When the mother of all privatization deals was announced in November 2006, it rocked Wall Street and the REIT industry. A proposed buyout of Equity Office Properties Trust (EOP) by The Blackstone Group, a $20 billion deal not including debt, would be the largest privatization in U.S. history. It was the latest in a string of announced or completed private equity deals that totaled more than $78 billion over the past three years. But the drama had just begun.

Less than two months after the blockbuster announcement came word that a group comprised of Vornado Realty Trust, Starwood Capital Group and Walton Street Capital had offered a competing bid of $21.6 billion for EOP. A week later Blackstone upped the ante by 11%. The bid was scheduled for a shareholder vote Feb. 5.

However the EOP deal ultimately pans out, it's touched off a debate about whether the privatization trend is cyclical or the result of unique factors that have converged over recent years. The emerging consensus? Private equity funds awash with money are swarming around REITs because they are considered solid values. Yet, this private equity trend also has made analysts question whether the momentum can continue.

“We see no evidence of a slowing in REIT privatization,” says Keven Lindemann, director of the real estate group at SNL Financial, a financial information firm in Charlottesville, Va. that studies the real estate industry.

Driving factors

What's causing the wave in privatization is open for debate, but analysts agree on two points. First, real estate privatization is part of a larger trend across many industries, says Douglas M. Poutasse, an investment advisor and principal at AEW Capital Management in Boston.

The trend spans businesses from the radio dial to the grocery aisle. Clear Channel Communications was purchased for $18.7 billion in November by an investor group led by private equity firms Thomas H. Lee Partners and Bain Capital Partners. Albertson's Inc. was acquired for $17.4 billion in early 2006 by Supervalu, CVS Corp. and an investment group led by Cerberus Capital Management LP.

Second, analysts agree that what's driving privatization is the fact that private equity funds have been awash with cash that needs to be invested. Barry Vinocur, editor of the industry newsletter REIT Wrap in Novato, Calif. describes these funds' resources as “a wall of money.”

Brad Case, vice president of research and industry information at the National Association of Real Estate Investment Trusts (NAREIT), concurs. “When you get that much money that quickly, it's tough to do that except by buying whole companies or whole portfolios.”

Another factor is mispricing of real estate in the public market, says Lindemann of SNL. “In spite of the run-up of REIT share prices, the private, direct market has outpaced REITs, and these portfolios are worth more in the direct market than the public market.”

That's one argument, but it contradicts another that's been made about the REIT industry. Bolstered by seven straight years of total returns that have beat the S&P 500, REITs collectively can't sustain that pace, some experts argue. Simply stated, the REIT industry may be overvalued. John Kriz, managing director of real estate finance for Moody's Investors Service in New York, subscribes to that point of view. “Given the run-up in REIT prices, the undervaluation argument retains less and less traction,” he says. “I don't buy it.”

There's no “blanket rule” for determining whether REITs are over- or undervalued, says Dale Anne Reiss, Ernst & Young's global and Americas director of real estate, hospitality, gaming, and construction in New York City. “It's a stock-by-stock analysis,” she says. Still, Reiss finds a fundamental flaw in the argument that REITs are overvalued. “Since a REIT's value is the price people are willing to pay for it, and private equity firms are willing to pay more, how can you say it's overpriced?”

Case makes a case for both sides. “For those who think REITs are overvalued, they don't have much to point to except how strongly REITs have moved up over the last seven years,” he says. “On the other hand, the story of 2006 is the acquisition of REITs and assets by private equity funds, which don't have a history of making bad investment decisions. The private equity money seems to think they're undervalued. It's tough to figure out which of those stories is right.”

To what degree Sarbanes-Oxley has played a factor in the private equity wave also is open to debate. The 2002 law passed by Congress requires publicly traded companies to adhere to stringent reporting requirements.

Many REIT executives have complained about the burden of complying with the measure. Kriz of Moody's says that it's not a significant factor in privatization. It's more of an excuse than a reason to go private, he says.

Whatever the causes, the private equity deals have grown ever larger over the past few years, defying expectations of many industry observers. “Everybody thought the industry couldn't keep up the pace, that it'd have to slow down, and [that each deal] was the last deal we were going to hear about,” says Lindemann. The EOP deal proved that “everybody who's thought that has been wrong,” he says.

