While other investment bankers involved in M&A activity have been sidelined for the past three years as deals evaporated, the men and women who handle mergers and buyouts of retail real estate companies and properties have been busy little beavers. Indeed, during that time mergers have cut the number of publicly traded shopping center REITs by nearly a third. And the number of mall REITs has dropped by 25%.

At a time when there is little demand for new regional malls, the giant mall REITs are buying growth through acquisitions — using shares that have risen between 55% and 82% in the past three years. That's why No. 1 mall owner Simon Property Group has launched the industry's first-ever hostile bid for No. 7 Taubman Centers Inc. Meanwhile, new investors have poured money into public REITs and private funds, adding to the oversupply of dollars chasing retail real estate.

It has the earmarks of a buying frenzy. Deals in retail real estate more than doubled last year — to $25 billion, according to Real Capital Analytics, a New York-based research firm. With so much demand by private investment funds for retail properties, prices have soared. Between the first quarter of 2002 and the first quarter of this year, mall cap rates plunged from 9.5% to 8.4%. For power centers — where big-box stores are tenants — cap rates fell to 8.05% from 9.5%, according to Grubb & Ellis. That drop in rate of return translates to at least an 11% increase in selling prices.

How High Can Prices Go?

According to Real Capital Analytics, 906 shopping centers sold in 2002 for an average of $101.16 per sq. ft., a price increase of about 4% over the 587 sales in 2001 for $96.88 per sq. ft. So far this year, some 180 closed or pending shopping center sales have fetched an average of $108.62 per sq. ft., a 7% price increase over 2002.

Prices for individual properties have reached the point where some veteran investors are no longer buying and are looking to sell parts of their portfolios for prices they suspect will not be seen again (see story, p. 33). John Bucksbaum, CEO of General Growth Properties, the No. 2 mall owner with a portfolio of 109.6 million sq. ft., says that his company recently stopped bidding on properties when prices got too high. But General Growth will still consider exceptional opportunities, Bucksbaum says. “There are certain, more meaningful assets that you're only going to get one opportunity to ever own,” he says. “And that's when you have to make a determination of how far you're willing to go.”

How far is too far? “People just have to understand that the greatest asset in the world at too high of a price is a bad investment,” says Lee Schalop, an analyst with Banc of America Securities.

Some industry execs point out that the market is seeing record prices paid just when the underlying fundamentals look like they are weakening. Consumer spending has softened and there are few signs of a robust economic recovery this year. Same-store sales for mall-based anchor tenants dropped by 5.7% in March 2003 compared with a year ago and have been falling every month since at least October 2002, according to data from Merrill Lynch Global Securities Research. At community shopping centers — mostly grocery-anchored strips that have been regarded as nearly recession proof — same-store sales fell 2.2% in February and dropped again in March by 0.8%, according to Merrill Lynch.

“If the sales environment doesn't begin to improve later this year, we believe that retail landlords could begin to face resistance from retailers regarding rental rate increases,” Merrill Lynch senior REIT analyst Steve Sakwa wrote in early April. “We may begin to see some retailers close stores and rationalize their store mix, thereby putting some downward pressure on what are seemingly high occupancy rates.” That scenario, he says, would not unfold immediately, however, because leasing activity for 2003 is already complete.

Still, anything that cuts into the rate of return from retail property ownership could reverse the flow of money into the sector — at least for acquisitions. Donahue Schriber, a California-based private REIT, saw prices moving up too quickly three years ago and shifted from purchasing retail properties to developing them. It now has $300 million worth of shopping centers in varying stages of development on the West Coast, says Thomas Schriber, president of the private REIT in Costa Mesa, Calif.

In a couple of years, the market may have changed enough to allow the firm to begin buying properties again. “There's so much money chasing so little product right now, and of course it's driving cap rates down,” Schriber says. “With our expected returns, we just couldn't compete.”

Another potential threat — although it would be a sign of a better economy ahead — would be a lasting rebound in the stock market. Money that poured into public REITs and into private equity funds from investors who needed an alternative to declining prices in equities, could then pour back into other stocks and non-real estate investments.

A key development to watch in this situation, analysts say, is the attempt by Simon (with its partner Westfield America Trust) to pull off the $3.55 billion takeover of Taubman, which would consist of about $1.75 billion in equity and the assumption of $1.8 billion in Taubman debt. Simon says 85% of Taubman's shareholders voted to accept the deal, but the Taubman family and its allies still control enough voting shares to block the takeover.

If the takeover fails to materialize, investors could sour on REITs in general, says Tom Dreyer, a principal of Trilogy Capital Advisors, a hedge fund focused on real estate securities. “It would be a major negative,” says Dreyer, whose fund owned a position in Simon but not Taubman as of late April.

On the other hand, if Simon and Westfield are successful in their takeover attempt, that could inspire more hostile takeover attempts, says Morgan Stanley REIT analyst Matthew Ostrower.

Simon and Westfield have their sights on a very desirable portfolio: 30 high-quality malls throughout the U.S. that generate an average of $456 a sq. ft. in sales, or about $200 more per sq. ft. than the national average. Simon and Westfield have offered $20 per share for Taubman Centers, roughly a 15% premium to Taubman's stock price.

“Certainly Simon can beef up its existing portfolio of high-end properties,” says Richard Moore, an analyst with McDonald Investments. “And management believes that it can run the company better than Taubman can.” As of late April, the contest had devolved into a legal battle to control Taubman's board.

