While Equity Office Properties Trust's $7.3 billion blockbuster acquisition of Spieker Properties, Inc. shook the commercial real estate industry in the first half of 2001, it wasn't the only deal to make news. Archstone Communities, Inc. and Charles E. Smith Residential Realty, Inc. announced plans to merge, and FelCor Lodging Trust, Inc. agreed to acquire MeriStar Hospitality Corporation. As these large, well-known REITs strategically assemble their portfolios, industry analysts have begun speculating about future consolidation among the approximately 190 existing publicly traded REITs and what effect it will have on the end game.

Is bigger always better? Will the REIT industry absorb a rash of mergers and acquisitions in the coming years? Those are some of the questions facing analysts and investors in REITs following a year or so of big-name mergers and acquisitions. While some analysts predict a wave of M&A activity with only a handful of REITs left standing, others expect a less drastic change in the industry. Analyzing the reasons for this year's mergers and acquisitions may deliver some insight about the potential for future activity.

"Three reasons come to mind for the rash of deals we've seen this year, the first being the belief among some people that 'bigger is better,'" says David Shulman, senior REIT analyst for Lehman Brothers. "Second, the stocks for these REITs were available at the net asset valuation or below, so the pricing was attractive. Third, some of the original founders were looking for an exit and were willing to be acquired, such as Charles Smith."

And sometimes the offer to merge or be acquired was just too good to pass up. "If you look at the recent mergers and acquisitions on a case-by-case basis, and particularly the Archstone and EOP cases, the management teams believed they had a once-in-a-lifetime opportunity to acquire a really special portfolio," says John Lutzius, senior analyst with Green Street Advisors. "REITs came out of a tough bear market in 1998 and 1999, during which they were more inwardly focused. Now that they have more stable capital markets, the management teams are looking at the industry as a whole like a group of chess pieces which can be moved around."

Location, Location, Location

Location of assets plays a role in how these chess pieces will be played, according to some analysts.

"Geography has a big influence on which REITs will get together," says Jay Leupp, managing director of Robertson Stephens Real Estate Equity Research. "In both the Archstone and EOP cases, the mergers and acquisitions were driven by a desire to diversify among regions as well as wanting to grow the companies."

Lutzius agrees, "Each management team is trying to construct an attractive portfolio, and geography definitely plays a big role in that portfolio development."

Other analysts think geographical considerations are of less importance to M&A activity.

"The East and West Coast mergers that we've seen have made sense because both of those areas of the country are growing quickly," says Anthony Paolone, analyst with CIBC World Markets. "The South and the Midwest tend to be slower growth areas. I think the focus is more on the faster-growing markets rather than geography."

Shulman says that having an East Coast-West Coast merger is not necessarily part of the strategy that companies look at. "REITs are looking more at whether a company fits strategically within their portfolio than they are looking at the geography of a merger or acquisition," he says. "Filling strategic holes and buying into markets they are not already in is a major part of the decision to merge or acquire another company. Some companies want to be in ‘supply-protected' markets, and that's part of the strategy, too."

Besides choosing to merge with or acquire companies in other markets, some REITs may also choose to merge with or acquire a REIT in the territory in which they already operate.

"Where firms overlap there are potential gains from [establishing a significant presence in] the market," says Shulman. "Instead of two companies competing, a combined company can be more of a market power. A company which goes from a 20 percent market share to 40 percent might get higher lease rates than would otherwise be possible, or at least protect themselves from lease rates dropping as much."

Publicly Traded Real Estate Industry Mergers and Acquisitions Activity, january 1999–june 2001

Focused REITs Will Continue to Dominate

While diversification from region to region is expected to become more common in future years, analysts do not expect any publicly traded real estate companies to diversify significantly in their product type through mergers or acquisitions.

"REITs will definitely continue to focus on a particular property type because their value lies in part in their expertise in a particular area. If they chose to invest in different types of properties they could put their value at risk," CIBC's Paolone says. "We won't see Boston Properties, Inc. suddenly acquiring a company which specializes in shopping malls just for the sake of consolidation."

According to Green Street's Lutzius, "There's a clear preference by investors to invest in focused REITs, which requires that they be focused by property type. So we haven't seen diversification by type of asset yet as part of the mergers and acquisitions trend."

One example of diversification within a product type that may become a common element in future M&A activity is found in the FelCor Lodging Trust, Inc. planned $2.7 billion acquisition of MeriStar Hospitality Corporation, which is set to be completed in the third quarter of 2001.

"While FelCor stayed with hotels, they added significant growth in a new area by acquiring MeriStar," Leupp says. "MeriStar's properties tend to be high-end hotels in major metropolitan areas and resorts, which adds an upscale element to the combined company."

Unique Opportunities Rather than General Trends

Most analysts agree that the deals which have taken place this year are not universal cases, and each must be analyzed on its own merits, which makes identifying trends more difficult.

"Most consolidations take place for a variety of reasons, not just purely financial considerations," says Leupp. "Consolidation activity is constantly happening in all types of markets. The mergers and acquisitions among REITs haven't been faster or slower this year than last year, but it's probably just happening when it needs to happen."

