After a record year for REIT M&A Activity, What Will 2007 Hold?

By Dees Stribling

In 2006, REIT deal making was on fire. Hardly a month went by without one REIT absorbing another, or a phalanx of private investors succeeding in their bid to take a listed REIT private. According to SNL Financial, a little more than $30 billion in REIT mergers, acquisitions and privatization deals had been inked through the first half of 2006, compared with $28.8 billion in similar deals for all of 2005, and just $5.7 billion for all of 2004.

Why the flurry of REIT deals? A variety of reasons all contribute to create a strong business climate for M&A activity. REITs' urge to merge isn't necessarily so different from that of other companies in other industries. The acquiring companies want enhanced market share, or economies of scale that come with a larger portfolio, or an expanded geographic reach. As for the acquired companies, there's the prospect of "maximized shareholder value," that is, a pot of gold at the end of the REIT rainbow.

One example of a company that seemed to be angling for better market position through acquisition in 2006 was Lexington Corporate Properties Trust (NYSE: LXP), which signed a $1.9 billion deal to buy Newkirk RealtyTrust

Holdings of Trizec Properties were acquired by Brookfield Properties and Blackstone Group.

(NYSE: NKT) in July. Lexington, which owns office and industrial properties in 39 states, acquired a base of retail properties from Newkirk and an entry into important markets such as California and New Jersey.

In a conference call shortly after the deal was announced, Lexington chief executive officer T. Wilson Elgin noted that the merger would create "the largest pure-play single tenant REIT in a sector that is highly fragmented, and where size and scale create very good operating efficiencies."

When Kimco Realty Corporation (NYSE: KIM) agreed to acquire Pan Pacific Retail Properties (NYSE: PNP) in July, it greatly expanded its geographic presence, especially on the West Coast. Pan Pacific owned about 22.6 million square feet of shopping centers in Arizona, California, Washington and other Western states. Kimco owned a few properties in the region, but most of its holdings were in the Northeast and the South.

However, the deal was more than just a strategic geographic expansion. The move was part of the Kimco's stated strategy to greatly increase its emphasis on asset management. A good chunk of the properties acquired from Pan Pacific will eventually be transferred to an array of Kimco joint venture partners, leaving Kimco with management contracts.

Going Private

Even though 65 percent (as of Sept.) of M&A deals in 2006 were amongst public companies, the private arena got a lot of attention as well. REITs' privatization was also brisk in 2006, with a number of factors converging to drive deals. First and foremost is the still-enormous volume of capital looking for a home, according to REIT observers.

"Insurance, pension funds, overseas capital—everyone wants real estate these days," says Stephen Swett, an analyst with Wachovia Securities. "Everyone sees REITs as an efficient way of building their real estate holdings, especially in the billion-dollar leagues."

For example, when DRA Advisors LLC acquired Capital Automotive REIT in a deal finalized in the last weeks of 2005, it represented a good opportunity for private equity player DRA to place $3.8 billion all in one go. For that price, DRA and the joint venture it formed with Capital Automotive's management received more than 350 retail properties focused on auto sales, totaling roughly 15 million square feet.

Properties of Reckson Associates will become a part of SL Green once the deal is complete.

"It would have taken an investor five or 10 years to put together a portfolio even remotely like Capital Automotive's," says Brian Hansen, director of the investment banking group of A.G. Edwards & Sons. "Why devote time and energy in pursuing smaller deals when you can have the whole pie?"

Not only is there a mass of capital looking for placement, but investors say they perceive that the public markets have undervalued REITs for some time now. "Private investors this year still saw opportunities to pick up not only portfolios, but management expertise, and at a good price," says Lou Taylor, senior real estate analyst at Deutsche Bank.

"Real estate has become an institutional class of investment," says David B. Rodgers, a REIT equity research analyst with RBC Capital Markets. "This year investors have been looking hard for unrealized value—value that the public markets haven't acknowledged."

