As the REITs Turn: The Continuing Private Capital Wave [ By Ellen Rand ] Unless you have been living in a cave for the past several months, you know that the commercial real estate world began with a giant splash when the Blackstone Group acquired Equity Office Properties (EOP) for a whopping $39 million, at the time the largest leveraged buyout accomplished. Then, Blackstone quickly sold off a sizable chunk of the 542-building portfolio. The ripple effects of that acquisition are still being felt. First, it was a major example of the continuing trend to consolidation and privatization in the REIT world. Second, it raises issues about buy-versus sell strategies -- after all, if a real estate seer like Sam Zell is selling, does that mean you should think twice before buying property now? Third, local markets are waiting to see what impact the new owners’ strategies (and willingness to pay top dollar) for former EOP properties will have. The EOP acquisition also represented the latest case to underscore the dramatic REIT contrast between the U.S. and much of the rest of the globe. In short, a current wave of private capital dominates the industry in the U.S., while the exact opposite is true in many other countries, with rapid REIT growth and enormous potential. Mike Frankel, global and Americas leader for real estate tax services for Ernst & Young in Dallas, reported that “we are working on a number of transactions all over the place. Latin America is picking up – you wouldn’t have said that five years ago.” According to Dennis Yeskey, national director of the Deloitte & Touche LLP Real Estate Capital Markets, the number of IPOs in the last six to seven years has been relatively small in the U.S., but “it’s the exact opposite globally,” he said. “The growth potential is enormous. Half the world’s REITs are in the U.S. But the growth potential is all global. The United Kingdom permitted REITs in January; Germany just introduced them after years of debate. They have always been in France.” He also named Hong Kong, Belgium, Singapore, Australia and the Netherlands as REIT-friendly, along with a very small market in Japan. “People like what they see in commercial real estate and are clamoring to invest in it,” he said. Large Capitalization, But Fewer in Number REITs’ market capitalization in the U.S. has never been higher, but as Barry Vinocur, editor of REIT Zone Publications, pointed out, the REIT industry is larger by market cap because of stock prices, not because of the number of companies or assets owned. “There has been a dramatic change; you have periods where it is attractive to be taken private,” he said. “A huge number of public office companies have gone away and you don’t see people lining up to take companies public.” Besides having the ready availability of private capital waiting in the wings, some REIT operators are opting out of being public for other reasons. As Dan Smith, managing director of RBC Capital Markets remarked, some owners underestimated the amount of reporting and restrictions that being public entailed, not to mention the constant pressure to pay dividends. “It takes them out of the market to grow,” he said. “As a private company they might be able to put cash to better use.” Dennis Yeskey observed that another spur to privatization has been that building values have risen faster than REIT share prices. “The sum of the parts is greater than the whole,” he said. “So the strategy became: break it up, leverage it up and make money. Real estate is a big, inefficient market. At above 40 to 50 percent leverage, the ratings agencies get nervous. In the private world, everyone likes 70 to 75 percent leverage – and the properties can support more debt.” Dan Fasulo, managing director of Real Capital Analytics, observed that taking a company private is “an efficient way to get a significant amount of cash out all at once,” he said. “Public markets are going to have to wake up and value [REIT] assets the way the private market does.” Fasulo expects that privatization will continue over the next 12 months. “Commercial real estate has had a tremendous track record for the last five years,” he noted. “The stock market is still not blowing out amazing returns. There has been a historical underweighting in real estate in major investment portfolios and there has been a lot of catching up.” But there may not be any major blockbuster deals announced soon. Mike Frankel said, “We’re in more of a plateau period now. Maybe people are catching their breath. There will be future acquisitions because there’s so much private equity to be spent. REIT stocks have pulled back some, which makes them better targets.” How much has the REIT world contracted? One indication is that by the end of the first quarter 2007, the National Association of Real Estate Investment Trust’s (NAREIT’s) index covered a total of 172 REITs, including: 30 industrial/office, 18 office, seven industrial, five mixed and 10 diversified REITs. By contrast, in December 2005, NAREIT was covering a total of 197 REITs, including 38 industrial/office, 24 office, seven industrial, seven mixed and 18 diversified REITs. To be sure, REITs are still a big business, with an equity market capitalization of close to $400 billion, according to NAREIT. They continue to generate respectable returns. As of the end of February 2007, the industrial/office REITs in the FTSE Group/NAREIT Equity REIT index posted year-to-date total returns of 5.94 percent. The Pleasures of Being Private Make no mistake about CenterPoint Properties’ 13-year experience as a public REIT, as CEO and 2007 NAIOP Chairman Mike Mullen described it. “The company really had remarkable success on Wall Street. The public markets were very good to us.” The company generated 20+ percent annual returns as a REIT and learned invaluable lessons about operations and discipline. But last year, when CalPERS offered to take the company private, it made that leap. It wasn’t as if CenterPoint and CalPERS had been strangers; for six years they had been investment partners, along with LaSalle Investment Management. It had been a happy partnership largely because, as Mullen explained, “Their appetite and desire for real estate mirrored ours.” Moreover, when CalPERS proposed the acquisition, it was contingent on CenterPoint management staying put. In Mullen’s view, “It was a terrific opportunity given who the buyer was. It was the same team we’d been working with, so we were comfortable with what life after purchase would be like.” Going private has meant a savings of approximately $4 million a year, Mullen noted, as well as a vast amount of time saved for senior management that otherwise would have been spent on managing the Wall Street side of the business – time spent with investors teaching them about CenterPoint’s business model, for example. “Now we can focus more on our core business,” he said. At the same time, he commented, the company has not changed the way it does business. It still operates with the discipline of a public company, only instead of reporting to many shareholders, it reports to one big one. Mullen observed that “The only reason to go public is to access capital. We’ve entered a cycle where private equity values our platform more than the public markets; we could no longer see the advantage to being public.” Mullen noted, the company cannot rule out the possibility that at some point three to five to seven years from now, it might opt to go public again. In the meantime, CenterPoint is enjoying its private status. “We’ve had a very good year and next year looks exciting, with large opportunities on the horizon,” Mullen said. Asked if he cared to elaborate, Mullen politely declined, remarking that “we’re enjoying not having to telegraph to the competition and to the whole world what we’re doing.”

