Judging the depth of commercial real estate's merger and acquisition activity can be tricky. Last year, a record $58.4 billion in mergers were completed, nearly double the $32.3 billion volume of activity in 1997, according to Real Estate Alert. Obviously, the market appeared healthy.

But 1998's numbers were skewed by the Starwood Hotels & Resorts-ITT deal, which was valued at $13.7 billion. Indeed, the number of actual deals fell from 67 in 1997 to 52 last year.

The good news for real estate advisors in 1998 was the average size of mergers doubled from the year before, but that's a trend line that might not continue in 1999 as there were some very large deals done last year - the Simon DeBartolo/Corporate Property Investors transaction was valued at close to $6 billion - and it is thought that this year some of the big acquiring companies of previous years might concentrate on performance instead of growth.

"Wall Street is looking to see if real estate investment trusts can now manage what they bought," says John Moody, chairman and chief executive officer of Cornerstone Properties Inc. The big, New York-based office REIT pulled off one of the major deals in the office sector last year when it purchased William Wilson & Associates for $1.8 billion.

"The investment community wants to see how REITs integrate the companies they acquired, to see if they can add internal FFO growth, if acquisitions really are going to be one plus one equals three," continues Moody. "The analyst community seems to be [de-emphasizing] acquisitions and mergers this year in general because they want to see how everything panned out from last year."

According to Jacques Brand, managing director at BT Alex. Brown, there will continue to be plenty of M&A activity in 1999. "This year for REITs is one in which they are going to have to rationalize assets and focus on their operations, integrating many of the acquisitions they made over the last couple of years," he says.

Most of Wall Street's investment banks that advise on real estate M&A obviously boasted a record year in 1998, but again that is skewed by some of the bigger deals. Merrill Lynch, Chase Securities, Goldman Sachs and Lazard Freres headed the list of Real Estate Alert's M&A advisors last year, but all four worked on the Starwood Hotels-ITT transaction.

Morgan Stanley Dean Witter boasted a banner year in 1998, with a No. 1 share in announced transaction volume and did so without the help of Starwood Hotels. Real Estate Alert ranked Morgan Stanley the fifth busiest dealmaker of 1998 with approximately $17 billion in transactions. Morgan Stanley, which uses a different criteria, says its M&A business was about $26 billion last year.

This year, Morgan Stanley expects to see a continuation of dealmaking among real estate companies. "My sense is there will be fewer deals, but they will be larger," says Scott Kelly, a managing director at Morgan Stanley. "Deals may be larger, and a good number won't fit the classic purchase of an operating company scenario." So far this year, Morgan Stanley advised on several major deals including the recapitalization of Patriot American, the merger of LaSalle Partners and Jones Lang Wootton, two real estate service companies, and AMB Property Corp. as it divested its retail business for about $1 billion.

Another 1999 deal that might be considered in the same vein is Irvine Apartment Communities recently going private, having its shares purchased by a wholly owned subsidiary of the parent firm, The Irvine Co.

The commercial real estate market has finally come to the realization that many of the real estate companies that went public in 1993 and 1994, at the height of the IPO market, are simply not making it, says Chris Niehaus, also a managing director at Morgan Stanley. "It's been about five years since many of these companies went public and a large number of these companies are still at or below their IPO prices," he says. "There is a lot of fatigue in the management teams of many REITs and there is an increasing level of frustration at the board level. Senior operating managers are beginning to seriously consider whether they want to continue to run what are mostly unsuccessful public companies from a share-price perspective."

The activity of the lodging sector also weighed the M&A tables last year. Of the 15 deals valued at $1 billion or more in 1998, seven were from the lodging sector. (Some of the deals were actually announced in 1997 but weren't concluded until 1998.) There were also two lodging-related deals - Crescent Real Estate Equities/Station Casinos and Equity Inns Inc./RFS Hotel Investors - that were announced and then terminated without completion in 1998.

The collapse of the Equity-RFS deal highlighted the effect of sagging share prices. Like many REIT-to-REIT deals, the agreement was predicated upon a fixed-share price.

However, shares of Equity Inns fell more than 30 percent prior to the proposed closing date. Looking at the deals last year, "We concluded that common stock was unlikely to be used as the currency for continuing deals," says Paul Reeder, director of REIT Research at SNL Securities in Charlottesville, Va. "The abandoned merger gives significant cause for re-examining the currency used in REIT mergers."

Reeder suggests future deals would need to be restructured with larger amounts of cash and/or preferred stock. An example of such a transaction was United Dominion Realty's acquisition of American Apartment Communities, a private REIT, for $787 million in preferred stock, assumed debt, cash and operating partnership units.

