REITs of spring

Through acquisitions and new platforms, real estate investment trusts and private equity real estate funds are increasingly crossing paths. By Aaron Lovell

In the words of one industry analyst, a real estate investment trust (REIT) is little more than a “box on a tax form.” Nevertheless, those little boxes have recently been at the center of some high-profile private equity real estate deals.

Public REITs are real estate companies taking advantage of a financial structure that offers the owners certain tax considerations—as well as guaranteed dividends for shareholders. As interest in the property sector has grown, REIT stocks have offered an easy—and oftentimes lucrative—entrée to the asset class for individual investors.

But increasingly, REITS have been taken off the public market by investment firms, other REITs, large state pensions and private equity real estate funds. Last month, the trend seemed to hit full-stride when the real estate arm of New York-based private equity firm The Blackstone Group acquired CarrAmerica for $5.6 billion in what is believed to be the largest take-private REIT deal ever. The transaction netted Blackstone 285 office properties—about 26.3 million square feet—located in 12 US markets, including Los Angeles, Dallas and Chicago, in addition to a sizeable presence in CarrAmerica's home market of Washington DC. The CarrAmerica acquisition was not even Blackstone's first REIT deal of 2006—in February, the firm paid $2.6 billion for hospitality REIT MeriStar.

The CarrAmerica transaction turned heads because of its size and the parties involved—but it was really only the latest purchase in an ongoing REIT shopping spree. There have already been a number of REIT buyouts in 2006: Chicagoland industrial-focused CenterPoint was acquired by the California Public Employees' Retirement System and LaSalle Investment Management for $3.4 billion and California-based LBA Realty paid $430 million for office and industrial REIT Bedford Property Investors. M&A activity remains steady in the sector as well, with two self-storage REITS, Seattle-based Shurgard Storage Centers and Public Storage of Glendale, California, completing a recent merger.

Not only have the deals been grabbing headlines, in some cases they've also touched off bidding wars. When Morgan Stanley and Onex Real Estate first approached Baltimore-based multi-family REIT Town and Country, they offered a per-share price of $33.90; the consortium's initial bid set off a flurry of activity, as competing firms began gunning for the apartment portfolio. Morgan Stanley and Onex eventually prevailed, but not before the price per share hit the $40 mark.

REIT-mania had arrived.

According to the National Association of Real Estate Investment Trusts, listed REIT returns, including dividends, are up 9.8 percent in 2006, compared with a 2.2 percent showing by the S&P 500 index. But the good performance in the public markets is only part of the story. Even at the values that certain REIT stocks are trading at, private equity firms seem to value them even more. In the CarrAmerica deal, for example, Blackstone paid stockholders $44.75 a share—a price that represented an 18.5 percent premium over the share's closing price the day takeover talks started to circulate.

“The public markets—through the way share price is arrived at—value the assets one way,” says Bruce Schonbraun, a managing partner of The Schonbraun McCann Group, a US real estate financial consulting firm. “The [private] investors value it another way. The buyers of the REIT believe the value of the underlying asset is greater than the equity capitalization that the market is attributing to it.”

In other words, the cost of capital in the public markets is greater than the cost of capital in the private markets—and private equity buyers are taking advantage of that perceived arbitrage. As a contrast, Gary Koster, a partner in the real estate, hospitality and construction group at Ernst & Young, points to the 1980s when the exact opposite occurred and private companies increasingly went public.

“Every [real estate company] plowed into the public sector,” Koster says. “Money was cheaper than in the private arena. The reverse is true today. Private institutional investors are willing to pay more for the bricks and mortar than the stockholders— which is saying something.”

Private equity real estate funds are also taking a page from their siblings in the leveraged buyout world, who have been targeting larger and larger publicly traded companies in recent years. As the amount of capital entering the market increases and investment opportunities in smaller and mid-sized assets dries up, firms are naturally looking for bigger targets where competition is limited. At the same time, some of the most wellknown opportunity funds are amassing much larger pools of capital, enabling them to put hundreds of millions of dollars to work in a single transaction. REITs, some of whom hold assets worth billions of dollars, become increasingly attractive takeover candidates.

“It's much more efficient to pick up assets in big blocks,” says Louis Wolfowitz, the managing director of real estate securities research at global real estate services firm Cushman and Wakefield.

Once publicly traded entities are taken private, there are other potential benefits for an acquirer. For one thing, public companies are often constrained from what they can do by the perceived need to hit their earnings forecasts. As Tim Works, senior portfolio manager at Colorado Public Employees' Retirement Association, told a panel at a recent conference in San Francisco, REITs are “focusing solely on the next 90 days to the detriment of long-term value.”

Once taken private, not only can the REIT “focus more on true value creation rather than quarterly earnings,” according to Works, they can also slash a number of costs, from Sarbanes Oxley infrastructure needs to the postage on mailing prospectuses to shareholders. Almost immediately, many legal fees, reporting obligations and investor relations responsibilities can be removed.

“There is a pretty heavy ‘public company price,’” Wolfowitz says.

In addition to more robust cash flow, there is also increased flexibility in how REITs are financed once they are taken private. On the public markets, REITs are legally constrained as to how much debt they can take on; private owners, by contrast, are free to lever up the acquired assets as high as lending institutions will allow.

“When you own an asset direct, you want to finance it as much as you can,” says Cushman's Wolfowitz.

