Real Estate M&A Roars Ahead
The pace of mergers and acquisitions (M&A) in 2006 has accelerated across virtually all industries and sectors, including real estate investment trusts (REITs). Blackstone Group's $36 billion tender for Equity Office Properties Trust (EOP; S&P investment rank, 3 STARS, hold; recent price, $48) last month represented the latest blockbuster in a long line of takeovers that has engulfed the U.S. property business over the past two years.
According to the National Association of Real Estate Investment Trusts (NAREIT), M&A activity among REITs increased from $14.7 billion in 2004 to $117.1 billion through the first 11 months of 2006.
A catalyst for this growth has come from private capital sources, which have pushed an enormous amount of cash into real estate. The percentage of M&A deals that involved takeovers by private entities skyrocketed from only 2% in 2004 to 57% this year, NAREIT stated.
David Lee, portfolio manager of the T. Rowe Price Real Estate Fund (TRREX), cites several factors behind the M&A boom in REITs, such as a growing interest in alternative investments, including real estate. "This desire has helped generate a pool of private capital that's participating in REIT M&A," says Lee. Low long-term interest rates, as well as improving commercial property fundamentals, are also boosting the M&A environment, he notes. The premiums being paid for the stocks would indicate that some public companies might be trading at discounts to their private market valuations.
Real Estate Alternatives
Sheila McGrath, REIT analyst and managing director at Ryan Beck, indicates that private-equity firms will pay a premium for REITs because they can leverage their money up to 90% (whereas REITs typically leverage deals at around 50%), thereby boosting returns. McGrath believes that private-equity funds are awash with capital. "The management fees that these funds generate are certainly a motivating force behind putting out capital," she says.
McGrath also notes that the implied low capitalization rates for real estate assets trading in the private markets make acquisition of REIT portfolios, in many instances, more attractively priced real estate alternatives.
According to Brad Case, vice-president of research & industry information at NAREIT, there are currently some 185 publicly traded REITs in the U.S., comprising about $440 billion in total market cap. "However, the number of REITs has remained stable the past several years because we have seen a number of REIT IPOs to compensate for entities being taken private," says Case.
REITs have been among the best performing equity sectors over the past few years. For the five-year period through November 17, 2006, the average REIT fund gained 22.7% (annualized), vs. a 6.1% gain for the S&P 500. Consequently, some believe REITs may now be fully valued or even overvalued.
Near Fair Valuations
While some investors might think that in the current M&A euphoria, smaller-cap REITs would make attractive takeover targets for larger REITs, McGrath believes it's more likely that small-cap REITs will sell out to private buyers rather than to other publicly traded REITs. "The more highly leveraged transactions used by private players achieve premium pricing for the equity," she says. "Consequently, it would be less likely that a straight merger with another company would garner the highest share price for the small-cap REIT."
Robert McMillan, an S&P analyst who covers retail, industrial, and self storage REITs, says he doesn't think there will be a lot of blockbuster M&A deals in his sector in 2007 if only because he believes that many of the stocks he follows are at or near fair valuations.
As a stockpicker, Joe Rodriguez, lead portfolio manager of the AIM Real Estate Fund (IARAX), says he doesn't purchase small-cap REITs just because they might make attractive takeover candidates. "Playing M&A is too speculative," he says. "We look at a REIT for its underlying growth prospects and see if they can outperform over the longer term." McGrath also says that the costs of being public and the aggravation induced by Sarbanes-Oxley rules may push some smaller-cap REITs to now consider more aggressively selling their companies.
Consolidation in Some Sectors
"The office sub-sector was one of high activity in 2006, punctuated by the planned buyout of Equity Office Properties," says Royal Shepard, an S&P equity analyst who covers office REITs. "In my view, valuations of the remaining publicly traded office REITs are approaching fair value," he says. "However, I wouldn't be surprised to see some additional consolidation over the course of 2007."
Standard & Poor's equity analyst Jason Willey says he expects there to be continued consolidation activity in the health care REIT and residential mortgage REIT sectors. "In the health-care sector, I expect the majority of the activity to be larger companies in the industry acquiring smaller public and private companies," he says. "I expect the interest from private equity investors will be more limited."
In the residential-mortgage sector, Willey says he believes the "challenging interest rate environment and a slowing housing market has left a lot of smaller players struggling and seeking out potential acquirers."
For the Long Term
About two dozen countries either have or are planning to establish REITs, including Europe's two biggest property markets, Britain and Germany, which will introduce their own REITs on Jan. 1, 2007. However, NAREIT's Case doesn't expect to see a significant rise in cross-border REIT mergers. "We have seen U.S. REITs purchasing individual properties overseas, or forming joint ventures with foreign property owners, but very few actually acquire entire real estate companies," Case says.
AIM's Rodriguez believes the outsize returns witnessed in the past two years have largely been due to privatizations. Going forward, he's comfortable with REITs delivering long-term average annual returns in the 7% to 9% range, supported primarily by fundamentals.