After lying low for 18 months, mergers and acquisitions are expected to make a return.

The real estate industry is ripe for consolidation, Everyone says so. Then why have no more than a handful of companies made deals over the past few months?

A few recent deals involved REIT-to-REIT combinations. Others involved pension fund acquisitions of REITs or public companies going private.

In 1997, in the REIT category alone, 12 transactions occurred. In the following year, 13 REITs bought other REITs. Activity fell in 1999, as the run-up of technology stocks moved capital out of REITs, public real estate operating companies and many traditionally attractive stocks in other categories.

Observers point to the stock market as the main reason for the drop. As capital moved into the virtual world, real estate stocks declined precipitously and killed off the developing mergers and acquisitions (M&A) market in that sector. "The major reason for the decline in M&A activity is that there have not been significant differences in [FFO] multiples, which would make consolidation a lot easier," says Martin Cicco, co-head of investment banking and real estate with New York-based Merrill Lynch & Co.

Throughout 1999, declining stock prices brought multiples into a state of near parity across the public real estate market. "A couple of points difference in multiples allows a premium to the acquired party and allows the buyer some level of accretion," continues Cicco. "Of course, the capital structure of both companies has to fit the equation, too. If one company is more levered than the other, it will alter the balance. Factors such as geographic fit and synergy come into play as well."

Still, the driving force in M&A activity among public companies is stock price. "It is totally a function of stock price," says Dale Anne Reiss, global industry leader with New York-based Ernst & Young Kenneth Leventhal Real Estate Group. "REIT stock prices have been depressed, and there has been no differential between well-managed REITs and not-so-well-managed REITs."

When stock prices are down, buyers and sellers find it difficult to agree on price, says Christopher Niehaus, managing director with Morgan Stanley Dean Witter, New York. "The seller insists that its stock is undervalued and demands a price closer to its intrinsic value," says Niehaus. "Likewise, a buyer believes its stock is undervalued and refuses to trade its stock based on the seller's perception of intrinsic asset values. So buyers and sellers end up in a circular argument and cannot cut a deal. This is why nothing much happened in the first half of 2000."

A brief pause in the action? Although M&A activity has been slow, circumstances may change in the second half of the year. Analysts insist that the real estate industry remains ripe for consolidation and that the recent lack of activity represents nothing more than a pause related to the financial markets.

"There are about 170 public REITs right now," says Bruce Schonbraun, managing partner with Schonbraun, Safris, McCann, Bekritsky & Co. LLC, a real estate consulting and accounting firm based in Roseland, N.J. "REITs are here to stay. They serve a solid purpose for investors. But there are too many of them. There is no fundamental need to have 20 shopping center REITs."

Sooner or later, in other words, REITs will begin buying other REITs. Not just yet, though. Just four major acquisitions reached completion in the first half of 2000.

Heritage Property Investment Trust Inc., a private REIT based in Boston, acquired Northbrook, Ill.-based Bradley Real Estate, the nation's oldest REIT, for $1.12 billion. Chicago-based Equity Office Properties, purchased New York-based Cornerstone Properties Inc. for $4.6 billion. Lennar Corp., a Miami-based homebuilder acquired U.S. Homes for $1.3 billion. And in Canada, Toronto-based Ontario Teachers Pension Fund purchased Cadillac Fairview, Toronto, a major developer and owner of commercial office and retail property in Canada.

A safe haven While these few deals inched toward completion throughout the first half of 2000, the financial markets changed: NASDAQ blew a gasket; the Federal Reserve Bank continued to raise interest rates; and the traditional stock market fluctuated wildly, with the New York Stock Exchange ending down about 10% after the first quarter.

In response, investors sought safe havens in the form of undervalued companies with good fundamentals. REITs fit that bill and opened their arms to these investors. According to Morgan Stanley's Chris Niehaus, REIT stocks emerged from their slump during the first half of 2000. "The Morgan Stanley REIT index was up 23% year-to-date through July, notes Niehaus. "And we are starting to see some activity. For example, the first REIT equity issue in a number of years occurred in early August, when Kimco did an overnight deal."

The offering by New Hyde Park, N.Y.-based Kimco Realty consisted of 1.8 million shares of common stock priced at $42.50 per share. According to Kimco, the proceeds will provide capital for Kimco Income REIT investments in retail properties.

As Kimco was preparing its stock offering, stock price movements across the real estate category created some winners and losers. As a result, several new deals materialized.

Denver-based Apartment Investment and Management Co. (AIMCO) announced plans to acquire Oxford Realty Financial Group, Bethesda, Md., for $856 million. Cranford, N.J.-based Mack-Cali Realty Corp. announced an offer to acquire Dallas-based Prentiss Properties Trust for $2.3 billion. And Equity Residential Properties Trust, the largest apartment owner in the United States, agreed to purchase Hartford, Conn.-based Grove Property Trust, for $461 million.

Diversifying the portfolio Analysts expect investors to gravitate toward large diversified companies offering consistent returns and liquidity, enabling these companies to target strategic M&A partners. The recently announced deals tend to illustrate his point.

