Published May/June 2012
REIT magazine recently talked with investment bankers to take the pulse of the economy, deal flow and today’s financing methods of choice. Common themes emerged, including the view that clients and investors are increasingly optimistic, something that should help the pace of mergers and acquisitions this year. While REITs have utilized Wall Street financing to shore up balance sheets in recent years, they will rely on it more for growth ahead, particularly through the acquisition of privately held assets. Initial public offerings will likely only include high-quality companies, unless issuers are willing to accept a significant discount. Interest rates continue to be a blessing for real estate, keeping the cost of capital low and helping attract investors looking for greater yield. Caveats include possible macroeconomic shocks, such as upheaval in the Middle East, high inflation and a greater slowing in China’s economy than anticipated.
All told, the bankers appear confident that REITs are well positioned versus their private peers as the economy gains steam.
REIT: How would you describe the mood of clients and investors nowadays?
Paul Ingrassia: The management teams are confident and optimistic about their futures. Investors are delighted with past performance and positive on future growth, but mindful of valuations. With respect to 2012 expectations, investors still favor the apartment, retail and office sectors, and sectors levered to an economic recovery.
Jeff Horowitz: Clients and investors are cautiously optimistic. Where they fall exactly often depends on their area of focus in terms of market or property type. There is obvious uncertainty in the macro environment, but in general, there is little to no new supply of real estate product, which is a positive dynamic for many existing owners.
Jackson Hsieh: It feels a whole lot better. Broadly speaking, our clients have the view that the global economy still has challenges in front of it, such as the situation in the Middle East. However, event risks such as the Greek debt crisis are not overshadowing investors, as there seems to be an orderly resolution to the Greeks’ dilemma. Our clients are now prepared to move forward with capital investment programs, because the fear of the economic bottomless pit has abated.
Matthew Lustig: It’s cautiously optimistic for those REITs that have an attractive cost of capital. I think there is a pretty strong bias toward acquisitions and growth. So it may be a pretty strong year for strategic activity.
Jim Taylor: Generally, the mood of clients and investors is very positive, with the strong recovery in public valuations and the return of liquidity. Those valuations have been accompanied by improvements in operating fundamentals across most asset types with some variability driven by asset class, location and market.
REIT: We saw decent M&A volume last year, especially with REITs snapping up assets and private companies. What lies ahead?
Horowitz: There will likely be a continuation of activity, which will ramp up throughout the year. For public companies, the attractive cost of capital generally allows REITs to take advantage of opportunities. In addition, as asset values have improved, REITs’ abilities to provide both stock and operating units to sellers is a competitive advantage.
Hsieh: This year we will see more of the same trend, with the added feature of more aggressive selling of non-core assets by REITs. The rebound in debt and equity liquidity for REIT issuers coupled with their attractive cost of capital will result in an overall increase in M&A volumes versus last year.
One real estate subsector that will see a lot of activity is the triple-net-lease business. The current public capitalization of that subsector is $20 billion; however, there are over $20 billion of net-leased assets owned by private or non-traded REITs that will move into the listed markets. We saw a similar phenomenon occur in the health care sector in the past 18 months, where a significant amount of private real estate was bought by Health Care REIT Inc. (NYSE: HCN), HCP Inc. (NYSE: HCP) and Ventas Inc. (NYSE: VTR).
Ingrassia: We expect that the superior multiples and access to cheap debt capital enjoyed by the best-capitalized REITs will lead to further consolidation of private sector assets and selective consolidation of less well-capitalized REITs trading at inferior multiples. With some companies trading near their 2007 highs and the market trading at overall robust levels, we expect some management teams to be more psychologically receptive to selling. These teams may conclude that their best means of capitalizing on the strong valuations of the larger consolidators may be through selling to them, rather than by changing investor perceptions of value.
REIT: How would you characterize the IPO market?
Hsieh: It’s still challenging for real estate issuers. There is a backlog of several high-quality multibillion-dollar private real estate companies that are evaluating IPOs. That said, the discount it is going to take to get interest on behalf of institutional investors is still significant relative to other industries, such as technology, industrial and energy.
Taylor: The market appears to be getting more receptive, but it is going to be very selective as to the stories investors will embrace. I think any entrant into the public market has to be thoughtful about how they will be positioned competitively against the other choices investors have in that particular space.
Lustig: I don’t see a huge amount of IPO activity other than in the very largest, highest-quality companies that don’t have to sell a lot of equity coming out. The economics tend not to point toward the IPO as the best financial deal for most companies in this general market.
There are exceptions to that. Hilton Hotels is a fine company that was taken private by Blackstone, and may well consider an IPO that could be well received, say like Hyatt Hotels Corp. (NYSE: H) was, as a big, branded company that owns a lot of its real estate.
REIT: What trends are you seeing with respect to financing?
Horowitz: As the demand for yield in a low-interest rate environment continues, we are seeing many companies access the preferred market. The investment grade, debt and preferred markets should have strong activity.