Hansen agrees. "There's a divide between valuations in the public and private markets," he says. "In some cases, the valuation of a REIT has been cheaper than the underlying assets, so naturally capital is going to seek out deals in those kinds of situations."

The Big Kahuna of 2006 A deal among deals in 2006 in terms of size was the June transaction involving Brookfield Properties Corp. (NYSE: BPO), Blackstone Group LP and their acquisition target, Trizec Properties Inc. Brookfield was already a significant office landlord in the United States with 48 million square feet of space in 67 properties when it joined forces with Blackstone Group to buy Trizec Properties Inc. and Trizec Canada for about $4.8 billion in cash and $4.1 in assumed debt. At the time of the merger, Trizec's portfolio consisted of 61 office buildings totaling approximately 36 million square feet, and Trizec Canada participated in U.S. real estate primarily through owning approximately 38 percent of Trizec. Late last year, Trizec bought a significant piece of Arden Realty Inc. as most of the rest of the company was bought by GE Real Estate. All together, Trizec acquired 4.1 million square feet—properties in west Los Angeles and San Diego—for about $1.6 billion. In the Brookfield-Blackstone purchase of Trizec, the purchaser was technically a joint venture owned by Brookfield and Blackstone that bought all of Trizec's shares at $29.01 per share and all of Trizec Canada's at $30.97 U.S. per share. The JV was financed with equity contributions of $1.3 billion by Brookfield Properties and various institutional partners, with the balance provided by Blackstone. Brookfield and Blackstone have divided management and operation of the properties acquired from Trizec, with Brookfield taking 18.5 million square feet in Houston, downtown Los Angeles, New York and Washington, D.C. Blackstone is managing and operating 5.4 million square feet in west Los Angeles, New York City and San Diego, according to both companies. The per-share prices paid by the buyers represented a premium of approximately 18 percent over Trizec's closing stock price of $24.60 per share just before the announcement. It was a significant, but hardly the only, example of private investors valuing a REIT significantly in excess of its public-market valuation. Trizec's president and CEO Tim Callahan offered a similar opinion in a statement at the time the deal was announced. "The company continues to be undervalued in the public markets," he said. "In recognizing the underlying value of the company's office portfolio, and especially its operating platform, the transaction maximizes stockholder value."

A disconnect between real estate fundamentals and REIT stock prices is nothing new, Swett says. "In the late 1990s, investors didn't want REIT stocks because they weren't tech-savvy enough, though fundaments were great. In the last recession, fundamentals were weaker but REIT prices went up. Real estate stocks typically don't trade tied to underlying valuations."

Privatization also has other perceived investor benefits, both financially and in some cases regulatory. Once private, ownership is typically freer to pursue expansion through higher leverage than public owners can use, Taylor says.

Private owners also are free of various kinds of government scrutiny, up to and including the relatively new Sarbanes-Oxley restrictions, though that particular law seems to have more cost impact on smaller companies than larger ones. Larger companies typically have more resources to devote to compliance. "Among smaller companies, the burdens of Sarbanes-Oxley are much more likely to be a factor in considering a sale or privatization," Hansen says.

Acquisitions Overseas

In some cases, M&A activity wasn't even confined to domestic deals. Archstone-Smith (NYSE: ASN) struck a deal in June to acquire Stuttgart-based Deutsche WohnAnlage GmbH (known as DeWAG) for about $649 million (€518 million). DeWAG, a public company, specializes in the acquisition and ownership of multifamily residential properties in Germany.

At the time of the acquisition, DeWAG owned roughly 7,600 housing units in more than 50 different German cities and suburbs. For Archstone-Smith, the deal represented an augmentation of its position in the German market, coming in the wake of the REIT's purchase of a 657-unit apartment portfolio in Berlin earlier in the year, and an 822-unit portfolio in Mannheim late in 2005.

