10/31/2023 | by Beth Mattson-Teig

REITs are continuing to undertake strategic merger and acquisition (M&A) activity, yet there is a clear shift in the tenor of deals getting done in the current challenging environment, according to analysts and legal experts.

Commercial real estate transaction volume is down across the board, M&A deals included.

The $63.9 billion in 2023 year-to-date REIT M&A activity is below the robust pace of deal-making recorded in the prior two years that reached $83.0 billion in 2022 and $99.4 billion in 2021, according to Nareit data.

Most recently, Healthpeak Properties, Inc. (NYSE: PEAK) and Physicians Realty Trust (NYSE: DOC) announced Oct. 30 that they plan to combine in an all-stock merger valued at approximately $21 billion. Realty Income Corp. (NYSE: O) also said it would acquire Spirit Realty Capital, Inc. (NYSE: SRC) for $9.3 billion.

Although total dollar volume is down, the 13 deals announced so far this year represent a solid number by historical standards. Public-to-public deals also have emerged as the dominant strategy, with such transactions accounting for $130.9 billion of the $140.9 billion in M&As that have occurred over the past two years, according to Nareit.

REITs are looking at public-to-public M&As as a path to growth that allows them to expand portfolios and scale up in a market where debt is more costly and difficult to access. “If they can utilize their share price and expand their portfolio that way, that’s something that they're considering more often nowadays when debt is so expensive and hard to get,” says Chris Hudgins, a research analyst at S&P Global Market Intelligence. M&A also can be a good avenue for tapping into quality assets where there is information and transparency on performance because of the public reporting, he adds.

The current market is more conducive for public-to-public deals as REITs can use stock as their currency, whereas private equity buyers that rely on cash and debt have a higher cost of capital. “If you're looking at any kind of privatization using debt, it's going to be more expensive. So, I don't think you're going to see a lot of those deals,” Hudgins says.

Large REITs acquire smaller competitors

In July, Extra Space Storage Inc. (NYSE: EXR) completed its acquisition of Life Storage Inc. for $16 billion. However, deals of this size are the exception in a market where smaller M&As are now more the norm. Taking Extra Space/Life Storage and the two deals announced Oct. 30 out of the mix, the average size of the remaining 10 deals that were either completed or announced this year averaged $1.76 billion, according to Nareit.

M&A deals are all unique. In some cases, it is a classic example of a big fish—with a strong balance sheet—acquiring a smaller competitor. In other cases, it may be a merger of equals to create efficiencies of scale by creating a larger company, or a small REIT may be motivated to align with a stronger partner. In all of these scenarios the increased scale from a merger is a positive.

Scale leads to greater operating efficiency, lower cost of capital on a relative basis, more liquidity in the stock, and more operating and strategic flexibility. “Some of the smaller REITs that are under pressure are exploring strategic alternatives because they need to,” Daniel LeBey, a partner at the law firm Vinson & Elkins, says. And on the buy side, some of the bigger REITs that have very strong balance sheets and stronger stock pricing relative to NAV see an opportunity to potentially acquire smaller competitors, he adds.

Several of the deals announced in the 2022-2023 period involved the acquisition of a relatively small high-quality portfolio of assets by a larger strategic consolidator. “The larger you are, the lower your cost of capital, and for REITs, it's all a capital game. The cost of capital is everything,” says Yoel Kranz, co-chair of REITs and real estate M&A at Goodwin Procter LLP.

For those smaller REITs, and especially those with lesser quality assets or in a less favored sector, the cost of capital is very high in today’s market. Piling on top of that are the fixed costs of the general and administrative (G&A) load for a public company. In some cases, it doesn’t make sense to be spending all of that money every year to maintain a public platform, Kranz says. The cost of capital and the G&A load are some of the reasons why a smaller company would like to merge with a bigger entity, such as Kimco Realty Corp.’s (NYSE: KIM) announced acquisition of RPT Realty (NYSE: RPT) for $2 billion, he adds.

Deals are happening on a case-by-case basis. However, the stories that are leading to M&A exits are when management teams can’t access capital to continue to grow, they can’t reposition assets, or they can’t get tax efficiency, Kranz notes.

Smaller companies are also navigating a gauntlet of shareholder activism. Several targets in recent REIT M&A transactions have had a history of activist investor campaigns. In the case of public companies, public bids put a lot of pressure on the management team and the board, with everything exposed under a very harsh, bright spotlight, he says.

