Saturday, April 24, 2010

REIT Merger Wave: Don't Hold Your Breath

Reprinted by permsion from REIT Wrap Special Report, April 14, 2010.

David Shulman*

The heated battle for General Growth Properties and the general increase in merger activity across corporate America has increased speculation that a new wave of REIT mergers will soon be upon us. Although certainly possible, don’t hold your breath. Simply put, with REITs trading at 130% of net asset value, according to Green Street Advisors, a Newport Beach, California-based buy-side boutique, it makes little sense for a REIT to pay 130 cents plus an acquisition premium and merger costs for 100 cents of assets. The more obvious play is to acquire assets in the private market for 100 cents which is now happening, albeit slowly.

Of course all of my investment banker friends, yes I do have friends in the banking community, would argue that an acquiring REIT can easily get around this issue by using their high-priced stock as an acquisition currency. In that case the acquirer would be paying with their own newly minted 130 cent dollars. It is not as simple, however. In order for a merger to be successful there has to be value creation for the acquiring company and merely purchasing assets does not create value unless the shares of the acquirer are truly over-valued (issuing what Warren Buffet has called “counterfeit currency”). In either case in order to create value the acquiring shareholders have to end up with more value at the end of the deal than at the start.

For instance if REIT A issues 25% of its stock to acquire REIT B, then upon completion of the transaction REIT A’s shareholders would own 80% of the newly combined company. Thus for the merger to work for REIT A’s shareholders 80% of A+B has to be worth more than 100% of A. This metric is a very high hurdle because, aside from the mall sector, there are no real economies of scale in REITland. Said differently it is very difficult for a REIT to create value though public-to-public mergers in the current environment. Yes there are savings to be had by “vaporizing” the G&A costs of the acquired company, but over time as firms grow larger the initial G&A savings wither away in the form of higher executive compensation and a larger bureaucracy. Indeed, the absence of economies of scale and the tendency for G&A to drift higher with firm size make it so difficult to point to successful public-to-public REIT mergers.

Nevertheless, the lure of using high priced stock for acquisitions is too hard for many REIT executives to resist. An easy way of disabusing them of this notion is to restructure the merger as a cash transaction. Would the buyer pay cash for an acquisition and fund it by a public offering of stock? From the point of view of the buyer this is no different than issuing stock directly to the seller. However, the fig leaf of directly using high-priced stock to pay for the acquisition would disappear and shareholders would be forced to look at the transaction’s true cost.

The discussion thus far has been generic so let’s focus in on the more micro issues as to who would be the buyers and sellers if there were to be a merger wave. It has been long known that there are too many small REITs trading in the marketplace that have no real reason to be public. Many of these companies would probably like to be acquired, but for too many obvious reasons there are no real bidders, especially at a significant premium to net asset value. If these companies weren’t taken over during the great privatization wave of 2004-07, when will they be taken over?

Moreover if you look at the larger companies in each sector it unlikely that a Vornado (VNO), Boston Properties (BXP) or a Brookfield (BPO) would buy a suburban office company. Any one of them might want to do a “strategic” deal in buying Los Angeles oriented Douglas Emmett (DEI), for example, but I doubt it would be for sale and if it were, it certainly wouldn’t come cheap. Remember in M&A parlance the word “strategic” is a synonym for overpay. It is also unlikely that an Equity Residential (EQR) or an Avalon Bay (AVB) would buy any of the smaller apartment REITs operating in the southeast or southwest.

In the case of the mall sector, there’s lots of speculation that once the General Growth saga is settled that “the loser” might be on the prowl for Macerich (MAC) or Taubman (TCO). We remember Simon (SPG)/Westfield’s (WDC) failed attempt to buy Taubman. But can you visualize Simon or Brookfield going after CBL & Associates (CBL) or Penn REIT (PEI) for example? Very unlikely.

That leaves the possibility of small- or medium- sized REITs buying each other. It is possible to visualize, for example, Camden (CPT) acquiring Post Properties (PPS) or Duke Realty (DRE) merging with Highwoods Properties (HIW) as well as M&A activity in the healthcare sector. Again all of these hypotheticals still have to overcome the merger issues I raised earlier.
For those reasons, it is my sense is that the “real M&A activity” will take place with public companies buying private assets. Although it is unlikely there will be the feeding frenzy that many though would emerge a year ago, many private assets will have to trade because they cannot support the capital structures they are burdened with. Some of these transactions will come in the form of purchasing whole companies that were privatized only a few years ago, but most will be in the form of one- off transactions such as the recent purchases of busted condominium projects by Equity Residential and Essex Property Trust (ESS). The economics of these one-off transactions are far preferable to buying an existing REIT at a 130%+ premium to net asset value.

Yes, the money spigots have opened to real estate investing and there are few bargains available in the private market for core real estate. Nevertheless, core assets might still be available at a “fair price” and non-core assets or core assets with leasing risk might offer significant opportunities for REITs with the appropriate skill sets. If I am close to the mark, then it looks like AMB Property Corp. (AMB) did exactly the right thing when it recently sold roughly $425 million in stock to make “…equity investments in co-investment funds, acquisitions of properties, portfolios of properties or interests in property-owning or real estate-related entities.”

*-David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and theUCLA Anderson Forecast. He can be contacted