Equity Inns shouldn't be singled out as a REIT that suddenly lost favor with investors. The whole REIT market badly stumbled last year (down about 20 percent) as almost all REITs were trashed by investors. So, why then was there so much M&A activity in 1998 if the REITs were suddenly out of favor?

The answer is that there were actually two markets last year. Most of the M&A activity was done in the first part of the year. By mid-year 1998, weakening share prices began to take a toll on new deals and then in late summer-early fall, the turmoil in the international capital markets all but killed off any deals that might have been in the works.

"There were a number of transactions that fell apart as a result of the dysfunctional capital markets which impacted both debt and equity. Some transactions were just made unfeasible," says BT Alex. Brown's Brand. "Companies waited for multiples to stabilize. Unfortunately, they stabilized at a much lower level."

Despite the low multiples, Brand says there is continued support for consolidation in the REIT sector. Despite how absolute multiples have declined on a relative basis, there have been a number of mergers. For example, the $5.2 billion merger of Duke Realty Investment Inc. and Weeks Corp., expected to close at the end of this month, is a transaction "in which the companies have relative multiples. The merger makes economic and strategic sense from a shareholder perspective."

In 1996, there were just five REIT-to-REIT mergers with a total transaction volume of $4.2 billion. Those numbers jumped to 12 mergers and a volume of $10.8 billion in 1997, and in 1998, the number edged up to 13 mergers with a volume of $11.9 billion.

"Excluding the lodging transactions which accounted for a substantial portion of M&A activity in 1998, volume will equal or exceed last year's total," says Brand. "We will continue to see merger activity within each one of the property sectors as companies, where it makes sense to have a larger asset base, are filling in geographically through mergers and acquisitions."

The net effect of '98 The collapse of the capital markets last year, as noted, severely slowed

down M&As over the last quarter of 1998. Unfortunately, this has produced a level of lower activity in the first part of 1999. "In the first quarter, we have seen the lag effect of the slowdown in dialogue which resulted from the deterioration of the market late last year," says Morgan Stanley's Kelly, adding that this trend is ending. "The run rate of business right now is as high as it has ever been. Whether or not that is going to manifest itself in the same volume as we did last year, we'll have to see."

M&As among commercial real estate companies is not going to go from where we are now to 100 deals in a minute, "but you are going to see an uptick in activity," says Richard Schoninger, managing director and group head of real estate for Prudential Securities. Actually, he suspects there will be an explosion of new business. "They may not be the big, blockbuster deals of last year but there will be a record volume of transactions."

Prudential Securities was involved in 10 M&A deals valued at $6.5 billion last year. Schoninger expects both the number and volume of deals will increase at Prudential in 1999. "For the first time, we are seeing a divergence in the stock performance of large cap REITs vs. small cap REITs," Schoninger reports. "Prior to 1999, they basically moved in step with each other and since January 1, large cap REITs are starting to do significantly better on a relative basis than small cap REITs, and this is also going to create the momentum for merger activity and consolidation. At the same time a lot of small cap REIT management teams are acknowledging that it is going to be very tough to survive and prosper."

Arthur Solomon, former managing director and head of real estate investment banking at Lazard (for the latest staff changes at Lazard Freres turn to "Industry Insider," p. 6) notes how the industry continues to question public status. "There are a lot of shareholders in public companies basically saying, 'We are selling at a significant discount to our underlying net asset value (NAV), and there is a question about whether staying public makes much difference,'" he says. Lazard Freres advised on about $30 billion in transactions last year ($19.3 billion and a No. 4 ranking in Real Estate Advisor's listing), including the aforementioned Starwood/ITT deal.

Solomon suggests this year will not produce the same level of M&As. "Strategic and financial imperatives still drive mergers and acquisitions, but now there is the cost of capital question," he explains. "The cost of capital is the major reason for this slowdown."

A secondary reason could easily be stock prices. Every deal needs a willing seller and a capable buyer, says Solomon. "Unfortunately, given the current price of most REIT stocks, M&As are more difficult. With volatility in the stock prices, it makes it a little bit tougher with respect to mergers. It doesn't make it impossible, just difficult."

Also suggesting a bit of a M&A slowdown this year at least as compared last year is Robert Lieber, a managing director with Lehman Brothers. In Lieber's view, the public-to-private market has stalled because the public company currency (stock prices) doesn't have anywhere near the same kind of value that it used to have. As a result the public companies aren't as aggressive about acquisitions as they were in the past.

In 1997, public-to-public deals represented more than 62% of all transactions, says Lieber. In 1998, public-to-public deals were a little less than 50% of total deals done. Conversely, in 1998, public-to-public deals represented about 35% of the market, up from 28% in 1997.

