IPOs have fallen off in the last four years. Are they primed for a comeback?

By Allen Kenney

Just four years ago, initial public offerings were the stars of the real estate show. Lately, they've been demoted to the side stages.

Twenty-nine companies went public in 2004, raising $8 billion in capital, according to data from NAREIT and SNL Financial. By 2007, that number had dwindled to four, with $1.8 billion raised.

In fact, it has become more likely for a REIT to de-list than for a new company to show up on the stock exchanges.

"Starting in late 2005 and picking up in 2006, there was a lot of REIT privatization activity," says Jason Lail, senior research analyst in SNL Financial's real estate group.

As the latest shifts in the financial markets come to bear, however, industry observers are starting to wonder if going public is ready for a renaissance.

"IPO activity could easily be a major theme within a year or so," says Mike Kirby, chairman and director of research for Green Street Advisors.

Like aging rockers dusting off their greatest hits, it's hard to imagine real estate IPOs gaining the same energy they had in their heyday. But that doesn't mean a comeback tour is out of the question.

Take It Easy

To understand why IPOs might make a comeback, it's helpful to identify the factors at play in real estate environments that are more amenable to private companies.

"To some extent, the reasons for the lack of IPOs are the same as the reasons REITs have been sold off and gone private," says Bryan Cave LLP's Alan Pearce, a partner who specializes in representing REITs.

Typically, private equity ventures tend to be much more highly leveraged than REITs, which face public market mandates to hold down their debt load. Loading up on debt provides companies with opportunities to achieve higher returns on their equity investments by capturing the gains on the spread between the cost of financing and expected returns on an asset. For instance, a company might be able to borrow money at a 3 percent interest rate to purchase an asset with an expected return of 7 percent, enabling the company to profit from the 4 percentage point difference.

In an "easy money" environment rife with enthusiastic lenders, private companies are able to capitalize on an abundance of low-interest borrowing to finance acquisition and growth. Access to low-cost lending means private companies can afford to pay higher premiums on potential acquisitions, giving them a leg up on REITs in bidding wars. "There was clearly a difference between what private and public investors were willing to pay for assets with the arbitrage created by cheap debt," Lail says.

The widening gap between the cost of debt and expected returns can provide enticing deal-making opportunities. On top of all that, private companies aren't subject to the public and regulatory scrutiny faced by publicly traded companies.

In that context, the IPO slowdown of recent years is easily explainable, according to Peter Slatin, editorial director of Real Capital Analytics.

"There has been a lack of IPOs because in the past few years, REITs have been on the losing end of most property bidding wars," he says. "REITs have been low on the totem pole of the capital stack of buyers."

In other words, real estate companies haven't had much reason to seek out capital through the public markets. Even distressed companies were better off refinancing their debt than they were going public to raise capital. In fact, it was more likely that a public company would be bought out and taken private.

"Easy capital fueled the leveraged buyer to move to real estate," says Lisa Sarajian, managing director of Standard & Poor's real estate finance group. "In that kind of environment in early 2007, if you're a real estate owner and there's a leveraged buyer out there that will pay up to get your assets, why would you go public?"

Kirby and Lail contend that pricing also has played a significant role in the recent dearth of IPOs. "In the past you've seen REITs trading at a premium to net asset value, but lower valuations make going public less appealing," Lail says.

Kirby maintains that "public investors collectively believe real estate values have further to fall." He notes that REIT stocks have been trading at "sizable discounts" to their net asset values—on the order of 15 percent, according to SNL Financial. Consequently, the capital acquired through an IPO would be of limited value to a company.

"IPOs make no sense in that environment," he says.

Stunning Debuts

Compare this most recent private equity boom to periods when going public was in vogue, such as the early half of the 1990s. More than 40 REITs completed IPOs in 1993, followed by more than 30 in 1994.

As the United States eased out of a significant economic recession, the surviving real estate operators were waking up to a brand new day. Their portfolios were intact. They hadn't gone bankrupt. The overall economic picture was improving, along with the real estate operating picture. Maybe best of all, not-so-lucky property owners were distressed and looking to sell.

"You had all these borrowers who had survived, they saw these growth opportunities in front of them and they wanted to tap capital to grow," Sarajian says.

The problem? Banks hadn't healed quite so quickly from the savings-and-loan-fueled financial crisis and weren't ready to satisfy the lending demand.