The Blackstone Effect
Shortly after the EOP acquisition, Blackstone sold or agreed to sell properties in Los Angeles and Orange County, California; New York City; Portland, Oregon; San Diego; Seattle; Washington, DC as well as in Boston and Austin, Texas. When the merger closed in February, Macklowe Properties bought eight buildings in New York City for $7 billion – a whopping $1,100 per square foot.

Barry Vinocur noted that Blackstone’s initial strategy was to sell off one-third of the EOP portfolio and keep the rest; but as the acquisition price climbed, the strategy changed: to sell two-thirds and keep the rest. These properties sold at prices that showed that “the nattering nabobs of negativism were 1,000 percent wrong,” he said. “So far it has been a great deal for Blackstone.”

It has been a diverse group of buyers, including opportunity funds, names well known in both private and public realms. For example:

• RFR Holding LLC acquired more than 1.6 million square feet in seven CBD buildings in Stamford for what industry observers reported at more than $830 million, or close to $500 per square foot. Rents in the properties are said to be below market rate. The city of Stamford held off on its property tax revaluation because of this sale; it expected that the buildings’ value would raise the bar in valuations.

• Maguire Properties paid $2.85 billion for 8.1 million square feet in 14 buildings in Orange County and downtown Los Angeles. The portfolio is about 92 percent occupied, with below-market rents, so Maguire sees opportunities to increase revenues over the next three to four years. One possible fly in the ointment: Orange County is suffering because of subprime lender difficulties, including the bankruptcy of New Century, a tenant elsewhere in Maguire’s portfolio.

• Shorenstein Properties of San Francisco closed on its $1 billion purchase of a portfolio of properties in the Portland area. The purchase will make it Shorenstein’s largest concentration of property in a single market. The purchase consists of 46 properties of more than four million square feet and three development parcels that could support an additional 550,000 square feet of office space. Shorenstein made the purchase for its eighth investment fund, formed late last year with $1.1 billion in committed capital, including $100 million from Shorenstein.

• Boston-based Beacon Capital Partners, LLC acquired 10 million square feet of former EOP property in Seattle. It also bought 19 office buildings in Washington, DC. Total price was said to be $6.35 billion. The principals of the fund are no strangers to Equity Office Properties, which had acquired Beacon Properties (a REIT itself at the time) in 1997. (Beacon Properties was named NAIOP’s Developer of the Year in 1996.) After EOP’s acquisition of Beacon Properties, its CEO Alan Leventhal became head of Beacon Capital Partners.

