Top-Level Transactions

Institutional investors find opportunitiesto diversify their portfolios.

A lthough capital continues to flow into commercial real estate at unprecedented levels, the real news is the intense competition for properties as well as the size, diversity, and complexity of transactions this money fuels. U.S. real estate investment trusts and REIT-like structures worldwide are taking advantage of this highly charged environment to diversify and grow their portfolios. How long will this climate continue? Analyzing recent transaction activity may offer clues about the future of instit utional commercial property investment.

The Market's Evolution

In 2004, the big stories were 27 REIT initial public offerings totaling more than $7 billion and 20 public REIT mergers and acquisitions involving $34 billion, most notably some very large transactions in the retail sector. In 2005, the big news was real estate private equity funds buying public REITs and hospitality companies.

What is the big story this year? Although public REIT merger-and-acquisition and IPO activity declined slightly during 2005 from the record-breaking 2004 levels, activity so far this year indicates that both trends show healthy signs of increasing. Transaction numbers and the volume of recent significant merger-and-acquisition activity are up with respect to private equity funds buying public REITs.

Private equity investor Blackstone Group has acquired more than $20 billion in hotel assets, including the La Quinta hotel chain for $2.3 billion in April.
photo credit: LQ Management LLC

Pension funds remain the single largest source of capital fueling institutional private equity funds' ongoing acquisitions. These pension funds, in search of yields that will generate the income needed to meet their rising obligations, remain committed to real estate as an asset class for a number of reasons. For instance, changing baby boom demographics and the associated need for increasingly higher yields on investments; the real estate market's past performance across all property types; real estate's worldwide appeal due to available information and research; and greater investor confidence, scrutiny, and increased transparency in financial reporting are key
reasons pension funds continue to seek real estate. In addition, commercial real estate can provide consistent cash flows and portfolio diversification.

Projected new capital flows into real estate from all tax-exempt investors will total $59.3 billion this year, according to an Institutional Real Estate survey, an increase of about 16 percent over 2005's figure. Of that capital, 26.7 percent is allocated to opportunistic investments, 26.2 percent to value-added strategies, and 21.8 percent to core real estate.

While pension funds historically have allocated some 4 percent of their total assets to real estate, many experts believe that this percentage may rise to 10 percent to 15 percent of total assets within the next decade. This monumental shift in asset allocations could well mean future annual commitments to real estate in excess of $100 billion.

Many large pension funds have sold investments to lock in higher returns and reposition their portfolios. For example, the California Public Employees Retirement Systems, or CalPERS, reported a 40.8 percent return on real estate investments during the year ending June 30, 2005, making it the best year in the fund's history - a result of property sales driven by unprecedented market pricing levels. Returns such as these clearly provide the impetus for many other pension funds to increase their allocations to real estate.

In addition to pension funds, tax-exempt endowments, high-net-worth individuals, and foreign investors continue to pour substantial capital into private equity funds. An estimated $118 billion is available this year for value-added and opportunistic real estate investments worldwide, according to a recent Ernst & Young survey.

REIT Privatization Increases

Today's institu tional real estate private equity funds offer a wide and varied menu such as core and value-added funds, real estate hedge funds, opportunistic funds, and mezzanine debt funds, among others. Real estate funds not only are making direct investments in properties, they now are investing in public companies including REITs.

Because of the fierce competition to acquire properties and the record-high pricing found across most asset classes, private equity funds have amassed billions of dollars and are searching for larger targets where the rarified atmosphere limits competition. Consequently, REITs have become attractive takeover candidates primarily because these funds believe an arbitrage exists between the value of a REIT's assets and its stock price.

REIT privatization reached unprecedented levels in 2005 and many industry experts believe that as many as 10 REITs may privatize this year. Generally speaking, REITs privatize for a few key reasons such as the disparity between the REIT share price and the underlying assets of the REIT, the high cost of Sarbanes-Oxley compliance, a propitious time to sell in a current climate of high demand and record low capitalization rates, and increased flexibility of operating as a private company.

From early 2005 through June 15 of this year, approximately 12 public REITs were acquired and taken private. A recent transaction that surprised many industry experts is Brookfield Properties and the Blackstone Group's joint-venture acquisition of Trizec Properties for $8.9 billion in equity and assumed debt. This sale was the second-largest REIT merger and acquisition transaction ever recorded, following only General Growth Properties' 2004 acquisition of the Rouse Co. for approximately $12.6 billion including equity and the assumption of debt.

