The rise in REIT acquisitions raises the question of where the true value of real estate lies
By
Steve Bergsman
The announcements came in rapid succession as 2005 was drawing to a close. CenterPoint Properties Trust (NYSE: CNT), the third-largest publicly traded industrial REIT, announced it would be taken private in a deal valued at roughly $2.5 billion. A few days later, Arden Realty Inc. (NYSE: ARI), the fifth-largest public office REIT, announced it was being acquired by GE Commercial Finance Real Estate in a $3.2 billion deal.
Although consolidating mergers have reverberated through the REIT industry over the past two years, the focus of the activity has shifted somewhat. Most of the 2004 mergers, such as Simon Property Group (NYSE: SPG) buying Chelsea Property Group, were between two publicly traded companies. On the other hand, 2005 may be remembered as the year of the public-to-private deal. In 2005, a number of the acquirers were fund-type organizations that intended to take previously public companies private.
Those deals included: The Lightstone Group acquiring Prime Group Realty Trust; DRA Advisors LLC buying CRT Properties Inc. and Capital Automotive REIT; ING Clarion Partners grabbing Gables Residential Trust; and Morgan Stanley Real Estate Advisors acquiring AMLI Residential Properties and teaming with Onex Real Estate to bid for The Town and Country Trust.
If anything, public-to-private deals are expected to pick up steam at least through 2006. “It will continue,” says Michael Frankel, national tax director and national director of REIT services for Ernst & Young. “Mid-price REITs are going to disappear, either by getting bigger and becoming large-caps, or they will be bought out by private concerns or larger REITs.”
Buying Enterprise Value
Once the deal closes, the CenterPoint acquirer, CalEast Industrial Investors, whose members include the California Public Employees’ Retirement System and LaSalle Investment Management, would get the largest industrial property company in the very important Chicago market. For its money, GE Real Estate, a unit of the very public GE, would absorb one of Southern California’s biggest office landlords.
The deals were considered a coup for buyers. But they paid dearly for it. The price tag on the CenterPoint deal read $50 a share, to which David Fick, the REIT analyst at Stifel Nicolaus & Co. Inc., observed, “we believe the buyers are clearly paying a substantial premium for management and strategy.” The price, as Fick interpreted it, was a 9.1 percent premium over the last closing price and a 13.1 percent premium over the average closing price over the prior three months.
The price tag on Arden was $45.25 per share, which Raymond James & Associates Inc. reported was a 13 percent premium above where shares were trading before takeout and a 22 percent premium to net asset value (NAV).
What made the CenterPoint and Arden deals interesting were not just the large premiums paid, but the impact felt throughout the industry.
Right after the CenterPoint transaction was announced, Lou Taylor, senior real estate analyst at Deutsche Bank Equity Research, issued a report in which he said his company was upgrading ProLogis (NYSE: PLD), the largest industrial REIT. He wrote, “Private institutional buyers have demonstrated that they’re willing to pay a significant franchise premium …. The implied franchise value for CenterPoint was 150 percent higher than our estimate. Applying that premium to ProLogis would add $15 per share to our valuation.”
After the Arden deal, Raymond James re-examined and raised its outlook on another prominent Southern California player, Maguire Properties, Inc. (NYSE: MPG). “The per foot valuation (in the Arden deal) bodes well for the shares of Maguire Properties, which has a higher quality portfolio than Arden,” according to Raymond James.
That in a nutshell is the point of the recent phenomenon. Despite a very handsome run-up in the share price of listed REITs, the demand for real estate assets has been so great since the turn of the millennium that individual property appreciation has far exceeded growth of share prices. As a result, the valuation the private market puts on a property widely transcends the implied value of a similar asset held in a publicly traded REIT’s portfolio. Additionally, private funds increasingly see value in the REIT’s enterprise value.
“You are really seeing a reaction where the private markets are evaluating the underlying real estate greater than the public markets,” says Bruce Schonbraun, managing partner at real estate consulting firm The Schonbraun McCann Group.
Richard Campo, president and CEO of Camden Property Trust (NYSE: CPT), uses the ING Clarion acquisition of Gables Residential Trust as an example of the prevailing REIT zeitgeist. “ING saw in Gables that public market pricing was not right,” Campo says. “ING felt that they could buy the stock higher than public shareholder valuation and still make money because the private valuation of the portfolio was even greater than what they actually paid.”
Campo estimates ING Clarion paid a 15 percent premium over the stock price and says it is likely they still bought the assets for less than if they were acquired individually.
The discussion of REITs being taken private will continue, Campo adds, “as long as there is a disconnect between the private value of real estate versus the public value.”
Advantage Private?
On one hand, the perception of value in listed companies has generated interest by the private entities, in particular, the private, institutional investment manager. On the side of the deal, shareholders believe they will receive a better payoff through a private exit. The investment managers sense opportunity and, hopefully, when all is said and done, a handsome reward for their foresight and risk.
“The way we looked at Gables was that we perceived we could do a few things with the company’s operating platform in the private setting that was difficult for it to do in the public setting,” says C. Stephen Cordes, a managing director with ING Clarion Partners. “That was what was attractive to us.”
First off, ING Clarion expected it could immediately recoup some of its investment, or as Cordes notes, “reap some gains from the portfolio.” At the end of 2005, ING Clarion put 22 of Gables’ 85 assets on the market. “For a public company, there is a limitation as to the number of assets that can be sold at any given time,” Cordes says. “By taking the company private, we are harvesting those assets and enhancing the return on the remaining assets in the portfolio.”
Secondly, ING Clarion has been focusing on Gables’ development portfolio. “Gables had a deep and well-established development infrastructure in the eight markets in which it operates,” Cordes says. “We are going to be increasing the amount of development. Gables was not given full credit for its development
efforts in its public format.”
