The REIT market is being propelled by consolidation.
Mergers and acquisitions are still driving the real
estate investment trust (REIT) market, particularly in the office and
small-cap sector. Analysts and money managers believe that
consolidation in the industry will bode well for REITs this year,
albeit at a slower pace.
Following a sizzling five-year period that saw real estate stock prices more than double, REITs still were generating double-digit returns. At this writing more big deals were in the works.
Australia's Centro Properties Group had agreed to buy New Plan Excel Realty Trust for $3.4 billion. This is Centro's third acquisition in the past year. Health Care Property Investors offered to acquire Sunrise Senior Living for $1.4 billion, which is a 20% premium over Sunrise's stock price.
In addition, Simon Property Group and Farallon Capital Management LLC agreed to acquire The Mills Corporation for $1.6 billion. Meanwhile Credit Based Asset Servicing agreed to acquire Securitization and Fieldstone Investment Corp. at 112% of Fieldstone's stock closing price in mid-February.
David Siopack, managing director of Charles Schwab Investment Management in San Francisco, expects acquisitions to hit particularly the small-cap and mid-cap stock sector. Potential targets are about 25 companies with market capitalizations below $250 million and 50 companies with capitalizations up to $500 million.
REITs have been enjoying an attractive ride over the last five years, growing at a 24% annual rate, according to the National Association of Real Estate Investment Trusts (NAREIT) in Washington, D.C. Last year, the FTSE NAREIT Equity REIT Index gained 34%, to the surprise of many savants who thought they were already overextended. The major reasons for such attractive gains: low interest rates, institutional buying, a hot real estate market and mergers and acquisitions of publicly traded REITs.
REITs are attractive targets because "they give the acquirer an operating company with a diversified asset base, as well as skilled management," says Greg Sukenik, analyst with Zacks Equity Research in Chicago.
In 2006, there were 40 mergers and acquisitions representing a transaction value of $82.4 billion. One-third of the acquisitions were by private companies. The rest were public.
The acquisitions of publicly traded REITs by private companies were driven by low borrowing rates. Acquirers used higher leverage to buy public, less-leveraged REITs, making capitalization rates attractive. The acquirers then sell off properties and keep the most profitable commercial rentals for themselves.
Public companies that acquired REITs benefited from economies of scale and larger market share of properties with low vacancy rates and rising rental rates.
Most of the prior mergers and acquisitions were concentrated in office and retail space. Siopack expects more consolidation this year in these sectors, as well as hotels.
On average, target companies are acquired at a 15% premium over their stock prices by the time deals are consummated over a period of four to six weeks. Consolidation of the REIT market continues to bode well for real estate stock performance this year, particularly in the commercial real estate sector.
In December 2006, American Financial Realty Trust announced the sale of its 36-story State Street Financial Center office tower in Boston for $889 million. Meanwhile Morgan Stanley Real Estate sold apartment properties worth $677 million.
This year through February, there were a handful of acquisitions, the largest being a $39-billion leveraged buyout of Equity Office Properties by the Blackstone Group. The Blackstone Group won a bidding war with Vornado Realty Trust that saw Equity Office Properties' stock rise 40% before the deal was consummated.
Going forward, however, the pace of acquisitions should slow, Siopack says. This could adversely affect stock prices. But small REITs that can benefit from improved management efficiency are in play.
"It is tough to get extra added value out of an acquisition of large REITS," he says, adding that "2007 is expected to be an active year, but not along the lines of 2006. Mergers and acquisitions are not sustainable at that level."
Once takeover activity subsides, Siopack believes REIT fundamentals will moderate over the next few years. Real estate stock performance should exhibit regression to the mean.
Nevertheless, REITs are expected to deliver their historical rates of return, between 11% and 14% annually. Growing occupancy rates and rising rental rates should boost dividends and earnings over the longer term.
Other analysts believe that merger and acquisition activity will moderate. Moody's Investors Service expects acquisition activity will slow as institutional investors reach their target allocation for real estate and other asset classes.