Historical context

This isn't the first time the REIT industry has seen companies taken private, says Vinocur. “There's been a privatization here and a privatization there, but nothing even approaching this magnitude. This is the most significant wave of privatizations the industry has seen.”

Indeed, in 2000, seven M&A and privatization deals were announced totaling $11 billion. In 2006, 22 M&A and privatization deals were announced totaling more than $100 billion, according to SNL. “That's a pretty significant uptick in the value, numbers, and size of transactions,” says Lindemann.

What's more, buyers have changed their short-term strategies over time. “We're used to seeing private equity shops team up to buy a firm, leverage it up, run it, and at some point sell it or take it public again,” says Vinocur. “Today's privatizations are really different. What we're seeing is that the privatizers slice and dice these portfolios within a short time of closing. So, the sector is shrinking more than consolidating because much of the real estate that's being bought is leaving the public space altogether.”

By “slice and dice,” Vinocur means that when some REITs are taken private, some of their assets are sold even before the ink is dry. For example, the day that Morgan Stanley Real Estate announced it was acquiring San Mateo, Calif.-based Glenborough Realty Trust for $1.9 billion, it also announced it was selling 13 properties in the Glenborough portfolio to Normandy Real Estate Partners in Morristown, N.J., for $537.9 million.

While acquisitions of publicly owned real estate by private funds get a lot of attention, most of the deals over the past few years have been public-to-public transactions, not public-to-private, says Case of NAREIT. Before the EOP deal, 60% of the transactions in 2006 by value were public-to-public.

Will the real estate taken private remain private? Probably not, says Kriz. “[When private investors have] squeezed most of the water out of the towel,” he says, “many of these assets will return to the public markets.”

What's next?

The velocity of privatization has raised questions among analysts about the vitality of the REIT industry, though Case at NAREIT isn't concerned. “Although the number of privatizations has been very strong, so has the number of IPOs. In terms of the number of REITs, there's been hardly any change over a decade.”

Vinocur doesn't size up the situation quite the same way. “There's a massive sucking sound of companies that have gone out of the REIT market,” he says. “If you measure the REIT sector by market capitalization, yes, it's been growing because REIT prices are up so much. But there's no question the universe of REITs has shrunk significantly.”

In addition, Vinocur says, recent IPOs by REITs have been small. “They're not bad companies, but smaller companies,” says Vinocur. “That's because the people who own large, private real estate companies don't have the need that requires them to come public.” NAREIT's numbers offer support for the arguments made by both Case and Vinocur. In 1996, there were 199 REITs with a combined $88 billion market capitalization. At the end of 2006, there were 183 REITs with a combined market capitalization of $438 billion.

Privatization has also caused concern among investors over the quality of REITs, says Vinocur. “There are those who argue that what you've lost are a lot of companies that aren't the strongest, or the best-of-class in their sectors, and the loss isn't meaningful, that it's a better REIT space,” he explains. “That's true, but you can't talk to anybody on the buy side who isn't concerned. Ask people how happy they are that so many office REITs have gone private.”

Reiss says she's aware of one pension fund that's reduced its allocation to REITs because there's a smaller pool of REITs in which to invest, but there is a bigger concern. “A lot of the liquidity and attractiveness of REITs has come in part because of transparency. If REITs keep going private, you run the risk of losing some of the transparency that's made real estate such an attractive asset class,” she says. “We're nowhere near that, but in theory, it could become an issue.”

Kriz waves off concerns over the number and quality of REITs. “There's been talk of smaller REITs folding their tents for years, and they haven't,” he says. “We've had IPOs, and election for REIT status is about to take off fast and strong in Europe. REITs are becoming more established as the global brand name for public real estate.

“In the mid-1990s, the word was that REITs would take over the world, and that didn't happen,” adds Kriz. “Now some are saying REITs will disappear, and that won't happen, either. The law of the real estate cycle hasn't been repealed.”

Window not open forever

The run of private equity will eventually have to end, according to Lindemann of SNL. “Arbitrage opportunities don't happen forever, and the gap between the value in the direct market and the public price will close. It's just a question of when.”

It may be later rather than sooner, given that large institutional investors continue to invest heavily in real estate, says Case. “We know from a survey of pension funds that large institutional investors are increasing their exposure to REITs. They've increased their target allocation to real estate for every one of the last five years, but they're still behind, and they plan to continue to invest in real estate.”