• Thomas Properties committed to acquire EOP’s Austin portfolio for $1.15 billion. The 10-building portfolio consists of 3.5 million square feet of Class A offices. The purchase was done in a joint venture with undisclosed institutional investors. Occupancy in the Austin portfolio is approximately 82 percent and the market is enjoying robust demand.

• The Irvine Company acquired 21 buildings in suburban San Diego at a price estimated at close to one billion dollars. The acquisition would mean that Irvine controls half of the Class A space in the University City area.

• Morgan Stanley purchased a 3.9 million-square-foot portfolio in San Francisco, a city that has experienced dramatic rent increases. Asking rents at One Market Street, for example, are said to be $90 per square foot.

These buyers “think there’s enough juice in the orange,” Vinocur said. “The whole idea that ‘If Sam Zell is selling, you don’t want to be buying’ was wrong.” In EOP’s heyday, one of Sam Zell’s mantras was “bigger is better,” the idea being that the company could create enough critical mass in ownership, enabling it to offer tenants spaces in multiple markets, and dominating a market in the process. That has not proven to be the case, Vinocur observed. “Bigger is not necessarily better. Better is better,” he said, adding “There are some benefits to scale and having a national platform in the retail mall business and for large, customer-centric industrial REITs like ProLogis, but I don’t think it works with office buildings or apartments.”

Dan Fasulo of Real Capital Analytics asserted that the Blackstone/EOP transaction has had a huge ripple effect. He predicted that it would contribute to 2007 as a record year for office sales, in terms of volume: more than $100 billion. “It’s a great vote of confidence in the office market,” he said. “Industrial is just as strong. The problem with industrial is deal size: it’s smaller and there is a lack of supply for investors to buy.”

Referring to the companies that have acquired former EOP properties, Scott Jamieson, senior vice president, Capital Markets, for Jones Lang LaSalle in Boston, predicted that “the mega portfolio phenomenon is far from over as secondary tier buyers of EOP’s properties look to divvy up their holdings and continue to sell off pieces.”

Impact on Rents?
Clearly investors (public and private) are banking on rent increases on rollovers and renewals over the next several years; it’s why they are willing to accept low cap rates now. UBS Investment Research calculated the Shorenstein Properties acquisition of the Portland portfolio at about 4.6 percent. UBS also calculated the Macklowe New York City purchase at a 3.6 percent cap rate.

Are buyers right to bank on rising rents, revenues and value? According to the real estate research firm Reis Inc.’s survey of the nation’s 79 largest markets, excluding New Orleans, rents in the nation’s office buildings increased 2.8 percent in the first three months of the year. At the same time, however, space demand was lower than it had been in 2006.

Dennis Yeskey of Deloitte & Touche believes that the days of cap rate compression are over. Rents are rising this year, he noted, although he cited Atlanta as one market that remains flat. “The game now is, what kind of rent increases can you get? And how much value can you create in three years with rent increases of five percent?” he said, asserting that “the gains will be lower than before.” Moreover, in secondary markets, he said, “the numbers go down quite a bit. Five percent is a big rent increase in secondary markets.” Still, more institutional money is selectively going into secondary markets (like Cleveland, Indianapolis, Memphis) and even tertiary markets (like Des Moines), he reported.

What impact will the changing of property ownership have on rents and local market dynamics? Probably not as much of an impact as the basic laws of supply and demand, industry observers believe. As Barry Vinocur of REIT Zone pointed out, “It’s really a local business. Some [markets] are going to recover more quickly. Some secondary cities are recovering strongly.” In the end, as Mike Frankel of Ernst & Young observed, “It depends on geography. It’s always going to be supply-and-demand.” Because change is the only constant in the commercial real estate business, do not expect that the march toward privatization will preclude some companies from going public again, or transforming portfolios into public entities. After all, while Sam Zell is actively pursuing life as a media mogul with the Chicago Tribune Company, Blackstone Group has already announced an IPO for a part of this famously private company.

Yeskey noted that before the consolidation wave, REITs represented seven to nine percent of the market. Now, he said, “Our industry is 95 percent private. But somewhere down the road, interest rates will change. Owners will be in distress or will want to cash out. And the public markets yearn for real estate.”

Ellen Rand is contributing editor to Development.