There's a new force to be reckoned with in the office market. Over the past 18 months, the top private equity firms in the U.S. — the same entities that are driving an economy-wide mergers and acquisitions wave gobbling up everything from fast food to healthcare companies — have plowed roughly $10 billion into the office sector.

Undeterred by dizzying prices and unfettered by the demands of public shareholders obsessing over quarterly growth, partnerships like Blackstone Group and other private firms are outbidding REITs on marquee properties. They have also taken down several public REIT portfolios, privatizing billion-dollar chunks of assets in the process.

This trend is affecting REIT investors and managers in two ways. Privatization activity, which has reduced the number of public office REITs from 30 to 25 over the past 18 months, is making it tougher for REIT investors to gain exposure to many plum office markets.

Since most of the recent privatizations targeted REITs with holdings in the nation's top markets, too, it may force office investors to bet on companies with less expected growth. The trend has also left many office REITs unable to prevail in the heated battle for assets that is increasingly being won by highly leveraged private buyers.

“No one can dispute the financial muscle of the private equity shops,” says Steven Wechsler, president and CEO of the National Association of Real Estate Investment Trusts (NAREIT), an industry trade group based in Washington, D.C. But, he questions the ability of the new players to compete long-term with the established industry leaders. “No one can seriously consider them to be investors with a long-term interest in operating commercial real estate enterprises,” he says.

Quiet giants

But don't underestimate the brainpower behind huge buyout shops like acquisition-hungry Blackstone Group. Not only has the firm bought and sold large commercial real estate assets over the past 14 years, it's also retained several seasoned REIT managers after taking their companies private. In two of its recent deals, in fact, Blackstone retained several top executives from both office REITs, CarrAmerica and Trizec Properties (NYSE: TRZ). The Trizec deal was still pending as of late September.

“One advantage we have as a private buyer is that we can use more leverage,” says John Gray, senior managing director at Blackstone's real estate group. His company owns a mixed bag of commercial properties — largely hotels — with an enterprise value, or the assumed takeover price, of roughly $43 billion. Nearly $10 billion of that total is office space. “We're also less interested in quarterly FFO (funds from operations) growth than absolute returns,” says Gray.

Private equity firms typically raise cash from wealthy individuals, pension funds, endowments and other institutional sources. They promise annual returns approaching 20%, which they attempt to achieve through a variety of strategies.

They can buy distressed assets at low prices and quickly revamp them to produce a pop in cash flow and valuation. Or they can hold for long periods and create value through further acquisitions or an IPO. Whatever the strategy, the goal is the same — to dispose of the asset in perhaps five to seven years and reap the target annualized return.

How are these players proceeding in commercial real estate? It's hard to say that their recent strategy has involved bottom fishing for distressed assets. They have focused on the most expensive properties, paying jaw-dropping cap rates as low as 3.8% for top-tier office properties like Manhattan's MetLife Building.

In 2005, privately held Tishman Speyer Properties shelled out a record $1.7 billion for the trophy property. Several REITs were in the bidding, says Cushman & Wakefield investment sales broker Scott Latham, but they couldn't match Tishman Speyer's heavy buying power.

In fact, when private equity buyers have taken out a public REIT over the past 18 months, they've paid a premium averaging roughly 6.7% above the closing share price before the deal was announced, according to SNL Financial, a Charlottesville, Va.-based research firm.

With private equity investors circling, total returns in the office sector have outperformed other property categories with the exception of apartments. Office REITs rose 29.8% for the year through Sept. 27 vs. a 24% gain for the overall SNL REIT Index.

“A lot of the share prices have risen on this takeout anticipation,” says Hans Nordby, a research analyst at Boston-based real estate consulting firm Property & Portfolio Research. Shares of Los Angeles-based office REIT Maguire Properties (NYSE: MGP), for example, jumped 7% in the week after Labor Day largely on rumors of a pricey takeout offer. The company declined to comment on the run-up in share prices, or the possibility of a privatization.

One liquid era

If the trend continues — or accelerates — the nature of the office market could change. With fewer properties held by listed REITs, market transparency will be diminished. There may be less of an impact on office liquidity given the strength of demand to buy on both the public and private sides of the real estate business.

The era of publicly traded office REITs is perhaps the anomaly in a long history of private ownership. Equity Office Properties Trust and Boston Properties only went public in 1997. The point: It's easy to forget that listed office portfolios are a relatively new phenomenon.

The shift to private ownership is sensible given that access to capital is no longer a challenge for large office portfolios, says Dale Anne Reiss, global director of real estate, hospitality and construction for Ernst & Young.

“Real estate makes sense in the private sector if there is capital available,” she says. “That wasn't always the case, which explains why so many office companies went public 10 years ago.”

