The REIT Race to Liquidity

Spring 2010
Clockwise from top: Michael Knott, Guy Langford, Bob Lehman, Scott Thompson, Mark Decker, Jeffrey Scott

$500 million here, $500 million there: pretty soon we’re talking real money.

Heartened by the market’s enthusiasm (as evidenced by the $30 billion in new equity raised for existing REITs last year), nearly a dozen commercial real estate companies had filed about $4 billion worth of offerings with the SEC by year-end 2009, with many more expected to file or in the process of organizing themselves to go public this year.

Jeffrey A. Scott, managing director of Eastdil Secured in Washington, D.C., reported that he knew of "a multiple of 10" REIT IPOs in formation this year. Who will make it out of the gate? "Some of that will be a function of how those already there end up being priced," he said. "The market will tell us how many will get out."

The offerings are either "blind pools" or companies with existing portfolios and include office, industrial, retail, hotel and specialty, such as healthcare and cold storage real estate. Some — and the ones most likely to gain traction, according to industry observers — are headed by seasoned pros who have headed REITs before, such as Tim Callahan, formerly of Trizec and Equity Office Properties, heading Callahan Capital Properties ($500 million) and Richard S. Ziman, founder of Arden Realty, heading Halvern Realty ($400 million.)

The new wave began last year with several REITs formed to invest in debt. The "big three" IPOs in this group were organized by Starwood Capital Group, Colony Capital LLC, and Apollo Management LP. Starwood raised nearly a billion dollars, twice as much as it planned to; while Colony and Apollo raised half of their goal, or about $200 million each. But industry observers believe that the window for these debt vehicles was open briefly and that the market is now waiting to see their performance before it accepts any new additions. Moreover, filing with the SEC does not guarantee that an aspiring REIT will become a reality. The market has so far been discriminating in its acceptance of REIT offerings. In the hotel sector, for example, Pebblebrook Hotel Trust was successful in raising about $350 million, while Chesapeake Lodging Trust Corp, which had aimed on raising about $250 million, postponed its IPO indefinitely.

Guy Langford, national real estate sector leader, mergers and acquisitions transaction services, at Deloitte & Touche LLP, agreed that of the IPOs in the pipeline, some will not become effective, or the pricing won’t be appropriate. "It’s tough to be a REIT without a market capitalization of at least $200 million," he said. "You’ll see a number consolidating to get to scale." His best guess is that fewer than half will make it through the gate, and possibly as few as a quarter.

One reason for the growth in IPO activity is that it has been very, very good for underwriters. Jeffrey Horowitz, head of real estate investment banking in the Americas for Bank of America, told the Wall Street Journal that "we have lists of companies we think are good candidates for the public market and we’re proactively reaching out to them." The bank earned $207.6 million in underwriting stock offerings by commercial real estate firms in 2009, including several blind pools.

Who will invest in these IPOs? According to Jeffrey Scott, "first and foremost, general market conditions will be critical, but there is a good appetite in institutional and retail investors for good REIT names. What counts is the reputation of the management teams and how business plans are differentiated. The trend has been to reward sector specificity. It’s not necessarily mandatory, but expect that to continue."

The Challenges of Going Public

For REIT proponents, the marked shift from private to public financing represents an excellent solution for well-managed, but capital-challenged companies, much as it did in the mid-90s. But going public is not for the faint of heart, nor for those who bridle at the concept of public ownership or who do not have the management and financial wherewithal to meet stringent and continuous reporting requirements.

Bob Lehman, real estate audit partner and global REIT practice leader at Ernst & Young LLP, outlined four compelling benefits for going public:

  • access to capital;
  • benefiting from an existing tested investment platform;
  • other synergies from a larger investment base; and
  • creation of "dry powder" to take advantage of market opportunities.

But the process of preparing to go public is highly complex and Lehman stressed some of the many challenges involved in doing an IPO, including structural, valuation and taxation issues. Assets are not usually owned in neat entity, for example. There are typically separate entities or partnerships. These must be rolled up and all would require the consent of partners and lenders. You must continually update the SEC with information while it is reviewing the offering. Accounting must adhere to stringent rules. "Some owners still do tax-basis financials, but if you have IPO dreams, you have to have GAAP [Generally Accepted Accounting Principles] financials," he said. You need audits and valuations for the last three years.

Then there is what Lehman called execution risk. "Once everything is in place, do you have a compelling enough story to get it done?" he said. "Do you have the infrastructure in place to produce reliable results so investors know what to expect? The market doesn’t like surprises." He also pointed out that "you need a billion and a half in assets to go public, and not in one building. You have to raise a half-billion dollars."

