Capital rush makes it REIT time to go private

Riding a wave of capital, alternative investment managers are cruising to take even more real estate investment trusts private.

"We have a very unusual situation today where early cycle fundamentals coming off the pandemic and into the recovery is coinciding with late cycle cost of capital," said Lisa Kaufman, Baltimore-based head of global securities at LaSalle Investment Management.

There was a record high in REIT privatization transaction value in 2021, and this year is expected to match or exceed it. "In 2021, we saw a historic amount of M&A (mergers and acquisitions) … 15 deals with $84 billion in total deal value, and that's well above average," said John Worth, executive vice president for research and investor outreach at Nareit, a Washington-based trade group.

While predicting privatization and REIT merger activity is difficult, "we are still in an environment with low interest rates and lots of available capital which are preconditions of M&A and privatizations," Mr. Worth said.

And alternative investment managers have a significant amount of capital that they're looking to invest, which could fuel more privatizations in 2022, he said.

REIT privatizations represented $27.7 billion of total REIT merger and acquisition transaction value in 2021, Nareit data shows. By comparison, there were $3.3 billion in REIT privatizations in 2020 and $1.3 billion in 2019, according to Nareit.

"We are still in an environment with low interest rates and lots of available capital, which are preconditions of mergers and privatizations, but obviously REITs had a tremendous year in 2021," Mr. Worth said. Last year, the FTSE Nareit All Equity REIT Index had a total return of 41.3% and the FTSE Nareit Equity REITs index was up 43.2%, Nareit data shows.

The rush in REIT privatizations is part of a fundraising boom for global alternative investment managers, raising more than $1 trillion over each of the last four years through 2021, Preqin data shows. The London-based alternative investment data company predicts worldwide alternative investment assets under management will reach $13.3 trillion as of Dec. 31, up from $7.2 trillion at year-end 2015.

The largest REIT privatization in 2021 was KKR & Co, Inc.'s and Global Infrastructure Partners' $15 billion transaction announced in November to take global data center REIT CyrusOne private for $90.50 per share in an all-cash transaction. CyrusOne's per share price is at a 25% premium to its closing stock price on Sept. 27, a CyrusOne news release said.

CyrusOne is one of three data center M&A transactions announced in 2021, reflecting investor interest in the sector, Mr. Worth noted.

"REITs are ahead of the curve in data centers," which along with logistics are sectors in which investors are "clamoring for exposure," he said.

Industry insiders say the impact of the overall REIT privatization trend on an institutional investor's portfolio depends on whether the investor owns the REIT or is invested in a fund acquiring the REIT. If the investor has the REIT in its portfolio, then it is most likely good for returns because many of the deals have been favorable for the REIT.

"Take-privates tend to get done at a premium to the stock price," which is good for investors' returns, said Evan Hudson, a New York-based partner specializing in real estate capital markets at the law firm Stroock & Stroock & Lavan LLP. For alternative investment limited partners, a REIT privatization is a way for managers to deploy capital quickly, or the fund will miss its targets, he said.

Managers looking to take REITs private "are exerting buy-side pressure on a relatively more limited universe of high-quality publicly traded REITs," Mr. Hudson said. "By and large, this is a seller's market for REITs, with a disproportionately wide and deep field of bidders vying to strike a deal so as to stay within their investment guidelines and avoid cash drag."

Alternative investment managers expect to earn high returns for investors because the value of the underlying properties exceed the REITs' stock price valuations, industry experts say.

It's also a positive for alternative investment LPs because privatizations help the managers invest the capital quickly on portfolios the manager feels are undervalued compared to their stock price, he said.

A model for these transactions is Blackstone Inc.'s $39 billion privatization of Equity Office Property Trust in 2007. Over 10 years, Blackstone estimated that it tripled its investment, a 2018 case study by the Wharton School of the University of Pennsylvania noted.

Managers currently looking for REITs to privatize are hoping for similar results.

"Abundant and cheap debt capital is clearly a driver," LaSalle's Ms. Kaufman said. While interest rates have ticked up a bit, real corporate rates — which compare long-term corporate bonds to long-term inflation expectations — are still well below the pre-pandemic period, Ms. Kaufman said. "That indicates to us that there are still downward pressure on capitalization rates" meaning that real estate values should rise, she said.

At the same time, many managers expect robust operating growth over the next few years. LaSalle expects 5% average annual internal operating growth (net operating income) of all of the REITs it tracks from 2022 through 2025, Ms. Kaufman said. By contrast, the average long-term REIT growth is around 2.5% or 3%, she said. The combination of growing net operating income, real estate values poised to rise and relatively cheap debt means "you want to buy now," Ms. Kaufman said.

LaSalle factors likely REIT mergers and acquisitions and their potential to boost returns as a secondary consideration in its portfolio construction, she said.

It's not as easy as choosing REITs in a hot or cool sector, Ms. Kaufman said. Companies have to be willing to sell, either because their stock prices are below the value of the REIT's real estate, or are smaller in scale.

However, not every REIT would fit LaSalle's portfolio, she said. LaSalle executives are looking for REITs in which the management team is dedicated to shareholder value and whose interests are aligned with shareholders by such things as compensation packages. For underperforming REITs, management has to have a clearly articulated turnaround strategy and be open to pursuing alternatives like a merger with another REIT or a sale if their turnaround strategy is unsuccessful, Ms. Kaufman said.

However, with REIT returns up more than 40% in 2021, alternative investment managers are not finding many bargains, Nareit's Mr. Worth said. "The dog that didn't bark" is the subdued pace of distressed REITs going private since March 2020 despite expectations that the pandemic could lead to distress, Mr. Worth said.

Despite relatively high 2021 REIT returns, publicly traded real estate is continuing to trade cheaply relative to bonds and private real estate, said Jonathan Litt, Stamford, Conn.-based founder and CIO of $500 million real estate manager Land & Buildings Investment Management LLC, an activist investor focusing on the REIT sector.

Real estate fundamentals were "very strong" in 2021 and are expected to be strong in 2022, he said.

For instance, apartment rents are estimated to grow 7.5% in 2022, compared to an estimated 6.5% in 2021, a Land & Buildings report said. Meanwhile, rents in self-storage and industrial, while still strong, are expected to decline in 2022 with self-storage rent estimated to be up 6.6% in 2022 vs 9.3% in 2021 and industrial rent to be up 10.1% vs 11.4% in 2021. Office rents are estimated to be up 2.1% in 2022 compared with an estimated 8.5% drop in 2021.

"There were nine M&A transactions in our space and we were involved in many of them as an activist investor," he said.

Land & Buildings is focused on apartments, single-family rentals, self-storage and warehouses, which company executives believe have the best supply-demand dynamics and will generate the most growth in rent, Mr. Litt said.

"I think we will continue to see M&A" in 2022 as long as REIT stocks are trading at discounted valuations compared to the value of the underlying real estate, he said.