With billions of dollars waiting on the sidelines to enter the market — some fund advisors estimate that number to be as much as $200 billion — this is easily the most liquid era that the commercial real estate market has ever known.

“The risk is that you end up with a hole in the public markets on the office side of the business,” says Doug Poutasse, chief investment strategist at Boston-based real estate advisory firm AEW Capital Management. Adds Poutasse: “We've reached a point where any office REIT could really go private.”

Who's next?

Even Equity Office Properties Trust (NYSE: EOP), the brainchild of real estate legend Sam Zell, is regarded as a potential takeover target. Shares in the Chicago-based company, which has a $14 billion market capitalization, have risen from about $30 at the start of the year to around $40 in late September.

Zell says that the flurry of office REIT privatizations “is a wonderful sign of the liquid market” for commercial real estate. “The REITs were really created to generate this type of liquidity, and the leveraged investors are willing to pay a lot for these portfolios,” says Zell, who believes many of the privatized office assets will be recycled back into the public market through sales.

So, is Equity Office preparing to go private? Zell says that the company has no formal plans to privatize. Even so, analysts and other market watchers speculate that anything is possible given the huge weight of capital that's gobbling up office REITs.

Analysts point to the company's recent asset sales — it sold $500 million worth of assets in the first half of 2006 and plans to sell another $2.5 billion over the next 18 months — as a sign that the company is tightening up its portfolio in preparation for a sale.

Equity Office, for its part, claims that the restructuring is meant to sharpen its focus in high-growth markets such as Austin, Texas and New York City — an approach that Boston Properties (NYSE: BXP) has exploited with success in the Northeast. The Boston-based office REIT focuses on a handful of large markets like Boston, New York and Washington, D.C.

Asset sales, however, may not mean anything other than EOP thinks it's a good time to harvest some gains. “Sure, some of the things that Equity Office is doing are consistent with putting the company up for sale,” says Stephen Tomlinson, a real estate attorney at Chicago-based Kirkland & Ellis. “But it could also simply be a re-focusing of its portfolio into some markets and out of many others, too.”

Highest bidder wins

For now, the bidding in the office market resembles a tug-of-war between public and private interests, says Kenneth Riggs, president of the Real Estate Research Corp. (RERC). “This is about who is willing to pay the highest price for commercial real estate assets,” he says. “The private buyers are willing to pay more for commercial real estate assets than the public REITs.”

Why? Because private investors want high-quality office assets, and the best source of supply are the portfolios of the public REITs. “Private investors are buying up REITs because they can purchase whole companies with many assets for less than it would cost to buy individual assets,” says Riggs, adding that the market for one-off asset sales involves a much wider spectrum of bidders. He does believe that rising share prices could offset the value proposition that bulk sales are cheaper, however.

Clearly, the private equity firms are not finished buying office properties. Blackstone, for example, raised $5 billion in its fifth general real estate fund in June. It's the largest pool of private capital ever raised for commercial real estate investing, and given Blackstone's ability to pile on debt, it could easily give the firm more than $9 billion in buying power, says Tomlinson of Kirkland & Ellis.

Public REITs typically only lever up to 50% of capital investment in a deal; private equity firms commonly go as high as 80% (see sidebar, p. 34).

Free at last

For REIT management, the privatization trend provides more than just the promise of a fat payday. It also allows many former REIT executives to continue working in the business under far less scrutiny. By selling to private owners, they can escape the increasingly complex demands of operating with public shareholders.

“When Sarbanes-Oxley was passed three years ago, I said it would spur more REITs to go private,” says Reiss of Ernst & Young. She says her prediction has proved accurate and that more privatizations are likely as REIT operators become more frustrated with the rules of Sarbanes-Oxley, the reform measure that was enacted to stop the kind of fraud and accounting abuses that were revealed in the collapses of Enron and Worldcom.

For owners and developers in the office market, perhaps the most important take-away from the private-equity influx is that these wily investors see great potential in their industry — they like the fundamentals. In fact, the pattern of privatizations closely matches the heat map of the strongest office markets.

CarrAmerica, which was taken private by Blackstone in a $5.6 billion deal in July, owned properties in two of the strongest markets in the nation, Washington, D.C and southern California. Vacancies in the D.C. market registered just 6% at mid-year, the tightest market vacancy in the nation. Office vacancy in Los Angeles was 9.9% at the end of June, down 2.3% from the same point in 2005.

Fundamentally sound

Nationally, expanding office payrolls continued to help drive office vacancy lower during the second quarter, reports Boston-based research firm Property & Portfolio Research (PPR). Office vacancy registered 16.2% at mid-year, roughly 80 basis points lower than the same period a year ago, which represented the 10th consecutive quarterly vacancy drop.

