(The long view is a new biweekly column that analyzes big-picture real estate issues through a global lens.)
It’s M&A season in the business world. In October alone, around $500 billion worth of mergers were announced globally, including AT&T’s blockbuster deal to buy Time Warner for $85.4 billion. Companies in industries spanning from telecom to pharmaceuticals to food and beverage are hot for mergers these days. But that same frenzy isn’t being seen at real estate investment trusts.
As of Nov. 8, there were $9.2 billion worth of REIT mergers in the U.S. and Canada in 2016, according to data from SNL – on track for the lowest annual merger volume since 2012. There have been some notable mergers this year – take the ones between Parkway and Cousins Properties and between Apple Hospitality REIT and Apple REIT Ten – but M&A activity is well below what’s being seen in other industries.
At first glance, that’s puzzling: some observers have been predicting a REIT merger wave for two years and many of the factors fueling acquisitions elsewhere, such as cheap debt and bullish stock markets, also apply to REITs. Yet, the opposite is happening, and here’s why: Even though they’re listed on stock markets, REITs behave very differently from most other public companies.
For an example of why few REITs merge, look no further than Vornado Realty Trust’s earnings call on Nov. 1. A day before the call, Vornado announced it would effectively split itself in two by spinning off its Washington, D.C. assets and combining them with properties owned by fund manager JBG Companies into a new REIT. One reason for the move, according to Vornado’s CEO Steven Roth, is that investors tend to prefer specialized REITs:
“At its best, pure New York unburdened by Washington has to trade much better,” Roth said.
Generally speaking, public companies merge because of the benefits of size. When one cable provider gobbles up another, the combined firm ends up with a big chunk of the overall market, enjoys economies of scale and gains pricing power because of less competition. All these factors will likely make it more profitable than the firms were before the merger. REITs, however, don’t benefit in the same way: Whether a landlord owns five office buildings or 10 doesn’t really affect pricing power, and the commercial real estate market is simply too enormous for one company to control, say, 60 percent of all U.S. office space.
In fact, growing too large can actually hurt a REIT’s standing on the stock market,as Steve Roth’s comments indicate. For example, when news broke on August 15 that Mid-America Apartment Communities had agreed to take over Post Properties, MAA’s share price fell by 4.9 percent in a single day, and it hasn’t recovered since. Investors often buy REIT shares to invest in underlying real estate markets. The more diversified a REIT is, the more difficult that gets. Those bullish on the New York market, for example, may prefer SL Green’s stock (which is almost exclusively focused on New York City) to Vornado’s (which has a significant chunk of its holdings in D.C.).
Speaking of SL Green: When news broke last year that the company was in talks to take over the embattled firm New York REIT, its stock price took an immediate beating. After SL Green publicly stated that it was not pursuing the merger, its stock price shot up by 5.5 percent in a single day. And that kind of reaction is common. “The few companies that have merged have not been rewarded in the market,” said John Kim, an analyst at BMO Capital Markets. After SL Green bailed, New York REIT appeared to have found a buyer in JBG. But the two companies called off the deal in August after it became clear that shareholders were lukewarm to it at best. Instead, New York REIT’s board decided to liquidate the company by selling its properties one-by-one.
Debt markets also play a role. “You don’t have the big, highly leveraged transactions that you had in the last cycle,” said Alexander Goldfarb, an analyst at Sandler O’Neill, referring to the last big REIT merger wave of 2005 and 2006. (Unlike some other analysts, Goldfarb doesn’t believe that REIT M&A activity is muted.) Banks today are generally more cautious underwriters, meaning REITs have to put up more of their own equity to fund acquisitions, making them more expensive and harder to pull off.
And finally, concerns over the health of the real estate market discourage mergers. We’re at the “end of the cycle for all property types,” said John Guinee, an analyst at Stifel, Nicolaus & Co.. For a takeover to work, the buyer has to pay a premium on the target’s share price. Paying that premium makes a lot more sense if you think property values, and by extension REIT shares, will rise in the future.
None of the above means takeovers aren’t happening, or that merger activity won’t pick up in the future. For all their disadvantages, REIT mergers can make a lot of sense. Stocks often trade at a discount to the net asset value of underlying properties, meaning REITs can pay less for real estate if they buy another REIT whole, rather than buying individual buildings from it. There have been some recent examples of investors normally thought to be direct buyers of properties buying REIT shares in bulk. Steve Witkoff, for example, became an activist investor in New York REIT. And in August, the Qatar Investment Authority, the resource-rich country’s sovereign wealth fund, bought $622 million worth of shares in Empire State Realty Trust, giving it about a 10 percent stake in the REIT.
Moreover, there are small REITs that could benefit from getting bigger to gain a higher profile along with better access to debt and equity investors, said Kim. “I think we probably will see more mergers,” he said. “In my opinion, there are too many REITs.”
(Read more of The Long View here.)