Run-up in Valuations

Whatever the outcome of the Taubman battle or the dangers posed by a soft economy, for now, nobody expects investors to suddenly give up on retail real estate. For good reason: While office and apartment REITs went south — losing 11.35% and 9.04%, respectively in the 12 months ended on Mar. 31 — retail REITs had a total return of 19.07%, according to the National Association of Real Estate Investment Trusts (NAREIT).

And the strongest performers are REITs that have been the most aggressive on the M&A front. The share prices of five retail REITs that have completed sizable mergers since 2001 — Developers Diversified Realty Corp., Pan Pacific Retail Properties, The Macerich Co., General Growth Properties and Simon Property Group — increased 20% to 40% between last summer and mid-April. Funds from operations (FFO), a predictor of REIT profitability, increased between 5% and 13% per share for the five companies between 2001 and 2002. Meanwhile, Wall Street predicts increases in FFO per share increases of between of 2% and 11% for the REITs in 2003.

The expectation of higher FFO stems from occupancy, which has generally grown to more than 90% over the last few years. In addition, though retailers have cut back on the rate of new store growth, they still are adding stores in top locations, including so-called fortress malls.

As of mid-April, retail REIT stock prices were at or near their historic highs. That, says Dreyer of Trilogy Capital, makes these stocks “fully valued to slightly overvalued relative to fundamentals.” But Moore of McDonald Investments suggests that retail REIT valuations could rise another 20% before the stocks become fully valued. Mall REITs have a price to projected FFO multiple of 8.2, Moore says, while shopping center REITs have a 9.7 multiple. Historically, REITs have peaked between multiples of 12 and 14.

Oligopoly Bound?

While analysts may disagree on valuations, they don't argue about consolidation. NAREIT reports that the number of shopping center REITs declined from 31 to 21 between 2000 and early 2003, while mall REITs fell from 12 to 9. The consolidation is on two fronts: REITs buying assets belonging to pension funds and families, and REITs buying each other.

The number of shopping center REITs could be cut in half over the next three to four years as a result of mergers, analysts say. Shopping center REITs with a market capitalization of less than $1 billion, of which there are 12, are the most likely acquisition targets.

Consolidation, in fact, may have reached a point where the companies that haven't bulked up will be at a significant disadvantage. Clearly, the big national operators feel they will have greater efficiencies and will be able to dominate leasing by the top credit tenants — leaving smaller operators at a possible disadvantage. “The separation between the haves and have-nots is widening, and that's what's going to create inertia for consolidation,” says Scott Wolstein, chairman and CEO of Developers Diversified Realty Corp. (DDR), a Cleveland-based shopping center REIT. In March, DDR acquired JDN Realty of Atlanta for $1.1 billion. “Bigger companies are in a better position to effect these transactions than they have been in the last couple of years.”

Beyond the possible Simon-Taubman deal, the big mall REITs are sticking with portfolio plays, buying individual malls or small groups. Even though REITs own about half of the malls in the country, vs. 15% a decade ago, there are still hundreds available. “There are still a lot owned by pension funds and families,” says Arthur Coppola, CEO of Macerich. “Those will be the acquisition targets over the next three or four years.”

Discipline To Be Tested

Despite the clear signs of overpaying by some private investors, analysts say that the big REITs have been relatively restrained. The cap rates for the handful of big deals that Macerich, Pan Pacific, Developers Diversified and General Growth have been involved in over the last few years typically have ranged between 8.5% and 11%. Those are rates of return that range from mediocre at worst to solid, if not spectacular. With so much demand for one-off deals, REITs have fewer good deals to choose from than they had a year or two ago, but there are still reasonable opportunities for buyers who know how to turn around troubled malls.

Net Effect on Tenants

Consolidation has ramifications beyond investment returns, of course. How will the downsizing of the REIT pool change the dynamics of the business? How will it affect tenants?

Alan Barocas, senior vice president of real estate at Gap Inc., says that the consolidation wave will inevitably lead to a clash. “As consolidation continues to accelerate, developers hope to tell shareholders that they will generate higher occupancy income, while retailers aim to minimize occupancy costs.”

But the sluggish economy has kept landlords from aggressively pressing the advantages of consolidation — including squeezing more money from retailers. Property owners had more leverage a few years ago when retailers promised Wall Street that they would expand square footage by 30% a year, says Kimberly Greenberger, a retail analyst with Lehman Brothers. “Retailers were under the gun to complete deals,” she says. “Now, retailers are basically promising the Street they're cutting back. That hurts the landlord's position: If the leasing deal doesn't get done, it's actually better for the retailer.”

The Street has been good to retail REITs over the past few years, but if fundamentals fall, the tables could turn.

Joe Gose is a Kansas City-based writer.

REIT Mergers: Who's Advancing

Pan Pacific Retail Properties
NOVEMBER 2000
Western Properties Trust
Pan Pacific Retail Properties
Final Price: $440 Million
The Macerich Co.
JULY 2002
Westcor Realty Ltd Partnership
The Macerich Co.
Final Price: $1.5 Billion
General Growth Properties
JULY 2002
JP Realty Inc.
General Growth Properties
Final Price: $1.1 Billion
Pan Pacific Retail Properties
JANUARY 2003
Center Trust
Pan Pacific Retail Properties
Final Price: $600 Million
Developers Diversified Realty Corp.
MARCH 2003
JDN Realty Corp.
Developers Diversified Realty Corp.
Final Price: $1.1 Billion
Source: Company financial releases and filings