Generating accretive value

There are some clear hurdles that are weighing on M&A activity that include liquidity, cost of capital, and the fact that many public REITs are trading at stock prices below their NAV. Much like the broader commercial real estate investment sales market, REIT M&A deals have been hampered by a bid-ask gap. However, the bid-ask gap is less of an obstacle in stock-to-stock transactions where both parties can look at the synergy analysis in connection with the transaction.

“Boards and management teams are kind of struggling to figure out what the valuations are of these companies right now,” says Blake Liggio, a partner in the real estate industry group at Goodwin Procter LLP. “But the bid-ask gap is not a hurdle to the public-to-public transactions that we’re seeing right now as long as you can have the synergy analysis prove out.”

Larger REITs, such as is the case with Extra Space Storage and Kimco, are buying smaller competitors in a stock deal where both sets of shareholders stand to benefit. Ultimately, the decision to approve and close the deal hinges on the belief that the stockholders are going to get a better return as owners of the combined company versus remaining independent.

In a stock merger, the acquiring company’s currency is its stock. So a buyer with more scale, more efficient operations, and higher NAV per share can offer returns that the smaller company often can't realistically achieve by staying independent, LeBey notes. “Those are the factors that tend to stimulate merger discussions between parties. And those are some of the factors that stimulated some of the transactions that have been announced this year and gotten done this year,” he says.

REITs are engaging in M&A deals that they expect to be accretive to values and FFO per share. For example, Extra Space Storage has said that it expects to gain about $100 million in cost savings by combining the two companies. In the $4 billion merger between Global Net Lease Inc . (NYSE: GNL) and The Necessity Retail REIT Inc., the company has estimated savings of $75 million after the first year. Kimco has estimated annual cost savings in acquiring RPT at about $34 million.

“The majority of deals you're going to see are building out on their plan of what they think might be best for their stock,” Hudgins says. REITs generally want to maintain their current portfolio standards, while also looking for comparable and complementary portfolios that would help make their stock be more appreciative. “So, it is not just a stronger player buying a weaker player, REITs are looking at M&A as a way to grow their portfolio using their stock price as opposed to going out and taking on more debt to develop or acquire properties,” he adds.

Outlook for M&A opportunities

The bulk of REITs are focused on blocking and tackling – managing debt maturities and managing portfolios in the current challenging market. Those REITs that are engaging in M&A deals are large companies, often the largest in their space, that are opportunistically scooping up smaller portfolios. That is a relatively small number, but you will continue to see those large companies continue to engage in M&A deals, Kranz says.

Smaller companies also may be more receptive to a merger or acquisition. In general, there are a lot of public REITs that are in “a bit of a rut” in the current environment where stock prices are down, interest expense is up, and operating results are under pressure, LeBey notes. “It’s hard for REITs to raise capital that isn’t dilutive. It's hard to get deals done, and it’s hard to see a realistic path to better results and better stock performance in the near term. So, if an acquisition proposal from a stronger, larger company comes along with a premium, boards have to consider it,” he says.

M&A opportunities exist across most property sectors, including multifamily, retail, industrial, and office. In each of those categories there are still some REITs that are trading at greater discounts than others where the stronger players could acquire some of their competitors that are experiencing bigger discounts in NAV. Office in particular is one sector where you might see a deal or two later this year, according to experts.

Despite M&A deals that have already occurred in self-storage and net lease, both sectors remain attractive for more activity. “Self-storage is a strong asset class that has performed exceptionally well through all of the turbulence of the last few years, and it remains a sector that is ripe for consolidation and growth,” LeBey says.

There’s also a lot of buzz around the looming investment opportunity in the mortgage space. At some point, interest rates are going to stop going up and will start to come down again, and that creates a huge amount of opportunity to raise capital and generate great returns in the mortgage space, he says. “I think that we are likely to see additional M&A activity as well as increased capital markets activity in the residential and commercial mREIT space in the coming 18 months,” LeBey adds.

Broadly speaking, REITs have strong balance sheets, with leverage that is at near historic lows. Over 90% of the debt REITs were carrying as of the second quarter was fixed rate with a weighted average term to maturity of just under seven years (79 months), according to Nareit. Yet there is still a market of “haves and have nots,” especially among REITs that have maturing debt or have a difficult time accessing capital to drive growth. Those challenges could spark more opportunities for M&A deals in the near term. “Some of the larger players will be better positioned to weather that storm, while many others will need to do something strategic. That means more M&A,” LeBey says.