Schonbraun points out that a private company also has much more latitude in how it runs and manages its business, streamlining its operations or shedding unprofitable assets away from the public glare. “[Private equity funds] can slice and dice and chop up companies,” he says.

For example, when a private equity firm acquires a REIT, it is faced with a decision regarding the portfolio's assets: do they liquidate the properties over a period of time or do they acquire the REIT, continue to operate the business and grow underlying cash flows?

The latter option, says Wolfowitz, demonstrates a strong belief in the management team, which should be less constrained then when it was running a publicly held company. “You're giving them more flexibility because they're no longer operating in a fish tank,” he says. He adds that in today's market there is increasingly a propensity towards the buyand-operate model.

“It's tough right now to push a buy-andliquidate strategy,” he says. “You're buying pretty expensive right now.”

THE BILLIONAIRES' CLUBSelected public-to-private REIT deals, 2005-2006

Date REIT Strategy Acquirer Price ($ bn)
Mar-06 CarrAmerica US office Blackstone $5.6
Mar-06 Town & Country Eastern US multi-family Morgan Stanley/Onex $1.3
Feb-06 Meristar Hospitality US hotel Blackstone $2.6
Feb-06 AMLI Residential US multi-family Morgan Stanley Prime $2.1
Jun-05 Gables Residential Southern US multi-family ING Clarion Partners $2.8

In the latest example of convergence, publicly traded REITs are launching their own private equity real estate funds.

While private equity real estate firms are responding to growing institutional investor appetite by acquiring and launching REITs, some listed REITs have taken the opposite approach—launching their own private equity funds.

Leading the way, industrial REITs like Denver, Colorado-based ProLogis and San Francisco-based AMB Property Corporation, have incorporated the private equity fund model into their overall investment strategy. Last year, for example, AMB launched a $2.2 billion (€1.8 billion) fund focused on Japan, with 13 institutional investors chipping in $446 million, or 80 percent, of the fund's total equity. The fund has already begun purchasing stabilized, income-generating properties throughout the country.

ProLogis has also launched funds in a number of markets, including two Japan-based funds, both joint ventures with the investment arm of the Government of Singapore, to invest in Japanese logistics facilities. Earlier this year, the REIT launched its latest fund, the ProLogis North American Industrial Fund, a $4 billion, open-end vehicle with a number of limited partners.

The fund vehicles can take a number of different forms, from a traditional joint venture with one capital partner—like the ProLogis/GIC partnership in Japan—to commingled, closed-end funds with multiple institutional investors.

Paul Congleton, the managing director for North American fund management and real estate research at ProLogis, says his company's approach so far has differed by geography, reflecting the maturity of capital markets and availability of capital in each specific market. The REIT started with a separate account, joint venture strategy in the US and later moved to a commingled, open-end fund model. In Europe, ProLogis began with a multiple-partner vehicle.

Louis Wolfowitz, a managing director at Cushman and Wakefield, agrees that the joint venture vehicles were the starting point, with closed-end funds considered the newer technology. He notes that the REIT-as-fund operator has more leverage in a commingled fund with multiple investors versus a JV-type fund with a single institutional investor.

Congleton says that using the fund structure has allowed ProLogis to diversify its revenue streams. Instead of simply generating revenue from rental income, he notes, a fund allows the company access to capital from rental streams, fees and the returns from the investment vehicle.

Wolfowitz points out that the vehicles can provide all manner of fees and carry for the managing sponsor, adding that sophisticated REITs may already have principals with plenty of private equity real estate experience. The fund structure also allows a REIT to “turbo-charge” its returns with these profits streams—although the boost can be diluted if the REIT contributes too much of its own capital to the venture.

“It's a much more efficient way to put capital to work,” Wolfowitz says.

Although there are risks for a REIT managing a private equity fund, Wolfowitz says the risk is mitigated somewhat as shareholders are partnered with the fund manager, rather than the fund's investors. So far, shareholders have benefited with both AMB and ProLogis posting earnings gains for last year relative to 2004, some of which was derived from their fund investments.

But it wasn't immediate. Congleton notes that it took some time for the company's fund strategies to be positively reflected in the stock price. “That's very gratifying for us,” he says. “We have long believed this has a long-term integrity to it.” As if to emphasize that point, he notes that ProLogis will most likely expand its fund offerings in the future.

As Congleton points out, the fund structure works well in logistics because the sector's low barriers to entry create a highly fragmented market with a number of small players. A fund offering from an established operator like ProLogis allows institutional investors to diversify their portfolio into the industrial category with a known partner.

Industry participants have been noticing the trend. Steven Burton, a managing director at ING Clarion Securities, recently told a panel at the Pension Real Estate Association conference in San Francisco that a number of REITs were looking closely at the ProLogis and AMB models, with the intent to launch their own funds.

“It's simply in response to the demand from institutional investors,” he said.

Another private equity participant at the conference added that, while US REITs were once “holier than thou,” they were now “turning themselves inside out” in respect to launching funds. Of course, if current market conditions persist, a whole host of REITs could begin looking at ways to turn themselves inside out to attract institutional money.

Still Bruce Schonbraun, a managing partner with The Schonbraun McCann Group, concludes that, despite the interest in private equity fund vehicles, they will most likely remain a sideline business.

“It's just another way to try and make money,” he says.