A question of priority
At a time when more countries are adopting REIT-type legislation and the number of REIT-like vehicles is increasing rapidly worldwide, it is interesting to note that the US-listed REIT market has recently taken a sharp turn towards privatisation.
This contrary trend in the US is evidenced by the large volume of merger and acquisition activity within the REIT sector involving public-to-private transactions. Since 2004, there have been 12 transactions that have closed with a collective value of over $23bn (€18bn) that resulted from a publicly-listed REIT being acquired by private interests.
The private interests involved with these public-to-private deals included either one or a combination of private real estate companies, investment advisers and more recently, private equity firms. In fact, a large private equity firm is substantially involved in three of the largest multi-billion dollar deals announced so far this year. Many industry observers foresee greater involvement by the large private equity firms given their access to significant amounts of capital and their penchant for deal
Prior to 2004, there were very few public-to-private deals among US REITs. In 2004, there was one public-to-private REIT transaction followed by four more completed deals in 2005. But 2006 is on track to set a record for public-to-private deals, with four having closed to date and three still pending.
The heightened interest in public-to-private deals among REITs is reflected not only in the growing number of transactions, but also in a significant increase in individual deal size. In 2004, the sole public-to-private transaction had a value of slightly over $250m. So far this year, two multi-billion dollar public-to-private deals with a total value in excess of $4bn have closed, and two deals collectively valued at over $8bn are still pending. If all announced public-to-private transactions close by the end of this year, the total value of all deals to date will exceed $15bn.
To a great extent, the growth in deal size reflects the greater feasibility of a large US-listed REIT being taken private. The largest US-listed REITs have a market capitalisation in excess of $15bn. Given private equity firms’ growing inclination to form consortiums and pool their equity capital to bid for ever larger transactions - which they then typically leverage with high levels of debt - the privatisation of a large US-listed REIT by these firms is becoming easier to accomplish. However, the strong sustained share price performance of the US-listed REIT market could make the economics of many public-to-private transactions increasingly challenging.
What are the key factors behind the REIT privatisation trend? Inexpensive debt, real estate asset pricing discrepancies between the public and private markets, and the rising cost and headaches associated with running a publicly-listed company are most often cited as driving the growth in public-to-private transactions. However, consideration must also be given to the motivations of management as many are comparatively large shareholders of the public REITs themselves.
Among the most significant drivers are the low cost of debt and the unprecedented levels of liquidity in the private market as they make it easier to obtain capital for taking the public REITs private. At the same time, the availability of inexpensive financing enables private investors to utilise more leverage than is generally possible in the public format, and thereby generate higher returns on the portfolio.
Publicly-traded REITs can be penalised by a lower stock price when the public market considers the leverage to be excessive or short-term earning expectations are not met. But operating outside the confines of public market scrutiny, the private format allows management more flexibility to use higher leverage and to pursue longer-term objectives without concern for the often short-term public market expectations.
Another motivating factor for public-to-private deals is that investors are generally able to obtain a better overall price for real estate assets if they acquire an entire portfolio of properties at once rather than each property individually. Also, in purchasing an entire REIT, investors have the benefit of acquiring an existing operating platform with an experienced management team and infrastructure intact.
Pricing discrepancies between the public and private real estate markets have also presented investors with significant arbitrage opportunities, further fueling the trend. Private investors in particular have been able to offer public investors a sizeable premium for their publicly-traded REIT shares. This is due to a share price discount that is often well below the private market value of the underlying real estate assets, and to the ability to employ higher leverage in a private entity.
Yet another factor is the Sarbanes-Oxley Act of 2002, which significantly increased the compliance burden of publicly-listed companies on US exchanges. Its impact appears to be being felt most acutely by the smaller listed REITs that are less able to spread the increased compliance costs over a large asset base.
There is irony in the fact that the greatly expanded reporting requirements of Sarbanes-Oxley have contributed to the public-to-private trend because when a REIT goes private, the result is reduced transparency with less data flowing into the public domain, along with less accountability and market overview.
Finally, the desire on the part of REIT managements to ‘go private’ has been a contributing factor. Their motivation appears to include the opportunity to cash-out given the high prices in the private market, the opportunity for incentive compensation that is not available in the public sector, and the desire to return to their entrepreneurial roots without the regulatory burdens and scrutiny of a public market.
Nevertheless, despite the current trend towards privatisation, it is clear that the US-listed REIT market is not about to disappear. Since 2000, there have been 24 REIT IPO’s, including two so far this year. This equates to over $15.2bn in initial public offerings. The number of secondary offerings of common equity over the same period was 430, equivalent to more than $40.6bn
By the end of 2005, there were 197 REITs listed in the US with a total market capitalisation of $330bn, according to National Association of Real Estate Investment Trusts. The peak was reached in 1994 at 226 listed REITs, but their total market capitalisation was only $44.3bn. Over the past five years, a combination of exceptional share price performance as well as common equity capital issuance has pushed the listed REIT industry’s total market capitalisation higher by an impressive 70%.
In fact, the current public-to-private trend can be viewed as a reaction to a particular set of capital market, regulatory and economic conditions in the ever-changing US real estate market.Many institutional investors continue to view the combination of market transparency, liquidity, low minimum investment size, tax efficiency, low transaction costs and dividend income stream as very compelling attributes of public REITs. For these reasons, the publicly-listed REIT in the US is here to stay, and is likely to remain the preferred route for many domestic and foreign investors to gain exposure to the US real estate market.
Mark Lindeis is vice president at Sentinel Real Estate Corporation