A battle is playing out between Newton, Mass.-based CommonWealth REIT’s management and two of its larger shareholders.

In late February, Corvex Management L.P. and Related Fund Management LLC filed a Section 13D and released two open letters to the REIT’s board of trustees calling for the company to call a halt to its “dilutive, value destructive” equity offering and debt repurchase plan or face legal action. In addition, the two entities made their own pitch to buy the remaining shares of the REIT for $27 per share.

On Monday, CommonWealth announced that rulings by the United States District Court for the District of Massachusetts denied two separate motions that sought to enjoin the closing of the equity offering. As a result, CommonWealth went ahead with an equity offering of 34.5 million shares—more than one-third of the company’s existing, fully diluted share base—that closed yesterday. Commonwealth sold the shares for $627 million.

CommonWelath expects to use the proceeds of the offering to purchase up to $650 million of unsecured senior notes due between 2014 and 2016 in a tender offer. CommonWealth REIT is an externally advised REIT that owns 76.8 million sq. ft. primarily office properties throughout the United States and Australia.

Corvex and Related have argued that the offering significantly undercuts the value of the stock. The two investment fund managers collectively own 9.8 percent of the outstanding common shares through their separate funds. In addition to describing the move as “preposterous”, Corvex and Related consider the offering to be further evidence of a “disconnect” that exists between the goals of shareholders and the CWH Board and REIT Management & Research LLC (RMR), the REIT’s external advisor.

Since the open letters were released Feb. 26th, Luxor Capital Group also has announced its support of Corvex and Related. The New York-based investment manager owns about 6.3 million shares or approximately 7.5 percent of the company,

“The real issue is that activist investors are giving a voice to a generation of CWH investors that they’re mad as hell and not going to take it anymore,” says Michael Knott, a managing director at Green Street Advisors in Newport Beach, Calif. “For a very long time, the company has generated uncompetitive total returns to its investors while reaping millions in fees.”

Discord has been building

It’s not unusual for REITs to conduct secondary offerings from time to time as a means to raise capital. Already in 2013 REITs have held 31 secondary equity offerings that have raised $9.4 billion, according to NAREIT. In 2012, REITs held 177 such offerings and raised $45.7 billion. So, there is no shame in raising equity at an implied cost of capital that is fair and for a use of proceeds that is smart, notes Knott.

So, why has this offering triggered such a backlash?

“CWH investors, particularly the activists here, are upset because management has generated a poor total return track record, and has a history of consistently raising new equity below where investors perceive the value of the portfolio in order to grow the fees for the advisor,” says Knott. Selling new stock at a price below the value of the portfolio dilutes value for existing shareholders, and that’s why the activists did not want this equity offering to occur. They see it as a transfer of wealth from existing shareholders to new investors participating in the offering, he adds.

“Poor quality external management has led to a faulty investment strategy and a high cost of capital,” agrees John W. Guinee III, an analyst that covers CWH for Stifel, Nicolaus & Co. Inc. in St. Louis.

CWH typically buys office and industrial properties in secondary and tertiary markets, often at premium pricing, and the REIT has seen its occupancies and rents struggle in the slumping real estate market. For example, CWH purchased three properties in the CBDs of Columbia, S.C. and Indianapolis last year for $255 million or $183 per sq. ft. In its third quarter earnings call, management announced that it recognized that over 50 percent of its assets (275 of 526 consolidated properties) were “challenged” or experiencing occupancies below 60 percent in weak markets.

The combination of depreciating property values coupled with the high cost of capital is producing continual share price deterioration, which has been driven by declining earnings and declining net asset value per share, Guinee adds. FFO has declined from $0.91 in first quarter to $0.82 in fourth quarter, and Stifel is estimating a further dip to $0.70 in first quarter 2013.

Although CWH did not respond to requests to comment for this article, CWH management has stated that the purpose of the announced equity offering is to deliver its balance sheet and improve its coverage ratios in order to appease the rating agencies and entice future tenants.

S&P downgraded the company’s senior unsecured debt rating last summer from a BBB to BBB- due in large part to eroding debt metrics resulting from deteriorating operating fundamentals. Guinee believes that the “2009-style re-equification” is being done in an effort to stave off additional rating downgrades on both the senior unsecured debt and preferred equity.

Fighting for control?

Although Guinee agrees with many of the points that Corvex and Related made in its two open letters regarding the company’s management issues, he believes the group of investors is overly aggressive in its assessment of net asset value. Corvex and Related have stated that they considered the value of the stock—prior to the offering—to be at $40 per share. “Right now, CommonWealth is a $15 stock saddled with RMR’s external management, egregious fee structure and low quality service, but a $25 stock as a liquidation play or in the hands of a high-quality, internal management team,” says Guinee.

RMR is not likely to give up the company without a fight. The firm collects about $77 million per year in high margin fees from its management duties at CommonWealth. In addition, losing CommonWealth would threaten its larger livelihood, which also includes external management of several other REITs including Select Income REIT, Government Properties Income Trust, Senior Housing Properties Trust and Hospital Properties Trust. Guinee gives the takeover bid about a 50-50 chance of success and expects that it will be a two-year process. If either the activist shareholders throw in the towel or CWH/RMR prevails after a lengthy court battle, the stock price will likely retract to about $15 per share, he adds.

A critical point to note is that CWH is not representative of most public REITs, emphasizes Knott. “Most public REITs have a clean structure whereby investors are aligned with management and everyone is in the same boat,” he says. That was part of the maturation of the REIT industry in the 1990s. Public investors demanded conflict-free structures in order to help recapitalize the real estate industry in the wake of the late 1980s bust.

But CommonWealth REIT and the other RMR-advised companies are different. They are externally advised, so the advisor—RMR—gets paid a fee based on the size of the asset base, not performance for investors. There is a clear misalignment between shareholders and management, says Knott. “This structure is why Green Street has never covered the RMR companies. The conflict is too difficult to value,” he says. Management is incentivized to maximize the value of the advisor, not the REIT. “They are not eating their own cooking, and that is the problem with the externally advised structure, which is prevalent largely among non-traded REITs, not public REITs,” he adds.