The rebound in debt and equity liquidity for REIT issuers coupled with their attractive cost of capital will result in an overall increase in M&A volumes versus last year.
— Jackson Hsieh
Lustig: You are seeing more perpetual preferred stock, just because it is considered equity and has no maturity date. It’s a higher coupon obviously than common stock and much more flexible than debt would be. Beyond that, the secured and unsecured markets are open, as are convertibles, though straight debt and the equity markets are more compelling at the moment.
Ingrassia: During the second half of 2011, bond spreads widened with investor uncertainty, and term loans were much more attractive to most issuers. Since the beginning of the year, however, bond spreads have tightened dramatically, and the cost advantage of term debt has largely disappeared.
REIT: The volume of REITs acquiring other REITs has been quite low in recent years—how does it look going forward?
Taylor: It’s not a very large universe and there is not a lot of prospecting to be done. Most companies understand the other companies in their space, and for the most part have made decisions as to whether they fit from a strategic perspective. While some sectors may be positioned for consolidation, such as hotels and strip centers, I expect more of the activity to be driven by private to public than I do public to public. Also, you may see more domestic REITs looking abroad for acquisition opportunities, given the ongoing dislocation in foreign markets.
Hsieh: Where you might see some activity is the bottom half of the indices, where the companies are not trading at big premiums to net asset value (NAV). I could see private sponsors trying to take those companies private, sell off the assets and try to work down the overhead. I’m not sure you are going to see that necessarily with public REITs buying these lesser performing companies.
REIT: How will REITs finance their maturing debt in the years to come?
Horowitz: REITs have had very strong access to a variety of capital sources. As a matter of course over the last three years, they have tended to deleverage. That trend will likely continue. Given the speed at which markets can change, REITs generally don’t want to get ahead of their skis from a capital perspective.
Lustig: The whole capital stack is open. REITs can refinance debt pretty easily today and almost always at lower rates than they have on their books. The bank market is wide open to term debt as well as for lines of credit. The insurance company market is wide open for secured debt for high-quality, stabilized properties, and the unsecured market is completely open for investment-grade credits. Securitization of commercial mortgages has seen a revival since the beginning of the year.
REIT: What are your thoughts about this era of historically low interest rates?
Lustig: It has been a boon for commercial landlords, and it has definitely supported property prices higher than they would otherwise be. It has allowed landlords who were overleveraged to hold onto properties that they otherwise would have lost and facilitated recapitalizations.
Hsieh: As interest rates continue to stay low, we’re going to have very vibrant flows into the debt and equity markets as investors seek yield. It’s a challenging environment for investors, as money market yields are basically nil. Investors are getting comfortable with the real estate investment thesis, as the supply-demand picture for the commercial real estate sector will only improve, and there is very little new commercial real estate construction occurring in this country.
Horowitz: In general, REITs are replacing maturing debt, or calling securities such that they can extend maturities at lower rates. In addition, many public companies have redone their bank facilities. Management teams are well aware of how quickly things can change, so they are generally taking a conservative stance with respect to financing.
Taylor: You always have your eye on what happens if rates spike. And some of the liquidity we’re seeing may prompt folks to go ahead and sell today versus taking the risk that the economic recovery and growth in rents may be more than offset by value diminution due to a rise in real interest rates. All else being equal, it takes a lot of NOI improvement to offset the diminution of a 75 to 100 basis points expansion in cap rates when they are as low as they are today.
Ingrassia: It has been bit of a virtuous cycle for the real estate owners, because you have the benefit of a low cost of capital and decreasing cap rates, which drive up asset valuations. The reverse is true for rising interest-rate environments, where you have an increase in cost of capital, lower net income and decreasing valuations as cap rates increase. That is more of a vicious cycle.
REIT: What are the key caveats for investors?
Taylor: The biggest issue for real estate—and frankly a lot of asset classes—is the unexpected disruptions in capital flows or other events such as higher-than-expected inflation, where the real estate just can’t catch up. Real estate then tends to underperform. But in an environment with moderate inflation, real estate does quite well and can significantly outperform other asset classes.
Hsieh: You always look for the things that are outside everyone’s purview right now, things can come out of nowhere and bite you, such as the political situation in the Middle East and slowing economies and real estate bubbles in China that could trigger a global liquidity issue. In the U.S., we don’t have great core rental-rate growth or real increased demands for commercial real estate space right now. However, our low interest rates will continue to positively impact cash on cash yields and return expectations for prospective real estate owners.
Horowitz: It’s prudent to be wary of leverage creeping up. If rates suddenly move, dividend payout ratios can quickly change and debt coverage ratios can be impacted.
Ingrassia: Intervention with Iran and its impact on the global marketplace is the largest risk looming on the horizon that investors are thinking about.
Lustig: It would seem federal taxes are slated to go up materially if you continue to have a government that can’t reach an alternative. The expiration of the Bush tax cuts at the end of this year could create substantial macroeconomic headwinds going into 2013. We’ll have to keep an eye on how they get addressed.
Charles Keenan is a regular contributor to REIT magazine.