There'll continue to be capital, agrees Vinocur, but he also can't predict where it'll be invested. “By all accounts more money is coming in at a greater clip than is going out,” he says. “But that doesn't mean the capital has to buy REITs and take them private.” Market forces such as interest rates and stock prices also will determine the future pace of privatization, which nobody can foresee, adds Vinocur.

“We're in the third year of this part of the cycle,” says Poutasse of AEW. “It'll continue this year, and at some point in the next two to three years the cycle will reverse as the markets shift away from the privatization trend in the overall equity market, not just in real estate.”

What might change in the future are the type and structure of future deals. While recent privatizations have focused heavily on the office and multifamily sectors, retail privatization could spike, specifically within the strip shopping center niche, Vinocur says.

“There could also be more club deals,” Vinocur adds, in which investors join with other players to tackle big deals. “No one firm will do a $100 billion deal, but three or four firms could team up.”

G.M. Filisko is a Chicago-based writer.

Why stay public? One CEO's thoughts

With all the REITs going private, it's natural to wonder why some REITs would choose to remain public. What's in it for them?

It all depends on whether you're asking management or shareholders about their goals, says Scott Wolstein, chairman and CEO of Developers Diversified Realty (DDR). The giant shopping center REIT based in Beachwood, Ohio, owns and manages more than 500 retail properties in 44 states, plus Puerto Rico and Brazil, totaling 118 million sq. ft.

“You go public to access equity for growth,” Wolstein says. The question is whether management will operate the business differently after privatization. “In most cases, the answer is yes,” says Wolstein. “Most REITs as public companies are managing for long-term growth and rarely are net sellers of real estate. Private companies, however, are more likely to be net sellers, and they're probably not going to be managing the company for long-term growth. It's a very different strategy.”

For shareholders, the question of whether to stay public or go private is one of self-interest. “Shareholders have to decide that a sale is more beneficial to them than continuing to hold their shares,” says Wolstein. “If they believe it's going to be difficult to sustain growth in the future, privatization may be a compelling alternative. If they feel the company will continue to generate significant earnings growth over time, going private isn't the best alternative for shareholders.”

Of course, if shareholders agree to go private, they've got to find a place to re-invest their profit with returns that match or beat the returns they had before the deal. That's easier said than done.

“It isn't a clear-cut what's right or wrong,” says Wolstein. “It's based on investors' perceptions about the future. Going private is essentially a sale. Is this the right time to sell, or would they like to continue to own their shares?”

DDR, which went public in 1993, has played a prominent role in the heated acquisitions market. The company paid $6.2 billion for Oak Brook, Ill.-based Inland Retail Real Estate Trust in late 2006. Wolstein says investors looking for privatization opportunities have also sniffed around DDR. “As representatives of the shareholders, we're bound to listen to anything that might be in their interest,” he says. “It doesn't mean we think it's the right approach or we're encouraging it. ”

Wolstein says with DDR's 38% return in 2006 and its three-year annualized return of 36.4% ending Dec. 31, 2005, he's never had a shareholder encourage him to take DDR private. As of mid-January, the company's stock price was $64.35 per share, under its 52-week high of $66.36 set in December 2006, but above the 52-week low of $47.40 established last February. “I'd guess that based on share-price performance, our shareholders are pretty happy about where things are going.”
— G.M. Filisko

ACTIVE IPO MARKET FOR REITS

Although private equity firms have taken a number of bellwether REITs private, 16 companies launched IPOs in 2005-2006 to become REITs. Seven of those companies are mortgage REITs.

Company Stock Symbol Sector
CBRE Realty Finance CBF Mortgage
Cogdell Spencer Inc. CSA Health Care
Columbia Equity Trust Inc. COE Industrial/Office
Crystal River Capital Corp. CRZ Mortgage
DCT Industrial Trust DCT Industrial
Deerfield Triarc Capital Corp. DFR Mortgage
DiamondRock Hospitality Co. DRH Hotel
Douglas Emmett Inc. DEI Industrial/Office
ECC Capital Corp. ECR Mortgages
Education Realty Trust Inc. EDR Residential
JER Investors Trust JRT Mortgage
KKR Financial KFN Mortgage
Medical Properties Trust MPW Health Care
Newkirk Realty Trust NKT Diversified
Republic Property Trust RPB Industrial/Office
Resource Capital Corp. RSO Mortgage
Source: NAREIT