSE: M) spiked higher after activist investors presented an upside case to converting its real estate assets into an REIT structure. As a result, investor focus on retail and restaurant REITs are "increasing," according to John Glass of Morgan Stanley who explored a potential "McREIT."

In a report published Friday, Glass initially pointed out that McDonald's already earns around half of its operating income from franchisee rents and the market is already "capitalizing" the income stream at nearly 12x EBITDA. The analyst added that this is an "often underappreciated" difference between the company and other restaurants that have pursued REITs.

Reasons For And Against Forming A McREIT

Glass pointed out that REITs trade at multiples of 12.5-14.5x CY16 EBITDA, which is higher than most restaurant operating companies. As such this is the "most compelling" and "obvious" reason to consider an REIT spin. In addition, REITs offer tax benefits which the analyst estimates could amount to $2 to $7 per share in savings.

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Another reason to form a REIT is the fact that McDonald's is already "viewed favorably" by the sale-leaseback community. In the US, McDonald's ground leased properties trade for cap rates of around 4 percent on average which are "well below" the average quick service restaurant fee-simple cap rate of 6.2 percent.

On the other hand, McDonald's charges its franchisees rent in the form of a percentage of sales – between 10 to 12 percent of sales in the US and 15 to 17 percent of sales in Europe. The analyst argued that this is "well above" his estimated market rates of 8 percent. The premium is justified by the company as it finds, develops and co-invests in real estate with franchises as part of a "service income." By removing the "service income" (a move that may be necessary to qualify for a tax free spin-off), the lost income stream would diminish the value of a REIT by $1 to $2 per share.

Moreover, it is "unclear" under a REIT structure who would be pay for capital improvements (McDonald's currently puts up about two-thirds of the capital to build a new unit and co-invests with franchises for remodels and renovations) while also creating the possibility of "friction" with franchise owners under a new agreement structure.

Chances Of A McREIT Are ‘Remote'

Glass concluded that while "mechanically possible," a conversion to a McREIT is "not likely" as the value creation to shareholders is "relatively modest" while REITs have underperformed year to date. Meanwhile the IRS recently announced a stricter ruling policy around tax-free spins which creates a "new potential roadblock" for potential REIT spin-offs.

Shares remain Equal-weight rated with an unchanged $102 price target.