The commercial real estate sector is still in the mergers and acquisitions mode, with two new deals announced last week involving a national brokerage firm and a commercial mortgage lender.

But the rationale for such transactions seems to be getting murkier, with industry analysts wondering whether the deals make sense for all parties.

On May 22, national brokerage house Grubb & Ellis announced a definitive merger agreement with Santa Ana, Calif.-based NNN Realty Advisors, Inc., an asset management firm that specializes in tax-deferred property exchanges, to form a joint real estate services firm with a total capitalization of $725 million.

On the same day, New York-based finance company iStar Financial, Inc. announced a definitive agreement to acquire the commercial real estate lending business and 30 percent of the $6.5 billion commercial loan portfolio of Santa Monica, Calif.-based Fremont General Corp. for approximately $1.9 billion. Fremont lends on all property types, including retail. In 2006, it originated about $800 million on retail real estate, according to Retail Traffic's 2006 Retail Lender List.

The Fremont deal comes as no surprise as the company was one of the lenders hit by the crash in the sub-prime market crash. On March 5, Moody’s Investors Service downgraded the company’s senior debt rating from B2 to B3, citing reduced financial flexibility. The deal with iStar Financial will allow Fremont to take down the risk on its debt and will extend iStar’s geographic reach. But it could end up being a Trojan horse for iStar, says Morningstar analyst Erin Swanson.

“The question in our eyes is how much exposure does iStar now have to Fremont’s non-performing loans?” she asks. “Depending on that exposure, the [actual] cost of the transaction can be much higher than the [$1.9 billion] purchase price.”

Of particular concern to Swanson is Fremont’s exposure to the condominium conversion market, a sector that has been over-developed in some markets. Financing on those deals comprises 45 percent of Fremont's commercial loan portfolio.

“There were conversion projects that were started that were then just scrapped off the board, so the initial supply went way beyond what the demand was,” she notes. “That was the one area of Fremont’s loan book that made us raise our eyebrows.”

In 2002, Fremont sold its workers’ compensation unit in order to concentrate on commercial and sub-prime residential real estate loans. The business initially generated good returns, but even then some real estate consultants warned that Fremont would take a big hit in the event of an economic downturn. That fear materialized earlier this year, when the Mortgage Bankers Association revealed that delinquencies on sub-prime loans rose to 13.3 percent in the fourth quarter of 2006, up 77 basis points from the third quarter.

Under its new chairman of the board Gerald J. Ford, Fremont now plans to concentrate on its retail deposit business. Earlier this spring Ford agreed to purchase $80 million worth of the company’s exchangeable non-cumulative preferred stock and is set to acquire additional common shares.

Since May 22, when Fremont’s stock was trading at $10 per share, its price rose by 19.5 percent, to $11.95 per share at the close of the day on May 29. iStar’s stock price has been relatively flat, moving from $47.60 per share on May 22 to $47.81 yesterday. After the transaction closes, early this summer, iStar’s assets will total more than $14 billion.

iStar and Fremont did not return calls for comment.

Brokers Beware?

The Grubb & Ellis deal, meanwhile, is raising eyebrows for another reason as analysts and consultants don't know what to make of the transaction or how it will help either firm. Grubb & Ellis chairman C. Michael Kojaian has said the deal will be good for the "long-term growth" of the company, but hasn't discussed specifics. A spokesperson for Grubb & Ellis emphasized that deal works because Grubb & Ellis’ and NNN Realty Advisors’ have no overlaps in their services therefore the parts can be added without making any major changes to how the firms do business.

After the merger is completed, the combined company’s headquarters will be moved to Santa Ana and the Grubb & Ellis board of directors will be expanded to nine members, including six nominees from NNN Realty Advisors.

The trend among broker mergers typically has been for two firms with complementary platforms to merge or for a national firm to buy a regional one to gain market share, according to Michael J. Lipsey, president of the Lipsey Co., a Longwood, Fla.-based real estate training and consulting firm.

In this case, however, the smaller firm--NNN--is buying a larger one Grubb & Ellis. After the deal, NNN's stockholders will own 59 percent of the combined entity, while Grubb & Ellis stockholders will own only 41 percent. Grubb & Ellis offers a great brand name for NNN, Lipsey says, but with no business overlap, he is perplexed as to what motivated the deal.

“When CB Richard Ellis and Trammell Crow get together, you can clearly see the benefits. When Jones Lang Wootton merged with LaSalle Partners, you could say, 'I understand.' I don’t understand this one – it doesn’t mean it’s not a good one, but I am not that familiar with NNN,” he notes.

Morgan Stanley analyst Jennifer L. Pinnick has a similar reaction to the deal. The benefits to NNN are clear, she wrote in a note on May 22 – the Grubb & Ellis platform will give the firm access to new transactions and increased equity for its TIC business. But with limited financial information available on NNN “we are unclear of the benefits to Grubb & Ellis at this time,” she writes.

Since the merger was announced Grubb & Ellis’ stock price rose more than 7 percent, from $11.62 on May 22 to $12.49 at the close of the day yesterday.

-- Elaine Misonzhnik