The solution? Go public. "These companies were pushed into the public marketplace and went public through IPOs, because that was the only place to go for capital," Sarajian says. "The capital was on Wall Street, not Main Street, because the banks were still licking their wounds from the savings-and-loan crisis."

Additionally, Sarajian says, some companies had mortgages coming due and were hoping to refinance their loans. In such instances, an IPO made for a palatable alternative to the locked-down credit markets.

"When all of these companies started forming REITs in the 1990s, they had no way of refinancing. That forced them to go public," Pearce says.

Back in the Black

While the current economic environment may not exactly mirror that of the two-year IPO upswing in the early 1990s, there are enough similarities to suggest companies could soon make IPOs fashionable again.

"One thing we do know is that the tolerance for very highly leveraged real estate has changed very dramatically in a relatively short period of time," Sarajian says. "Since the credit crunch began in August 2007, the game has definitely changed dramatically."

Sarajian says the cheap borrowing and "frothy" real estate valuations that persisted between 2005 and the early half of 2007 paved the way for transactions like The Blackstone Group's much publicized acquisition of Equity Office Properties Trust in February 2007 for $39 billion, the largest leveraged buyout in history. Blackstone's all-cash offer for Equity Office's portfolio was able to trump a higher proposal from Vornado Realty Trust (NYSE: VNO) consisting of both cash and stock. Blackstone financed its bid using $31 billion in debt, leaving the company with an equity stake estimated at less than 15 percent of the company's assets. REITs, in contrast, usually prefer a leverage ratio closer to 50 percent or 60 percent in such transactions.

Private equity groups' fleeting fame came to a "screeching halt" soon after the Equity Office take-private, according to Kirby, primarily because of their focus on leveraged returns. "The credit crunch caused interest rates to move higher, and at the same time, bankers remembered that deals should actually have equity in them. Therefore, leveraged returns available to private equity players have plummeted," Kirby says.

Data from the Federal Reserve Board's latest survey of senior loan officers on banks' lending practices illustrate the dramatic swings in the sector in the last four years. Beginning in the first quarter of 2004, the data shows that lending institutions as a whole began to ease their credit standards for commercial real estate borrowers, a trend that continued up until the end of 2005.

According to the Fed data, however, lending practices began to reverse course in early 2006 and saw the most dramatic developments in the fourth quarter of 2007, when 50 percent of survey respondents reported ratcheting up lending standards. Approximately 80 percent of domestic banks reported tightening their lending standards for commercial real estate in each of the first two quarters of 2008. A separate sample of major lenders revealed that one-third said their banks' credit standards for approving commercial real estate loans had "tightened considerably." The survey also showed that almost half of the domestic banks and 45 percent of foreign lenders reported decreased demand for such loans during that period.

As interest rates creep up, that attractive spread on expected return begins to shrink. Additionally, if banks grow hesitant about lending, all of that once-cheap debt dries up. As such, an IPO becomes more attractive to a growth-hungry company, much like it did during the early 1990s, according to Sarajian.

"The supposition that you could see more companies go public is not unreasonable," she says. "Once again, you do have some healthy borrowers or operators looking to tap the capital markets."

To acquire the debt that will be available in the present market, being a publicly traded company actually should provide a "huge competitive advantage" to REITs over private companies, according to Kirby. With commercial mortgage-backed securities (CMBS) remaining frozen for the time being, he says, accessing the secured debt market is a foreboding proposition for private companies.

In contrast, as the unsecured debt markets have started to thaw, REITs have found a lending market that is growing increasingly more hospitable. And Kirby foresees a significant portion of the assets acquired in the last few years making their way back onto the market, touching off more potential bidding wars. All of which bodes well for REITs and could spur IPO activity, he says.

"If real estate values continue to fall, it is easy to envision a day when public-market values exceed private-market values," he says. "At about the same time, many private-equity and opportunistic players may need to unwind some of the large portfolios that they purchased in the last few years. Much of the real estate that went private in recent years is likely to be public at some point down the road."

Even when the credit markets are set back in motion, Slatin speculates that the latest downturn will have a lasting impact on the commercial real estate industry. It might remind companies why REITs shot up the charts in the first place.

"Even when the credit crunch lessens, we won't see a return to the kind of private equity activity we saw before," he says. "REITs provide a more stable basis for property acquisition and management these days."