More and more investors have discovered the appeal of REITs. Creatures of tax law, REITs provide transparency, liquidity, more permanent management and corporate structures, easier access to all forms of capital including unsecured debt, and greater overall property market efficiency.
Consolidation in the Japanese REIT sector seems more than likely when valuations fall. As a comparison, the overall market capitalization of US REITs grew from $44.3 billion to $224.2 billion during 1994 through 2003, but the number of REITs declined from a peak of 225 to less than 175. Australia provides another example of consolidation. In Australia, there are 80 listed LPTs and other property firms with a total market cap of over $50 billion, and LPTs control nearly half of the institutional quality commercial real estate in Australia. However, the sector is dominated by five LPTs which account for 40 percent of the sector’s market capitalization. The top 10 LPTs make up more than 65 percent of the sector.
In 1997-98, US REIT NAV premiums hit peak highs around 25-30% premiums to NAV. These numbers declined in the REIT bear market of 1999-2000 when REIT stocks significantly underperformed the overall market. By early 2000, REITs valuations hit bottom and were trading at more than a 10% discount to NAV. In this environment, a number of large REIT LBO/MBO transactions were consummated including Berkshire Realty, Sunstone, Irvine, Walden Residential and Patriot American. More recently, Capital Automotive, Gables Residential and CRT Properties have approved plans to go private at premiums of 9-15% over market price in 2005. In Oct 2005, MSREF announced its intention to acquire AMLI Residential for $2.1 billion, a 21% premium to market and a 1.9% premium to Green Street NAV.
As companies compete for deals, asset prices continue to rise and cap rates continue to fall thereby making it more difficult to generate the returns demanded by the public shareholders. The pressure to reach critical mass will increase: with size comes the ability to cover wider territory, to save on expenses, to lower the cost of capital, and to increase liquidity. Additionally, private real estate firms can use more leverage than counterparts in the public market which provides additional financial clout to bid on pricey deals. Couple these with the changing of the guard at many private empires, and consolidation is likely to occur.
Naysayers might argue that management entrenchment, tax concerns, poison pills, and a variety of other factors will prevent consolidation. These issues do exist and are real barriers. In addition, REITs are not cheap enough in the aggregate for the LBO/M&A business to grow dramatically at current valuations. However, I believe the structure of the REIT group and the timing of the property and market cycles will put enough pressure on the industry to consolidate (and decapitalize) over the next several years; consolidation forces will overcome these impediments.
REITs that trade at a discount to NAV are not always cheap; NAV discounts are not necessarily a strong buy signal. Instead of the gap being closed by a sharp rise in REIT prices, it might be closed by capitalization rates rising. In other words, rather than have rising real estate prices, real estate values might decline.
REITs that trade at a premium to NAV are not always expensive. One can argue that public REITs offer more than asset value; REITs come with management teams and operating companies. Thus, there is asset value and potentially intangible value.
Calculations of NAV are dependent upon cap rate assumptions, and market cap rates are reflective of prevailing market conditions. However, private market buyers often incorporate higher cap rates in order to account for higher internal rate of return requirements and higher capital expenditure reserve assumptions.
Recall that private market buyers generally seek 20%+ leveraged internal rates of return (IRRs) for their funds. This IRR can be broken down into two parts: an initial cash-on-cash return and future growth. In other words, private market buyers will typically price an LBO with a higher cap rate than market expectations in order to achieve required return hurdles.
REIT investors want high-current income, and REITs must leverage in order to maintain high dividend payments. An LBO is a significant financial restructuring with an investor base that does not need or want the current income stream. In the following cases, we incorporate similar deal and transaction costs.
The MSREF/PRIME acquisition of AMLI was structured as a take-private acquisition by a private REIT. The offer is at a 1.9% premium to NAV, and the transaction was structured to allow PRIME a step-up in tax basis.