"The question is whether the leveraged buyout of Equity Office Properties represents the high watermark, or the tip of the iceberg in leverage buyout activity," says Moody's analyst Christopher Wimmer. "The REIT privatization party may not be over, but it could be time to switch. The current conditions that have led to the spate of privatizations-lower interest rates, easy mortgage underwriting terms and capitalization rate compression-are sure to change."
J.D. Steinhilber, president of Agile Investing, a Nashville, Tenn., investment advisory firm, is less sanguine about REITs. The ratio of REIT stock prices to adjusted funds from operations (Price/AFFO) is 18.8, which is the highest multiple ever recorded for REITs. "The REIT asset class appears to have reached a valuation extreme that is likely to prevent any further appreciation without a sizable correction."
Joe Betlej, Ivy Real Estate Fund manager, is cautious. He believes the REIT market will go through a correction, but in the long term expects REITS to return at least 11% annually.
"Any time you have strong moves either way, you are setting up for greater volatility," he says. "REITS were up sharply the first month of this year. Now there is a correction. It's expected in any investment when you start getting to historical levels of valuation."
As long as economic growth continues and borrowing rates are attractive, the public real estate market probably will remain reasonable. So there will be more mergers with private companies. The downside: There are only limited universes of candidates that can be acquired.
Betlej says he is buying REITs on fundamentals, not on whether they will be merged or acquired. The fund's holdings are growing cash flows at a 9% annual rate and have high returns on capital compared with their peers.
He favors companies that show strong growth and operate where supply is constrained by such factors as high new-construction costs. He likes upscale hotels that cater to business travelers and corporate users.
These are hotels that can raise their room rates. Hilton Hotels is one of his largest holdings. The company merged with Hilton Group PLC, its international operating arm. Hilton now has one of the largest international portfolios in the hotel sector. The company sold off some properties last year. Sales and earnings are growing at 8% and 13%, respectively. The company is generating a high return on capital.
Betlej also likes REITs with regional malls, such as Forest City Enterprises. The REIT owns offices, apartments and regional malls. The company's earnings are growing at 12% annually and profit margins are 11%.
One of his recent acquisitions is BioMed Realty. The company provides laboratory space, of which there is a nationwide shortage, for the pharmaceutical and biomedical industries. BioMed Realty acquired 16 properties last year and expanded its laboratory rental space. Total revenue increased 59% and net income was up 105%. Earnings are expected to grow nearly 12% next year.
Glenn Mueller, Ph.D., real estate investment strategist with the Dividend Capital Group in Denver, expects 2007 to be a solid year for REITs as long as there is no recession or catalyst for a stock market crash. "The signals for 2007 keep changing each week for positives and negatives for the economy," Mueller says. "Housing starts down by 14% is the latest signal that the economy will slow in 2007, and thus interest rates should stay the same or fall slightly. This is good for commercial real estate, unless employment growth also slows below 100,000 jobs per month."
Mueller also favors the office-space market because there is no new construction. He's forecasting flat occupancy rates for 2007. However, rents should grow 5% and 4% in 2007 and 2008, respectively.
Apartment occupancy is benefiting from the high cost of single-family homes and problems in the homeowner loan market. The condo conversion craze has subsided. He expects rents to increase 5% and 3.5% in 2007 and 2008, respectively.
Industrial occupancy is also flat, but rents should increase 4% in 2007 and 2.5% in 2008.
Retail occupancy rates are expected to decline this year. A strong supply forecast and a moderating economy is causing shopping centers and malls to cut back on expansion. Nevertheless, rental income growth should grow at 4% and 2.5% in 2007 and 2008, respectively.
Hotel occupancy is forecasted to improve slightly in 2007. Revenues should grow 6% to 7%, in 2007 and 2008.
Large holdings of the Dividend Capital Realty Income Fund that Mueller favors include:
Brandywine Office. The company is growing earnings at 7% to 10% annually. Office properties are restricted in the areas in which it has rentals, and the company has high-quality tenants.
Archstone Smith. An apartment REIT, it is benefiting from people who can't afford to buy single-family homes, and is expected to grow earnings at 8% to 10% annually.