According to R. Scot Sellers, chairman and CEO of Archstone-Smith, the acquisition was spurred by conditions within the German residential real estate market. "Germany has a low home ownership rate, and rental rates are affordable for the majority of the population, providing significant room for future increases," he says. He also noted that the DeWAG deal represented a chance for Archstone to acquire assets at a "significant discount" to replacement cost.

Deals of Fortune The frenetic pace of REIT transactions continues in 2006, as a staggering number of companies announced intentions to merge, acquire or sell. On July 23, Lexington Corporate Properties Trust (NYSE: LXP) announced an intention to purchase fellow diversified-REIT Newkirk Realty Trust, Inc. (NYSE: NKT) with a $20.97 per share closing price. The newly named Lexington Realty Trust will be an amalgamation of each REIT's management teams and will focus on single-tenant properties. In a note commenting on the deal, Ryan Beck & Co. REIT analyst Shelia McGrath said, "Stepping back and looking at the transaction from a pure real estate basis, we view the transaction as an attractive one." Also in July, GMH Communities Trust (NYSE: GCT) announced its preparation to solicit acquisition bids for some or its entire portfolio, trading at $13.05 at press time. Paul Puryear, a managing director of real estate research with Raymond James & Associates says this company's turn of events is not surprising. "GMH's stock price has been hit and has dropped below its IPO price from two years ago," Puryear says. "The company has lost its multiple and it perceives that it would be awhile before it could be earned back." As GMH possesses both campus apartments and military housing as part of its portfolio, Puryear says the company could realize value through selling its military properties while retaining the campus apartments. "Splitting the portfolio up would make the company more attractive, especially since there's good demand for college housing assets right now," he says. On Aug. 31 BNP Residential Properties (NYSE: BNP) announced that Australian property firm Babcock & Brown had acquired its portfolio of 31 apartment communities and 40 restaurant properties for $315 million. This deal is also expected to close by the fourth quarter. With the fall season came more transaction announcements from the health care sector. On Sept. 8, Ventas, Inc. (NYSE: VTR) announced its definitive agreement to acquire 67 health care and senior housing properties for approximately $649 million. Upon the deal's expected completion in the fourth quarter, Ventas will lease the properties to a subsidiary of the tenant, Senior Care, Inc. On Sept. 13, Health Care REIT, Inc. (NYSE: HCN) announced its agreement to purchase Windrose Medical Properties Trust (NYSE: WRS) for $877 million. During a conference call announcing the merger, Health Care REIT Chairman and CEO George Chapman said his company's deal fits within its objective to take advantage of a full spectrum of senior housing and health care investments. "Through the combination with Windrose's portfolio, we obtained a critical new mass in a targeted asset class that otherwise could take four or five years to build," Chapman says. "Together, we have the ability to provide a wide spectrum of property management and development capabilities, the potential for increased investment volumes and the opportunity to lower our cost of capital." On Sept. 18, Hospitality Properties Trust (NYSE: HPT) agreed to purchase TravelCenters of America Inc. for approximately $1.9 billion. The deal comes just four months after TravelCenters reaffirmed its commitment to seek out a new investor to help finance its growth strategies. "As was the case with previous ownership transitions, we expect business as usual at all TA TravelCenters locations," Tim Doane, president and CEO of TA says. "As we expand and enhance our services, we will continue to offer fleets, owner-operators and motorists the highest-quality travel center services available." On Sept. 20, GEO Group Inc. announced that they agreed to purchase CentraCore Properties Trust (NYSE: CVP) for $356.1 million. The deal will give GEO 13 correctional facilities, which totals more than 8,000 beds. On OCT. 5, Health Care Property Investors Inc. (NYSE: HCP) completed its acquisition of CNL Retirement Properties Inc. for $5.3 billion.

Scott Farb, managing principal of the national real estate practice at the Santa Monica, Calif.-based accountancy of Gumbiner Savett Inc. expects that more international M&A will likely take place as other countries formalize structures equivalent to U.S. REITs. That's because REIT-like vehicles represent liquidity in overseas real estate, as well as transparency of financial information—a more familiar target. REIT-like vehicles are in place or nearly in place in some western European and east Asian countries, along with Canada, Mexico, Brazil and Australia.

