The heady rush of taking real estate investment trusts from public to private has evaporated in today's credit-market crunch. And so, it's time to face a new reality, says New York attorney Robin Panovka, a renowned expert on REIT mergers and acquisitions. We are either in the midst of a significant commercial real estate downcycle, or we are sliding into one.
REITs can be considered leading indicators, Panovka says, because the values of these trusts change more quickly than values in the private market.
"The fact that REITs are now trading at what is believed to be a significant discount to their estimated net asset value (NAV) -- 20 to 25 percent in some cases -- may be an indicator of what is going to happen with private sector valuations," he said. His prediction: more strategic mergers of REITs as the industry consolidates and, long term, more and more institutional-grade assets migrating into REITs. "The wild card is what will happen in the credit markets," he added.
Speaking at Risk, Reward and Real Estate, a real estate conference sponsored by the W.P. Carey School Center for Real Estate Theory and Practice, Panovka was blunt, brisk and strategic.
Panovka is a partner at Wachtell, Lipton, Rosen & Katz, where he specializes in mergers and acquisitions, strategic transactions and corporate governance, and co-heads the firm's real estate and REIT M&A groups. He coauthored "REITs: Mergers and Acquisitions," published by Law Journal Press. Acting as legal counsel to the Silverstein development group, he also has been involved in redeveloping the World Trade Center. He teaches, too, as an adjunct professor at New York University's REIT Center.
The REIT stuff
Panovka told conference participants that REITs represent 20 to 25 percent of the $1.4 trillion commercial real estate equity markets. Almost one-third of REITs are composed of shopping-mall properties; hotels and retail take up almost one-fifth each, with apartments, warehouses and office space making up the rest. The trusts are popular for several reasons, he said, including liquidity, transparency and accountability. Then there's the convenience factor -- buying and selling shares in a hotel REIT is a lot simpler than finding, inspecting and purchasing a 100-unit property on your own.
Another plus: monitored closely by analysts, rating agencies and market-watch publications, REITs take on much less debt than the private real estate market. REITs also are less likely to default in bad times. Instead, Panovka said, REITs will cut dividends, rather than default on their mortgages. About those dividends: granted special tax status, REIT administrators must use 90 percent of a trust's profits on dividends to investors. Since dividends can be stashed in a tax-deferred retirement account, financial planners often recommend REIT participation to investors saving for their golden years.
"We've seen huge growth, and increasing liquidity in REIT stocks. When you own a REIT, you really own liquid real estate," Panovka said.
Initially authorized by Congress in 1960, REITs really took off in 1991, growing at a compound rate of 24 percent annually. As a result, there are 150 REITs today with more than $550 billion in properties and a market capitalization of more than $350 billion. The favorable financing terms available in the last couple of years spawned a new trend: privatization, in which some significant REITs, such as Zell's Equity Office Properties, were taken private. But that trend relied on huge amounts of cheap debt, and that kind of money is no longer available.
Panovka said, "Some argue that 150 REITs is still far too many. We need about 30 American REITs -- four or five in each property section."
Like many of his colleagues, Panovka spent much of mid-2005 to mid-2007 spinning off deal after deal. His firm was involved in Tishman Speyer's and Lehman Brothers' $22.2 billion acquisition of Archstone-Smith, as well as Ventas' $22 billion buyout of Sunrise Senior Living, The Mills Corp.'s $7.9 billion sale to Simon/Farallon and Innkeepers USA's $1.5 billion sale to Apollo.
With regard to the privatization of REITs, though, once the credit market changed last summer, so did REIT reality. As Panovka told conference participants, "REITs are now trading at a significant discount to their estimated net asset value, and that is creating all kinds of pressure."
Pressure to consolidate?
He's right. REITs are trading at near historic discounts of 20 to 30 percent to the net asset value. Once dividends slow or stop, stock prices fall. As REIT stocks decline, the leverage ratio grows. Stocks that were solid can start to look over-leveraged. Also, as the weaker REITs miss their dividend payouts and their stock price suffers, stronger REITs should be in a position to acquire them using their own stock as currency.
Panovka anticipates continuing consolidation in the REIT space, as the larger REITs with strong balance sheets continue to grow. Look for continuing migration of assets into REITs, as well as REIT-REIT combinations. True believers expect growth will continue until REITs will control 50 to 60 percent of institutional-grade commercial real estate nationwide. Over time, more institutional real estate will cycle into REITs.
Through 2008, we will see fewer and smaller REIT deals, he said. He predicts that the number and size "will likely stay low. The credit markets are the wild card -- without credit, private equity players are sidelined," he explained. And that could lead to increased public to public (REIT to REIT) transactions.
"Just a little credit could stimulate things and get private equity players back in the game," he added. The drop in REIT share prices, which is, arguably, a 20-30 percent discount to net asset value, could mean that easing of the credit markets just a bit could stimulate deals in which private equity players buy REITs and quickly sell their assets in the private markets.
Hedge funds attack
Currently, several hedge funds and activist shareholders are targeting REITs, Panovka said. Eager to spend some of their pent-up capital, hedge funds are buying REIT shares, then badgering REIT administrators to de-leverage and sell assets.
"I can think of five or six REITs under attack by hedges right now. They buy stock, then start sending the nasty letters with demands," he noted. It's a myth that REITs are takeover-proof, he added, pointing to Public Storage's March 2006 hostile takeover of Shurgard Storage Centers. Public Storage's earlier attempts to buy Shurgard, in 2000 and 2005, failed, but after a seven-month siege, Shurgard shareholders accepted a multi-billion dollar offer. As Panovka put it, "we will see more hostile deals."
Besides more consolidation through mergers and acquisitions, he also sees a trend towards increasing globalization. "Clearly, since the dollar is cheap, global capital will flow in. Investors will buy real estate at a discount due to currency rates," he explained. Expect increased cross-border investment by U.S. REITs, as REITs seek higher returns abroad. But true multinational REITs are "a fantasy" at this point, he said, too complex to implement.
- In 2007, there were 21 REITs with a market capitalization of more than $4 billion each.
- REITs contain more than 24,000 properties in the U.S., valued at more than $550 billion.
- Worldwide, the largest REITs are in Asian countries.