What's driving this are measurable gains in office-using employment growth. This key segment of the labor market grew by 1.8% during the 12-month period that ended in July. Overall payrolls, by comparison, only expanded by 1.3% during that period.

PPR projects national office vacancy to fall by 1.4% over the next four years, which would place national vacancy about 0.4% above its historical average at year-end 2010. This good news is tempered by some mediocre gains on rental rates. While national office rents ticked up for the fifth straight quarter by 2.6% through mid-year, rents are still 18% lower than their peak levels.

In other words, many tenants who signed five-year leases (the average office term) in mid-2001 are renewing at substantial discounts. Yet it's tough to speak broadly on rental rates, as cities like San Francisco and Austin posted stellar gains while laggards such as Detroit and Cleveland actually saw rents decline over the past few years.

“This is a slow burning recovery in the [office] market. You have to expect that portfolios concentrated in the markets with the strongest growth potential will continue to be taken private,” says buy-side REIT analyst David Harris of Lehman Brothers.

PPR expects the office market to gain momentum through 2007, one enabling factor being the low levels of new construction underway. At mid-year, for example, just 1.9% of national office inventory was under construction. This is quite low by historical standards.

New construction has averaged 4.4% of inventory every year since 1982. The translation: It doesn't appear that a supply-driven slump will materialize over the next two to three years in the office market, says Dr. Sam Chandan, chief economist at Manhattan-based real estate research firm Reis Inc.

All this adds up to more demand for office properties and more attention from private investors. “Every listed office REIT has to make a business decision. How much longer will there be such strong demand to buy their portfolios?” says Reiss of Ernst & Young. “That's what every listed REIT needs to ask itself.”

Parke M. Chapman is senior editor.

EXIT PACKAGE

Nearly $16 billion in office REITs have gone private over the past 18 months. More listed REITs are expected to leave the public stage in the coming months.

Date Buyer Target/Ticker Purchase Price
8/06 Morgan Stanley Glenborough Realty Trust/GLB $1.9 billion
3/06 Blackstone Group CarrAmerica Realty/CRE $5.6 billion
2/06 LBA Realty, Inc. Bedford Property Investors/BED $903 million
12/05 GE Real Estate Arden Realty/ARI $4.8 billion
6/05 DRA Advisors CRT Properties/CRO $1.7 billion
2/05 Lightstone Group Prime Group Realty Trust/PGE $550.6 million
Source: SNL Financial

Major dilemma for office REITs: buy or build

Private investors have come to dominate office investment sales, and for one very good reason: the added purchasing power of high leverage. Unlike public office REITs, whose shareholders have less of a stomach for debt-drenched portfolio deals, private players can pile on leverage and, in many cases, outbid their listed competitors.

During the second quarter, for example, private equity funds closed on $5.25 billion in office deals. They also had more than $20 billion in office properties under contract, reports Real Capital Analytics. By contrast, public REITs booked only $1 billion in acquisitions during that period, a slight drop from the first quarter.

As a result, public REITs are relying increasingly on development to build their portfolios. That approach is not without risk, of course, as soaring construction and land costs have made it painfully expensive to assemble sites and build on them. It's still cheaper to buy than build office in most markets, considering the high replacement cost, but that gap is narrowing.

“The only growth mode that's open to office REITs is development,” says Doug Poutasse, investment strategist at Boston-based pension fund advisor AEW Capital, citing Boston Properties (NYSE: BXP) as an example. “There's just so much leveraged private money out there that it's very hard to compete for existing buildings.”

Even on the development side, however, the public REITs may be outgunned. Nearly half of all office sites sold over the past 18 months were bought on behalf of private investors.

One of the most active developers among office REITs is Atlanta-based Cousins Properties (NYSE: CUZ). The company, which builds apartment, retail and industrial properties, built several of Atlanta's largest office towers in the 1990s, and is still active. It's now developing a 520,000 sq. ft. skyscraper in the Buckhead section of Atlanta, part of the sprawling mixed-use project known as Terminus. The 27-story Terminus 100 tower will be completed next spring. The space is already 60% pre-leased.

“Most of the office buildings that we develop are due to some special circumstance,” says Tom Bell, CEO of Cousins Properties. “If a tenant wants 300,000 sq. ft. in a market, we may build a larger building and take the risk on the remaining space.”

Even so, Bell agrees that it's challenging to buy existing properties. He describes the amount of private capital that's looking to find a home in the office market as “astounding.” While the veteran corporate executive says that he's shocked at the volume of capital that's sidelined, Bell doesn't expect this logjam to break up anytime soon. That should keep demand cooking for office properties, he says.

“I would guess that pension funds will allocate more into the real estate market,” says Bell. “And I'd also guess that other capital sources continue to press into the market, too.”
— Parke M. Chapman