"If you take a look at supermarkets, department stores, banks and newspapers, they used to be regional enterprises and now they are national," says Schulman. "It's part of a natural trend for real estate companies to make the switch from being regional companies to national companies. My guess is that there are too many REITs and that over time there will be more mergers and acquisitions as the industry rationalizes. If you look at the history of the American economy, companies in other industries over time have merged and then split apart. But we've never seen real estate companies of the size some of them are getting to be today. Time will tell if the big companies stay together."

The time element is a determining factor in identifying trends among REITs, analysts agree.

"In the long term, this [REIT] group is definitely consolidating, but in the shorter term there's not necessarily going to be a wave of mergers and acquisitions," Paolone says.

According to Jonathan Litt, senior real estate analyst with Salomon Smith Barney, "Generally there are five to 15 [REIT] mergers per year, so there hasn't been a tremendous change in terms of numbers of mergers this year. The difference is that some very large companies were involved this year, so the increase in mergers has been in terms of size. In our opinion, in the future there will be a handful of $100 billion REITs and 30 or so smaller ones with assets in the $2 billion to $10 billion range."

Steve Sakwa, senior REIT analyst at Merrill Lynch & Co., agrees that, while mergers and acquisitions will likely continue to take place, the industry probably won't dwindle down to only three or four giant REITs.

"Some companies have been against selling or merging, and unless the CEO is tired of running the company there usually are no financial reasons to do it," Sakwa says. "For example, Summit Properties has been able to sell some assets and redeploy, so now they are self-funding and have no driving financial need to merge with another company."

Personalities Count

In addition to financial considerations, personality plays a part in the decision to merge with another company or not.

"Our company has never had the thesis that there will be only 10 or fewer REITs. There will be fewer in the future and there will be selected transactions here and there, but the industry still has plenty of entrepreneurial leadership that precludes mergers taking place," Sakwa says. "The founders really want to run their businesses themselves. The REIT group has come back some this year, so there's less pressure on them to merge. There's a second life to REITs so there's no compelling need to sell out."

Lutzius agrees that the management team has a big impact on mergers. "In some cases mergers depend on the personalities involved and the willingness of the management team of the company to be acquired to step down," he says. "REITs have a limit by law on how concentrated their ownership can become, which has the effect of making it more difficult for a hostile takeover of a REIT. The management teams must be willing to cooperate in any deal between REITs."

Large or Small?—Each Has Advantages

Leupp predicts that while the publicly traded REIT industry will eventually have 50 to 75 companies as opposed to today's near 200, "We won't see massive consolidation among REITs in the future. The reasons for this are the unique nature of real estate as an industry and the control-oriented nature of the executives who run these companies."

Both large and small REITs have their advantages and attractions for investors.

"From a long-term industry standpoint, bigger will be better, particularly if a company becomes large enough to be listed in the S&P 500," says Paolone. "Right now, REITs are viewed as a specialty section of the stock market, and having a REIT be part of the S&P 500 would help the acceptance of REITs overall from a market standpoint."

In addition to achieving more market acceptance, larger REITs enjoy other advantages.

"Economies of scale, the diversification benefits and greater liquidity are all benefits of large mergers or acquisitions, but it will take a few years to see just how much of an advantage these are," says Litt. "But smaller REITs have their advantages, too. They are more nimble and can be more opportunistic. It can be far easier to grow a small company faster, although the big companies will still have the advantage of the economies of scale. The mid-range REITs will have by far the most trouble, because they are too big to grow quickly but too small to enjoy the economies of scale."

Shulman and other analysts look to the future for the answer on how successful some of the larger REITs will be.

"It's an open question whether the economies of scale at the regional level will be there at the national level," says Shulman. "They'll gain some economies of scale in insurance and finance, but the managerial costs involved may be dis-economies of scale."

According to Leupp, "From a view of 50,000 feet looking at the industry you can see the benefits of consolidation, but from the ground, when you are talking about a particular REIT merger the picture is not so clear. While a REIT could get better as a result of a merger, the premium paid by the acquiring company needs to be weighed against the advantages of the merged company."

"Small REITs," according to Leupp, "will have a harder time driving up their valuation because they are so illiquid. But a few companies have been able to do this by staying very specialized. For example, Alexandria Real Estate Equities, Inc. has been successful specializing in medical research facilities."

Paolone agrees that specialization can be the key to a strong smaller REIT. "Running a small, focused REIT can be a good thing," he says. "For example, Essex Property Trust, Inc. has created good shareholder value by sticking with what they know (West Coast multifamily properties) and creating a strong management team with lots of expertise. From the shareholder standpoint there will always be plenty of small REITs that make a good investment and will continue to do so."

In general, bigger can be better sometimes, but small can be a good thing, too. While the REIT industry should expect a steady pace of mergers and acquisitions in future years, analysts vary in their predictions of how many REITs will be operating in the long term. As most of them note, "only time will tell."