Last year was a challenging one for the commercial real estate sector. The pandemic induced uncertainty across the industry as rental collection rates declined, putting pressure on asset values, including the share prices of most real estate investment trusts (REITs). That caused M&A activity in the sector to fall off a cliff as buyers and sellers couldn't come to terms on values. Two notable pre-pandemic deals even fell apart amid the initial uncertainty.
However, with coronavirus vaccines rolling out, there's finally a light at the end of this dark tunnel. That's giving REITs more confidence to do deals, including resurrecting those that collapsed amid the initial chaos. Here's a look at what could drive an acceleration in REIT M&A activity in the coming months.
New buyers emerge
Goodwin, a global corporate law firm, recently put out a report analyzing the 32 new REIT M&A transactions announced from January 2019 to March 15, 2021. It noted 87% of them were public-to-public deals, with the rest go-private transactions.
For example, notable deals have included Simon Property Group's (NYSE: SPG) $3.4 billion acquisition of fellow mall REIT Taubman Centers last year and Prologis' (NYSE: PLD) $13 billion purchase of fellow industrial REIT Liberty Property Trust in 2019.
However, in recent months, we've seen an increase in go-private transactions. For example, private equity firms Blackstone Group (NYSE: BX) and Starwood Capital are teaming up to take hospitality REIT Extended Stay America (NASDAQ: STAY) private in an all-cash transaction valuing it at $6 billion.
Meanwhile, leading alternative asset manager Brookfield Asset Management (NYSE: BAM) agreed to privatize its publicly traded real estate affiliates Brookfield Property Partners (NASDAQ: BPY) and Brookfield Property REIT (NASDAQ: BPYU). Brookfield and its institutional partners will pay $6.5 billion in cash, Brookfield stock, and preferred units to acquire the rest of Brookfield Property that they don't already own.
On top of that, an investor group has offered to take office REIT Columbia Property Trust (NYSE: CXP) private at $19.50 per share. Columbia hasn't accepted that proposal. It has launched a strategic review process to explore a possible sale to this group or another buyer.
One of the driving factors behind these go-private transactions is the belief among institutional investors that the public market isn't fully valuing these REITs. The investor group trying to buy Columbia wrote in a letter to the REIT's board that they "believe in the long-term value of Columbia's high-quality office holdings." However, they feel "stockholders are not likely to realize the value of the Company's assets in the foreseeable future if the Company remains on its current course in the public market."
Brookfield Asset Management hinted at something similar when it made its initial offer to Brookfield Property. CFO Nick Goodman stated that "the privatization will allow us to have greater flexibility in operating the portfolio and realizing the intrinsic value of BPY's high-quality assets."
While privatization transactions have been on the rise in recent months, that doesn't mean corporate mergers will necessarily take a back seat. Quite the contrary, as more REITs could seek a merger partner to increase their scale. That's because the right combination can reduce costs and improve investment returns.
The most recent example of a scale-driven corporate merger was a deal between mortgage REITs Ready Capital (NYSE: RC) and Anworth Mortgage Asset that closed earlier this year. According to the press release, the transaction created a "scaled commercial mortgage REIT with a combined capital base in excess of $1 billion and a diversified investment portfolio." It also "substantially improved operating leverage due to increased scale." Ready and Anworth went from the 11th and 14th largest mortgage REITs by equity base, respectively, to the seventh-largest following their merger.
Given the scale advantages REITs can achieve by combining, it wouldn't be surprising to see smaller ones in the same subgroup join forces. Those combinations could improve their cost of capital and reduce their operating costs, which would enhance their ability to create shareholder value. Smaller REITs operating in the office, retail, lodging and resort, and healthcare sectors could all benefit from the improved scale they'd gain in a corporate merger. Each subgroup currently faces some pandemic-related headwinds and has more than a dozen publicly traded REITs competing for investor capital and growth opportunities.
Expect a flurry of deals (and investment opportunities) in 2021
Overall, Goodwin noted three catalysts that could drive an acceleration in deal-making this year:
- Pent-up demand: Institutional investors have large cash war chests, which, when combined with historically low interest rates, could fuel "a flurry of REIT M&A activity."
- Ability to reach a consensus on valuations: With more clarity on the economic recovery, buyers and sellers can narrow their valuation differences and agree on a price.
- First mover advantage: Historically, M&A transactions immediately following a downturn have yielded the best returns, which could drive forward-thinking REITs to get ahead of their competitors by going on the offensive.
Add it all up, and it appears as if M&A will speed up this year. That makes now a great time to buy REITs, since a flurry of deals should boost valuations across the sector.