Cordes adds that the deal was more than just about acquiring some desirable real estate assets. “We feel we have a great acquisition here in terms of the overall company. It’s a great management team run by David Fitch, the CEO; great people; and high quality assets. We are recapitalizating a going concern.”
Evolution of Investment Managers
The discrepancy between the public and private valuation of real estate assets has been around for a while. However, if that has been the case, then why the recent surge in public-to-private deals?
The most obvious reasons deal with markets and pricing. There have also been a number of evolutionary movements on the structural side of the institutional investment markets.
For example, take the maturation of the investment managers, those facilitating these deals. “The INGs of the world were basically intermediaries between the pension funds, large institutional clients and the private real estate market,” Campo says.
Essentially, the deal-makers would gather capital from the institutional entities, then go out and acquire properties on their behalf. Now, because of competition, investment managers offer value by buying the operating platforms and taking over companies.
“They are adding another layer of value-added propositions to their investors,” Campo says.
Coincidental to this maturation has been the elevation of the comfort factor within the institutional community for investment property. Investors are, in short, much more comfortable with having real estate in portfolios and want, or need, more of it.
Afloat on Liquidity
“There is a huge amount of liquidity globally looking for a home,” comments Ross Smotrich, a managing director of Bear, Stearns & Co. Inc. “This is global liquidity. There is money in Europe looking to get into U.S. real estate; there is U.S. money going back to Europe and Asia. In the last year or two, the world has become a lot smaller from a real estate perspective.”
High asset values have been driven by this huge liquidity to some extent. However, underlying real estate fundamentals are also improving, which attracts even more capital.
“Quite a number of institutional investors believe they are not fully allocated when it comes to real estate,” notes Arthur Oduma, senior equity analyst for Morningstar Inc. “A number of deals by institutional investors are being done with money from pension funds and insurance companies.”
Part of the attraction, other than being fully allocated, is potential returns. While institutional investors can get a 4.5 percent return on a 10-year Treasury, they envision at least a 6 percent return on REIT deals.
“Real estate has a much better relative value compared to other investments,” Oduma says. “If investors put money into the privatization of REITs and can get a 6 percent initial yield that also has the potential to grow if the rental market gets stronger, that’s better than a 4.5 percent fixed.”
With institutional investors looking for real estate possibilities, investment managers are now armed with sufficient capital to make possible the multi-billion dollar deals needed to take companies private.
Time to Do a Deal
On the corporate end, the underlying causes for some individual deals have to do more with timing than market opportunities.
A number of companies that went public in the early to mid-1990s did so because they needed to recapitalize and used the public markets to do so. Some of those firms became the giant REITs of today, others didn’t. Now it is years later, institutional capital is seeking real estate exposure with a proven operating platform and the chief executive or chairman is a little closer to retirement.
“The tax rates are low and prices are high,” says E&Y’s Frankel. “It’s a good point in time” to do a deal.
For some executives it’s the 10-year itch. “Their companies have been around for a decade and the management can sit back, look around and note the high market valuations,” Smotrich says. “They very well might ask themselves, ‘is this something I want to keep doing going forward?’ For some senior management, the answer is no.”
“Private markets are paying seriously high prices for institutional grade real estate,” Fick says. “Management teams have lived through multiple cycles and don’t see things getting much better than they are today. Some executives are gaining in age and would like to have another life. This is a liquidity opportunity.”
Sarbox Effect
DRA Advisors is one of the more active investment managers taking public REITs private, and was involved in two major deals in 2005. The company acquired CRT Properties Inc. and its portfolio of Class A office buildings located in suburban high-growth Sunbelt cities. It also purchased Capital Automotive REIT, a provider of specialty financing for automotive-related real estate.
REITs have begun to consider privatization for several operational reasons, says Paul McEvoy, DRA’s senior managing director. These reasons make potential candidates more receptive to DRA’s message that in today’s environment, it is more advantageous to be private than publicly held.
The reasons why public REITs might consider going private would include the problem of operating expenses, especially in today’s Sarbanes-Oxley environment. “For small to mid-sized REITs, the accounting expense for regulatory filings has doubled, that also includes increased staffing,” McEvoy says.
That expense puts the smaller REITs at a disadvantage because a $6 billion company and a $2 billion company will have approximately the same costs, but the larger one can allocate the expenses over a wider portfolio. Industry estimates place compliance costs around $1 million annually, and those costs are relatively non-existent if a company is private.
Secondly, there’s the leverage factor. Increasing leverage beyond 50 percent or 55 percent will probably earn a REIT a public spanking, yet in the private world, banks will allow borrowers to leverage up to 75 percent. A number of REIT execs believe to grow faster and enjoy a lower cost of debt, it might be prudent to become private.
“The desire to maintain an investment grade rating is a great thing, but for real estate it impedes the leverage a public REIT can use,” McEvoy says. “In the private world, you can support 55 percent or more leverage and still have very attractive, rateable debt.”
Finally, and this circles back to the issue of pricing differentials between public and private, it is the time in the cycle. “Going back a few years, there was an arbitrage between private and public real estate, with a 20 percent to 25 percent premium for contributing real estate properties to companies going public,” McEvoy says. “Today, it is the opposite. Private markets are valuing real estate at a higher level than public markets.”
Listed REITs have had a great run, McEvoy says. “But now there is an arbitrage in value. Wall Street values real estate on the FFO (funds from operation) versus the private real estate model, which is really an internal rate of return. It’s enterprise value versus bricks and sticks.”
Flexible Rules the Day
Value Proposition