This transaction comes on the heels of the Blackstone Group's previously announced $5.6 billion pending acquisition of office REIT CarrAmerica Realty - a transaction that dwarfed the largest announced REIT acquisition of 2005, Arden Realty's sale to GE Real Estate for $4.8 billion. In fact, last year eight publicly traded REITs were sold or announced involving more than $20 billion, as compared with 2004 when only three REITs went private for a total cost of $2.6 billion.

Private equity activity indeed spans the gamut of all commercial real estate property types. (See table.) In addition to the property type transactions illustrated, significant merger-and-acquisition activity in the hotel sector includes the following deals.

  • In the past two years, the Blackstone Group has gobbled up more than $20 billion worth of hotel companies including its most recent announced purchase of MeriStar Hospitality for $2.6 billion. Recent purchases also include Wyndham International for $1.44 billion, La Quinta for $2.3 billion, and Extended Stay America for $2.0 billion.

  • Colony Capital, along with Kingdom Hotels International, recently purchased Fairmont Hotels for $3.3 billion. In addition, they acquired the Raffles Hotels & Resorts luxury chain in 2005.

  • Starwood Capital Group recently acquired the Paris-based luxury hotel chain Groupe Taittinger.

Many experts predict that this steady stream of REIT privatizations is likely to continue - a trend being fueled by two separate factors on the buy side. In certain cases, many value-added and opportunistic funds are looking to take advantage of REITs' development pipelines and are willing to pay premium prices to gain control of their real estate assets. Secondly, many investors are eager to acquire a group of properties in a single, large transaction. At the same time, some REIT managers consider privatization because it eliminates the pressure to accommodate the demands of shareholders.

Although the trend toward private equity funds acquiring public REITs continues, some companies are moving in the other direction by forming their own private equity funds that potentially could go public at a later date. This strategy identifies public markets as a possible exit route for privately held real estate companies - a strategy that might emerge from the big REIT acqui sitions of 2005 and 2006, particularly if market conditions change.

Given the density of available institutional capital, a number of public REITs recently have created private equity funds as a way to access the flow of capital into real estate. For example, two large industrial REITs, ProLogis and AMB Property Corp., recently launched their own private equity funds. In 2005, AMB successfully started a $2.2 billion fund focused in Japan with institutional investors providing approximately 80 percent of the fund's total equity. In March, ProLogis launched the ProLogis North American Industrial Fund, an open-end fund that raised $1.85 billion from a global institutional investor base. If current market conditions continue, look for many other REITs quickly to follow suit and create their own private equity funds as vehicles to further access institutional money.

The public REIT vehicle is becoming a more widely utilized structure for institutional private real estate investors and could potentially become an exit strategy for many private REITs. For instance, Kohlberg Kravis Roberts recently raised $839 million in a REIT IPO. J.E. Roberts, a real estate advisory firm and opportunistic investor, also recently created a publicly traded REIT called JER Investors. This trend is likely to continue as market conditions change and companies seek liquidity by way of public markets. Many private REITs invariably will need to examine this strategy to provide liquidity for their investors as well.

Last year Colony Capital and Kingdom Hotels International purchased Raffles Hotels & Resorts, which includes luxury properties such as the Raffles L'Ermitage in Beverly Hills, Calif.
photo credit: Raffles Hotels & Resorts

Looking Ahead
At the end of 2005, slightly fewer than 200 U.S. REITs existed and REITs and REIT-like entities began appearing in Europe and Asia. However, REIT-like legislation enacted worldwide has provided new opportunities for property owners to obtain liquidity, access new sources of capital and potentially provide tax benefits to owners and investors. Given this continued trend toward greater foreign REIT-like legislation, U.S. REITs are likely to increase their overseas merger-and-acquisition activity as well as their capital commitments to real estate projects throughout the world. Additionally, this REIT-like legislation will continue to provide access to global real estate markets to individual high-net-worth investors seeking an alternative to the current competitive nature of the U.S. real estate market.

Some 20 countries including Australia, Belgium, Brazil, Canada, France, Greece, the Netherlands, China (Hong Kong), Italy, Japan, Singapore, Mexico, Spain, and Turkey recently have passed their own legislation creating REIT-like structures. Australia and the Netherlands currently have the most established REIT markets. Germany recently announced plans for its own REIT market and similar legislation also is pending in the United Kingdom.

As the year winds down, the industry can expect more sophisticated and complex transactions of larger magnitude to continue as entities take advantage of abundant capital and increasing worldwide opportunities. The emerging industry developments are likely to continue on a global basis as the number of potential acquisition candidates grows, capital remains plentiful, and market fundamentals continue to improve.

Scott Farb, CPA

Scott Farb, CPA, is managing principal of Gumbiner Savett\'s national real estate practice in Santa Monica, Calif. Contact him at (310) 828-9798 or visit