Grabbing the baby from the bathwater

Over the past year, investors have fled real estate investment trusts, lumping them in with fears about the subprime meltdown and the housing market. Now REITs are on the rise again, but they are still trading at discounts. Could this be the perfect time for some public-to-private buyouts? By Dave Keating

Public-to-private buyouts. The Blackstone Group's mammoth $39 billion (€30 billion) take-private of Equity Office Properties in early 2007 was only the largest example in a trend of private equity-backed takeovers of public real estate investment trusts. Before that deal, Blackstone had also teamed with Brookfield Properties to acquire Trizec Properties in a deal valued at $7.2 billion. And in May of last year, Tishman Speyer and Lehman Brothers announced a $22 billion bid for multi-family REIT Archstone-Smith. In fact, not. According to news reports, 15 percent of US REITs were de-listed in the second half of 2006 and the first half of 2007.

“There was a lot of publicity about the subprime sector problems and problems in the housing market, and perhaps in people's minds it all got lumped together with real estate, even though it's a separate industry with separate metrics.”

Of course, hindsight is a wonderful thing, but as it turns out these take-privates may have jumped the gun a bit. At the time, these private equity buyers may not have appreciated the full impact that the coming subprime crisis would have on the value of REITs in the United States. Starting in March of last year, REITs began to start seeing an increasing outflow of investment as people became concerned about what they were hearing regarding the subprime situation and how it would affect the housing market. But it wasn't until the summer of 2007 that the decline really started to take hold. When the markets became engulfed in the credit crisis and homeowners started defaulting on their mortgages, investors started pulling out of REITs by the boatload, thinking the stocks would be affected. By the end of the 2007, US REIT stock prices had lost 15.7 percent of their value.

“There was a lot of publicity about the subprime sector problems and problems in the housing market, and perhaps in people's minds it all got lumped together with real estate, even though it's a separate industry with separate metrics,” says Frederic Leffel, an attorney with New York-based law firm Savills Granite.

All of this led to a situation where, by December 2007, REITs were trading at a 24 percent discount to net asset value, according to research firm Green Street Advisors. Perhaps some of those private equity firms that took REITs private at the end of 2006 are wishing they had waited a little longer.

“In retrospect that was the height of the market,” says Leffel. “The prices were then at a premium to underlying asset value. Now we're in a situation which is the opposite of that.”

Of course in Blackstone's case it doesn't much matter because they had a massive sell-off of Equity Office's assets almost immediately after taking the REIT private. But considering the REIT was at a premium to net asset value (NAV) when it was bought, some of those properties may have gone for more than they're worth, and the buyers could now be left holding the bag.

REITs on the rise
Since the New Year struck however it's been a different story. Investors seem to have changed their minds about REITs, realizing that troubles in the subprime sector are not likely to affect the performance of this long-term play, and that the property assets in these portfolios are not necessarily connected to the market troubles. According to a recent research note from Keefe, Bruyette & Woods, March was the third consecutive month of positive inflows into US REITs, following 10 straight months of outflows before January that ranged from $150 million one month to $2.8 billion in another.

REITs are now heading in the opposite direction from their stock index counterparts. From the beginning of the year to May the equity REIT index gained about seven percent at the same time that the Dow Jones Industrial Average fell around 3.5 percent and the Standard & Poor's fell about 4.5 percent. REITs are still trading at a discount to their NAV but with institutional investors feeling that REITs are going to be okay, now could be the perfect time for a buyout.

“Last month [in April] REITs were trading at negative 20 percent to NAV,” says David Lynn, a managing director for research and investment strategy with ING Clarion Real Estate. “Now [in May] it's minus 10 percent. The investment community is realizing there was too much of a risk premium factored in there. So there's a good opportunity for the rest of the year. But I don't think you'll see the 20 percent discount again.”

“Before, some investors probably didn't want to catch a falling knife, they didn't want to get into the REIT market if those values were going to drop even further, or if fundamentals were going to worsen considerably” he continues. “But once you see that inflection point, you'll see investors come in.”

However those buyouts are unlikely to come again in the form of a massive take-private like Blackstone's Equity Office transaction. For one thing, jitteriness over the current state of US real estate would probably prevent such a massive transaction from being conceivable. For another, the buy and sell-off approach used by Blackstone would be unlikely to work in the current climate.

“I would be very surprised if we saw another Equity Officetype transaction,” says Leffel. “It would be tough to put together very large transactions like that that make sense. You can't count on your ability to bust up and sell off those assets anymore.”

Instead, private equity buyers looking into potential REIT buyouts will likely be looking at a holding strategy rather than a buy-and-sell one. Leffel says there are likely many REIT managers who are very interested in going private right now, and equally as many private equity fund managers who would like to take them there. But the deals that will work in the current environment will be smaller, targeted toward reorganization strategies and more focused on long-term strategy for the assets.

“There are a lot of small REITs that are struggling and shouldn't be public, and some of those managements would be eager to get out,” he says. “They're spending far too much of their resources on compliance, and the public structure is unwieldy for some of the small- and middle-cap companies. On the other hand, there are some companies that could be restructured. Their assets could have been cobbled together when they became a REIT, and it might be best now to untangle that. Or there may be some companies that are overleveraged, and they could be taken private to deleverage some of their assets.”

By sector, apartment and healthcare REITs have remained popular. The office sector is coming with a lot of uncertainty these days, and office REITs have reflected this uncertainty. Office vacancies are increasing in most markets across the US, and it is thought that many office landlords will have to lower rents to attract tenants and keep them in the building.

Equity REIT earnings in Q1 2008

% Above/below % change in Consensus % Same Store NOI
Sector consensus, average guidance, average change, average growth, average
Office 2.6 0 0.4 5.2
Office/Industrial 0.8 3.9 2.5 0.4
Industrial 2.9 0.2 0.5 2.1
Regional Mall 1.7 0.3 0 3.5
Shopping Center 1.9 0 -0.3 1.5
Self Storage -0.6 0 0 3.1
Triple Net 2.1 -1.4 0.1 N/A
Multifamily 1.3 0.5 0.1 4.1
Healthcare 0.7 1.6 0.2 N/A
Student Housing -19.4 0 -0.8 4.2
Hotel 1.2 -0.9 1 N/A

New REITs on the block
In continental Europe, several countries such as Finland, Italy and Germany have either recently introduced REIT programs or are about to. Despite the fact that the last year has seen a temporary retreat from these vehicles, many countries are continuing to plow full-speed ahead with plans to institute REIT frameworks. Both India and China are considering starting REIT programs in those countries, with India maybe instituting such a scheme by the end of this year.

However, even though these new programs will present another exit opportunity, circumstances seem to suggest that now is not the best time to be looking toward creating REITs for an exit, whether under a new or existing system. In India, even if the new system goes into effect there will be much uncertainty around it given some of the recent turbulence with publicly traded real estate companies, particularly the dramatic withdrawl of the Emaar MGF IPO.

In the US, the timing also doesn't seem great to be bundling up a portfolio of assets and exiting them via a REIT. With valuations still so low, but on the rise, such a strategy would likely be better for a later date. “The appetite would not be great right now for an underwriter to take a company public,” says Leffel. “There's been so little in new issuance.”

There will be many private equity firms, both those interested in buying out a REIT and those interested in creating one down the line, that will be watching the situation closely over the next few months. The worst may not be over for the subprime shock, and though REITs globally seem to be steadying, another jolt could spook valuations down once again. For now though, it appears that conditions may be good for a wellexecuted REIT buyout.