"What you saw in 1998 was the continuing trend of private firms looking to recognize value by tapping into what the public market was willing to pay for assets," says Lieber. "And a lot of that was driven by deals that were hatched in the early part of 1998 and then the parties spent the rest of 1998 trying to hold these deals together in the face of a rapidly declining market."

This year differs from last year in part because, at the end of the first quarter 1998, REIT stocks were all trading at relatively good multiples and valuation as compared to underlying NAV or liquidation value. The public was valuing these companies at a premium to the underlying asset. The market was so buoyant it lifted practically all stocks in the sector. Even crummy REIT managements were feeling pretty good because their stock price traded reasonably well. That all changed rather quickly. Starting in June 1998, those same multiples headed downward.

"What you are seeing today is a real separation taking place between those companies that are going to survive and those that have merely pretended to be public companies because it was chic," says Lieber. "With REIT stocks trading where they are today, many of these companies truly are trading at values which are at discounts to the underlying NAV and management is under pressure."

REIT share prices have declined dramatically over the past year and sectors of REITs are now trading at a discount to their NAV. Probably the hardest hit is lodging which is trading somewhere in the neighborhood of a 30 discount to its net asset value. It makes some of these companies fairly attractive as takeover targets, but not necessarily by another REIT.

Share prices have declined because of the mathematical relationship between their market cap and the amount of debt they carry. The decline in share prices automatically causes their debt equity ratio to rise. "Since Wall Street does not favor highly leveraged REITs, some of them are now at the point where their leverage ratio is so high that no other REIT could take them on because it would then increase their own leverage ratio beyond an acceptable limit," says Claude Werner at Deloitte & Touche's national center for applied real estate research and technology in Atlanta.

"Ordinarily in corporate finance you would assume if a company is in trouble it's a possible takeover target," he adds. "With the REIT market right now, at least from the standpoint of a REIT-to-REIT takeover, the exact opposite is true. Today, only a relatively healthy REIT would be an attractive takeover, merger or acquisition target. In some ways the normal corporate finance principles that you would expect during consolidation activity are exactly reversed."

Werner's take is a fair one, says Charles Lowrey, a managing director at JP Morgan and head of its real estate investment banking for the Americas unit. "But it doesn't work in all circumstances," Lowrey asserts. "There are some companies that are now large enough that they could acquire a small REIT with higher leverage and, just by the larger companies' sheer size, its leverage would only be slightly affected, not enough to be penalized or downgraded. These types of transactions may lead to big companies getting bigger, because they could absorb a company with high leverage."

JP Morgan advised on about $19 billion in transactions last year. "We are now busier than we ever have been, with transactions that look like they have a reasonable chance of being completed," Lowrey adds.

Multifamily merger-mania Last year, the multifamily sector saw a good amount of M&A activity. Of the 15 deals valued at more than $1 billion, four were multifamily deals - including Merry Land & Investment Co./Equity Residential, Oasis Residential/Camden Property, Avalon Properties/Bay Apartment Communities and Security Capital Atlantic and Security Capital Pacific. Lowrey predicts this sector will remain busy in 1999.

"Thirty-five percent of all transactions done recently were in the multifamily sector," he says. "There are still too many multifamily companies. Sectors like multifamily in which there are still a significant number of companies are ripe for consolidation."

Lowrey also suggests, as multiples have come down from the highs of 1996 to 1997 to a "steady state where investors are expecting about a 15% total return. Companies that investors think aren't going to make it going forward will begin to decrease off of that multiple. Others that are the survivors and consolidators will increase above that. The differentiation between those two will be the basis upon which numerous transactions will get done in the future."

Currently, there are 214 REITs and a number of non-REIT real estate companies that are publicly traded and that represents just a small amount of $1 trillion in commercial real estate across the country. Last year, there were 13 REIT-to-REIT mergers, and recently some of big lodging companies such as Starwood and Patriot American have either already de-REITed or decided to de-REIT. However, virtually every year except 1998 there have been more REITs than the prior year as new companies such as Host Marriott assume publicly traded structure.

"One of the benefits of being a publicly traded corporation like a REIT is you can access a variety of capital sources, public and private," says Steven Wechsler, president and chief executive officer of the National Association of Real Estate Investment Trusts in Washington, D.C. (For a complete Q&A with Wechsler, please turn to p. 84.) "REITs certainly have the capability to tap the private and public debt capital market as well as to issue stock. Given today's trading levels, for many of the REIT companies, stock management for the moment means deferring transactions involving stock."

Wechsler suggests 1999's M&A activity will not only be comparable to 1998, but it may actually pass it. "We will continue to see REITs successfully raising debt capital when they are selling and buying and there will be times that individual companies will raise equity," he says. "Management would like to see stocks substantially higher to do so, but people have to make decisions based on shareholder value and business needs. This is the normal course of events."