Few investors and analysts applauded when Brandywine Realty Trust announced its acquisition of Prentiss Properties in October. During the first three days after the announcement, Brandywine's shares dropped nearly 10% to $27.83. “A lot of investors don't see how this deal helps increase Brandywine's earnings,” says Barry Vinocur, editor-in-chief of Realty Stock Review, an investment newsletter in Novato, Calif.
With the $3.3 billion merger, Brandywine, a REIT that dominates the Philadelphia office market, will double the amount of space it owns to 49 million sq. ft. Prentiss, a Dallas-based REIT, owns properties in Washington, D.C., Texas, and California. The deal is expected to close late this year or early in 2006.
Brandywine officials say the acquisition will enable it to expand beyond its Mid-Atlantic base into high-growth markets. But some analysts are dubious that a larger company will result in better returns. While Brandywine has produced a healthy performance in its home market, analysts fear that the merged company will face tougher competition in cities such as Washington, D.C. and Austin.
“I liked Brandywine as a local sharpshooter,” says Joseph Betlej, vice president of Advantus Capital Management and portfolio manager of Ivy Real Estate Securities Fund, an investor in both REITs.
Some analysts argue that Brandywine simply paid too much. John W. Guinee, an analyst with Legg Mason, says that Brandywine shares had a capitalization rate of 7.8% based on net operating income. The company paid a cap rate of 7% for the acquisition. “We think the real estate transaction is fundamentally dilutive,” wrote Guinee, who has a hold rating on the shares.
In recent years, several REITs have been on an acquisition binge. For malls, the additional size provides some benefits, says Ralph Block, senior REIT portfolio manager for Phocas Financial Corp., an investment advisor in Alameda, Calif. Giant mall owners have leverage to negotiate better terms with national retailers.
But Block says that mergers hold few advantages for owners of office buildings. It is simply too difficult to dominate a city like Washington, D.C. and exercise leverage with tenants. “Size doesn't seem to make a great deal of difference in increasing your competitive capabilities,” he says.
In the past year, there have been several REIT mergers. General Growth Properties bought Rouse, while ProLogis acquired Catellus. Like Prentiss, the sellers may have been tempted by strong bids. “The savvy guys at Prentiss may be selling at what they perceive as the top of the market,” says Vinocur.
Block says that mergers sweep through an industry when certain conditions prevail. In some cases, weak companies have bloated costs. Then efficient operators often attempt takeovers, hoping to squeeze more profits from the acquisitions. But there are few opportunities to cut REIT costs. “In the REIT world, you don't have a lot of bloated overhead, so it is hard to justify mergers and acquisitions,” Block says.
M&A activity tends to rise when there is a wide gap in stock prices between companies. Firms with high price-earnings ratios can use their inflated stock as currency to buy cheap shares. But no such gap exists in the REIT industry; shares of most companies trade in a narrow band.
Vinocur is convinced that the odds of success are stacked against Brandywine and others who try to grow through acquisitions. Integration of management teams can be tough, he says. “Most of the time when a REIT has bought another REIT, the long-term results have not been great.”