The Mack-Cali deal, for example, seeks to create a large national company with depth in a variety of geographic markets, a strategy that may provide investors with increased value as well as liquidity. "This transaction substantially enhances the growth potential of our companies and establishes a new company with a highly-attractive national platform," says Mitchell E. Hersh, CEO of Mack-Cali, who also will serve as CEO of the combined company. Hersh adds that the strategic benefits of the acquisition go far beyond adding diversity, liquidity, scale and increased operational efficiencies to Mack-Cali's combined portfolio.

"This transaction is about depth. Both companies are confident that the long-term winners in the real estate industry will be national companies with regional strength that can provide their customers with unparalleled levels of choice and service," he says.

The Equity Residential-Grove Property combination focuses on a strategy designed to enhance geographic reach. "This acquisition substantially increases our presence in high barrier-to-entry New England markets, particularly suburban Massachusetts, says Douglas Crocker II, president and CEO of Equity Residential.

Obviously, not all REITs and public REOCS will satisfy investors' demands for value. As a result, the investment community will play a key role in determining which REITs will remain independent. REITs that attract investments will build stock multiples powerful enough to tender offers. Those that don't attract investors and raise their stock prices may still attract buyers if they have assets another real estate company views as strategically important.

On the other side of the equation, companies that don't want to deal with investor demands may prefer to look for buyers or to return to private ownership with a stock buyback.

"One of the key issues facing public companies today involves management interests that may conflict with shareholder interests," says Jacques Brand, managing director and head of real estate investment banking in the United States and Europe for New York-based Deutsche Banc Alex. Brown. "Take Bradley Real Estate, for instance," says Brand. "This is a company that was willing, in the face of some obstacles, to look for ways to maximize value for shareholders."

In light of Deutsche Banc's advice, the Bradley decided that the best way to maximize shareholder value was to sell to Heritage Property Investors. "We might also advise a company in a different [but still undervalued] position on how to take itself private," continues Brand.

Deutsche Banc did just that earlier this year when it helped Los Angeles-based Castle & Cooke Inc., assemble a $615 million take-private transaction that is slated to close in September. Castle & Cooke develops residential real estate, resorts, and commercial real estate. With Deutsche Banc's help, Castle & Cooke will continue its work away from the scrutiny of the public investment arena.

While M&A activity in North America may have been sluggish during the first half of the year, the same is not true in Europe. According to Brand, European financial restructuring has produced numerous deals, as companies divest and acquire to bring their operations into more comfortable balance.

For example, Deutsche Banc recently advised London-based Allied London Properties, on a $227.5 million take-private transaction, which re-named the company Arrow Property Investments. Deutsche Bank provided private equity, senior and mezzanine financing for the transaction.

While the on-again, off-again M&A activity in the real estate market in the United States is fueled by stock prices, the strategies behind the deals have followed classical business patterns. "What's happening in the REIT and commercial property business happens in all healthy businesses," says John Kriz, managing director of real estate finance with Moody's Investors Service, the New York-based global rating agency. "Some companies buy and others merge to increase strategic traction," says Kriz. By participating in M&A activity, these companies show that they are no longer a bunch of development jocks or an assemblage of assets."

Racing to 2001 According to Jay Leupp and Paul Penney, analysts with the San Francisco office of Robertson Stephens, a full-service investment bank that focuses on growth companies, the current rally in REIT shares "is likely to continue through the remainder of 2000."

If stock prices do indeed continue to rise, a year that began slowly with little M&A activity may end up racing into 2001. And next year, new tax laws may further alter the balance for REITs. In 2001, new tax laws will permit REITs to engage in non-traditional real estate business.

"Next year, REITs can invest in activities, up to a certain percentage of assets, that are not real estate oriented," says Brand.

"This means that REITs can undertake technology initiatives in areas such as electronic commerce and telecommunications. Such activities will not only enhance the value of assets but also provide new sources of income."

The result?

More winners, more losers, and perhaps, a return to higher speed mergers and acquisitions.

No more than a handful of completed or announced transactions characterize the merger and acquisition activity within the North American real estate market during the first half of 2000. While the following list of transactions indicates trends in merger and acquisition activity, it is not meant to be a comprehensive survey.

Completed transactions: - Chicago-based Equity Office Properties Trust purchased New York-based Cornerstone Properties Inc. for $4.6 billion.

- Boston-based Heritage Property Investor acquired Northbrook, Ill.-based Bradley Real Estate Inc. for $1.12 billion.

- Toronto-based Ontario Teachers Pension Plan Board acquired Cadillac Fairview Corp., also of Toronto, for $2.3 billion.

- Lennar Corp., a Miami-based homebuilder, acquired U.S. Homes for $1.3 billion.

Transactions announced in 2000: - Denver-based Apartment Investment and Management plans to acquire Bethesda, Md.-based Oxford Realty Financial Group Inc. for $856 million.

- Chicago-based Equity Residential Properties is expected to acquire Hartford, Conn.-based Grove Property for approximately $461 million.

- Cranford, N.J.-based Mack-Cali Realty Corp. plans to acquire Dallas-based Prentiss Properties Trust for $2.3 billion.