Overseas REIT-equivalents also are interested in buying U.S. REITs, if recent transactions are harbingers of things to come. Australian listed property trusts, which Farb says are one of the "most established" overseas REIT structures, were particularly active in 2006.

In the summer, the Australian limited property trust Centro Properties Group agreed to buy Heritage Property Investment Trust (NYSE: HTG), owner of more than 150 supermarket-anchored properties totaling 28.7 million square feet, in a $3.2 billion U.S. deal, which more than doubles Centro's holdings in the United States to approximately 49 million square feet.

According to Centro, most of the acquired assets will be moved into funds that it co-owns or manages. "The pipeline of available assets coming to us through this deal is significant and the assets are very appropriate for those investment opportunities," Centro CEO Andrew Scott said during a conference call after the deal was announced.

In September, Babcock & Brown Australia Pty. Ltd., another listed property trust from Down Under, agreed to buy BNP Residential Properties Inc., a U.S. REIT specializing in multifamily properties on the Eastern Seaboard. The Australians will pay $756 million for the company and its 8,180 apartments.

Jumping into the Trend

The momentum for acquisitions and privatization also affected other REITs, especially those that specialize in properties outside the main real estate food groups. For instance, in August Morgan Stanley Real Estate agreed to buy Glenborough Realty Trust (NYSE: GLB) for about $1.9 billion in cash.

Though not tiny, Glenborough isn't among the largest office REITs, owning 45 office properties totaling about 8 million square feet in Boston, California, New Jersey and Washington, D.C. Morgan Stanley was willing to offer more than the public market valuation, paying approximately 8.2 percent over the Glenborough's closing price before the deal.

The purchase came on the heels of another August acquisition by Morgan Stanley. In that deal, the investment giant bought Saxon Capital Inc. (NYSE: SAX), a residential mortgage REIT, for $706 million.

At the time of the deal, Saxon serviced about $26 billion of non-prime residential mortgage loans. Saxon also purchases, originates and securitizes non-prime residential mortgages, with a mortgage loan portfolio of about $6.5 billion. Subprime lending is a business into which Morgan Stanley wanted to expand, as evidenced by the fact that it was willing to pony up a 29 percent premium to Saxon's last closing share price for the opportunity to use Saxon as a base for that expansion.

In a REIT merger that represented a major consolidation in a property sector, Public Storage Inc. (NYSE: PSA), completed its acquisition of Shurgard Storage Centers Inc. for about $5.5 billion in August. The transaction further expands the nation's largest self-storage company, bringing its ownership to about 2,100 facilities in 38 states and seven European nations.

Public Storage, like Morgan Stanley in buying Saxon, paid quite a premium over Shurgard's final closing price, some 39 percent. When asked about the steep price during a conference call, Public Storage president and CEO Ronald Havner Jr. simply said that both companies know the self-storage industry extremely well, "and both companies have concluded that it's an appropriate consideration." In other words, it's worth it to be number one in your niche.

A Look into 2007

Opinion is mixed on whether the momentum of thisyear's wave of acquisitions can continue into next year. Will 2007 offer even more opportunities for M&A and privatization?

"We believe the news confirms that capital remains available for property investment. We would not be surprised to see more transactions, particularly in the office sector," says Lehman Brothers analyst David Harris on the Trizec deal this year.

Other property types may not maintain their momentum, however. "It will be harder to do these kinds of deals in the multifamily sector," Wachovia's Stephen Swett says. "Stocks in the sector have gone up, but can they move higher from here? Can the sector provide the earnings growth investors want to see? These are still open questions."

Deutsche Bank's Taylor says that M&A in various property sectors probably will continue, but he doubts there will be quite as many large deals as this year. "There are still many smaller REITs to be acquired, but I doubt that the pace of huge deals will be so brisk in 2007," he says. "There are only so many of those to be done."