In considering whether or not to go public, ask these questions:

  • Are we willing to be transparent?
  • What’s our appetite for scrutiny and do we have the organization to do it? If not, how do we get closer to being able to execute?

Going public is expensive. Lehman said that "five to 10 million dollars is probably not out of range, with a couple of billion dollars in assets, to go through the SEC process."

A successful IPO today involves niche assets; company management and strategy; capital structure post-IPO; price; and scalability. Noting that the big REITs have big war chests now, "you may get value by being part of a larger entity," said Lehman. Considering all the challenges involved, he expects some IPOs will start while others will not finish but merge with other REITs by the end of 2010.

Scott Thompson, partner and co-manager of the real estate and golf practice group at the Los Angeles-based law firm Greenberg Glusker Fields Claman & Machtinger LP, said that IPOs should not be undertaken just for refinancing purposes. "If that’s the only reason, it’s not a good model for success," he said, adding that investors are looking for some level of growth in the stock price, not just dividends, for a combined six to eight percent return. "A well-positioned, well-managed company offering a combined seven to eight percent doesn’t seem crazy to me," he said. "If you believe there will be inflation in the next five years, and I do, it’s a great hedge against inflation. You’ll be able to increase your rent in the next three to five years."

Thompson expects to see more REIT issuances in 2011, as it takes considerable time to organize what he called administrative cleanup work "and those efforts are taking place now." He remarked that it’s not too late to start considering becoming a REIT over the next two to three years. "You haven’t missed the boat," he said. "At $200, $300 million, these are not giant deals. There’s going to be a sense that REITs can buy good real estate at reasonable prices, including iconic properties that you wouldn’t have seen on the market otherwise." The companies that will be most rewarded will be the ones who are most transparent, he said.

"Don’t ‘hide the ball,’" he advised. "You do that, you’re done. You need a team that embraces the concept of a public company."

Competitive Advantage: Public vs. Private

What does this tide of liquidity mean for private owners and investors who do not wish to go public? Does it mean stiffer competition for quality assets? Does it mean that such assets are likely to attract higher prices and lower cap rates? Will it solve the dilemma of maturing debt in a climate where values are well below 2007 peak levels?

Some observers believe that even if all the IPOs make it through the gate, it still won’t be a game-changer either in terms of the way most commercial real estate is held in the U.S. or as the solution to the need for fresh capital in the next few years as loans come due and the velocity of transactions speeds up.

Jeffrey Scott of Eastdil said that people have to remember that the marketplace is huge and that public REITs represent only a small fraction of it. "It may mean more public companies that can react with speed," he said. "If it makes the market more liquid it’s good for private owner/operators. It returns functionality to the market."

Regarding the competitive advantages of private developers versus public REITs, Guy Langford of Deloitte & Touche said, "A developer would have the advantage to work through problem loans of a bank." He believes private developers should approach local and regional banks and ultimately take over ownership of their distressed properties. "REITs would need Board approval and many don’t have the skill sets to work through loan portfolios."

REITs will be part of the equation in working out debt problems, but added that "I don’t think public markets will be the answer on their own." He estimated that some $80 to $90 billion in private equity is on the sidelines, as are sovereign wealth funds. "There’s a need for CMBS 2.0, a positive sign that securitization is coming. The mechanism is painfully slow and unwieldy. There’s a need for RTC 2.0."

Michael Knott, senior analyst at Green Street Advisors, observed that "we will see a continued surge of potential IPO activity, as long as REITs continue to trade at a premium to underlying asset value. The good news for private owners is that as long as real estate is worth more on Wall Street than on Main Street, they have more flexibility and opportunity to go public." One caveat, though, he said: As private financing becomes a little more available, it helps the cause of private companies that want to stay private but would have looked at becoming public for lack of options.

Scott Thompson of Greenberg Glusker does not foresee a return to a pricing bubble driven by the increased liquidity of the public market. "The survivors are going to be very surgical about assets they pick up. There’s not a sense of ‘if we don’t like this deal there won’t be another around the corner.’ We’ve come back to normal, sensible growth expectation."

Mark Decker, managing director and group head, real estate investment banking, Robert W. Baird & Co., expects that in the next five years, we’ll see "the most active REIT market in the history of the industry." Still, public ownership represents 10 percent of institutional quality commercial real estate. Even if it becomes 20 to 25 percent of the market, it will continue to be a minority.

Decker believes that the private markets will represent fertile acquisition opportunities for deep-pocketed long-term investors. "We’re in a market where there’s smart institutional money," he said. "It’s looking for proven companies with existing business models. Simple is better, without a lot of complexity." Decker also envisions a time when there will be REITs devoted to infrastructure, as well as more in prisons and student housing. We haven’t seen a marina REIT, or anything related to agricultural/farming or airports.