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REIT M&A activity continues to heat up in 2006

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It is clear that large private equity investors and public REITs have realized the efficiencies inherent in buying an entire REIT as opposed to bidding in a competitive frenzy for individual trophy assets in the open market.

To date, 18 REITs have announced or completed transactions in 2006, following nine REIT transactions in 2005. There are two types of transactions taking place: public mergers and REIT acquisitions by private interests. While most media attention has been given to the companies being taken private, it is interesting to note that since 2004, 42 REITs have gone public.

As recently as Oct. 23, Santa Monica, Calif.-based Douglas Emmett Inc. completed its IPO and raised $1.4 billion, the largest IPO for an equity REIT. According to the National Association of Real Estate Investment Trusts (NAREIT), 39 percent of REIT transactions in 2005, valued at $5.7 billion, were due to REITs acquiring other publicly traded REIT companies. The remaining 61 percent of transactions, valued at $9.1 billion, were the result of a private interest acquiring a public REIT company.

Those developments have continued to gain momentum in 2006. As of Oct. 1, 41 percent of the pending transactions, valued at $14.7 billion, are the result of REITs acquiring or merging with other publicly traded companies. Fifty-nine percent of the pending transactions, valued at $30.7 billion, are the result of private interests acquiring a public REIT.

The $8.9 billion sale of Chicago-based Trizec Properties Inc. offered a clear representation of a number of emerging trends in a year marked by significant privatization and consolidation. This sale to a venture between Brookfield Properties and The Blackstone Group is believed to be the largest real estate acquisition on the part of private equity investors and will likely be the cornerstone of a banner year for REIT transactions. It also illustrates that the transactions are growing in size, and office assets are continuing to attract interest.

This transaction comes on the heels of the Blackstone Group's previously announced $5.6 billion acquisition of office REIT CarrAmerica Realty, a transaction that exceeded the largest announced REIT acquisition of 2005, ING Clarion's acquisition of Gables Residential Trust for $4.9 billion.

In August, SL Green Corp. (NYSE: SLG), a public REIT, stated it will acquire Reckson Associates Realty Corp. (NYSE: RA), also a public REIT, for close to $6 billion. SL Green Corp. owns and operates 29 buildings totaling 17 million square feet in the midtown Manhattan area, and plans to expand with the acquisition of Reckson's NYC portfolio. The deal is expected to close in January 2007.

Additionally, on Oct. 23, Developers Diversified Realty Corp. (NYSE: DDR), another public REIT in the business of acquiring, developing, owning and managing primarily community and neighborhood shopping centers, announced its merger agreement with Inland Retail Real Estate Trust Inc., which owns shopping centers mostly in southeastern states. The transaction has a total enterprise value of approximately $6 billion and is expected to close in the first quarter of 2007.

What's fueling the appetite for M&A?

REITs, historically undervalued by Wall Street investors in terms of net asset value, are selling out to private investors who are willing to pay top dollar and enjoy the added advantage of being able to leverage their money up to 90 percent, increasing their returns.

Given the fierce competition to acquire properties and the record-high pricing found across most asset classes, private equity funds have amassed billions of dollars and are searching for larger targets where the competition is limited. Consequently, REITs have become attractive takeover candidates primarily because these funds believe an arbitrage exists between the value of a REIT's assets and its stock price.

Generally speaking, REITs privatize for a few key reasons such as: the disparity between the REIT share price and the underlying assets of the REIT, the high cost of Sarbanes-Oxley compliance and being a public company, a favorable time to sell in a current climate of high demand and record low capitalization rates, and increased flexibility of operating as a private company.

Private equity investors have another advantage: they are not constrained by rules limiting leverage levels. REITs typically leverage deals around 50 percent, where recent public-to-private transactions illustrated leverage of 90 percent. This differential often prices many REITs out of deals when competing for assets against the private sector.

Because there is typically no corporate-level tax for REITs, the preferred acquisition structure has been forward cash mergers -- an asset purchase followed by the liquidation of the REIT. In some cases, it's cheaper for an investor to buy the whole REIT and sell off the assets. A number of recent transactions have followed this strategy, including Blackstone's plans to flip $1.8 billion of the Trizec purchase and a portion of the Meristar Hospitality purchase after it flipped a recently acquired D.C. portfolio from CarrAmerica. According to Real Estate Weekly, "Trizec Properties recently completed the sale of 13 office properties and certain other assets totaling approximately 13.3 million square feet, located in Atlanta, Charlotte, Chicago, Dallas and Minneapolis, as well as its joint venture interests, to affiliates of Blackstone and third parties for an aggregate cash consideration of approximately $1.8 billion."

The numerous transactions and high valuations are also being fueled by a glut of capital as private equity investors set new benchmarks for equity fund raising. Last year was perhaps a record-setting year for real estate funds raised by private equity investors, with $8.3 billion raised in the United States.

The primary source for financing for most of the REIT acquisitions has been Commercial Mortgage Backed Securities, or CMBS, transactions, which have reached an unprecedented volume this year. The CMBS mortgage level hit $130.5 billion through September, compared to $110.69 billion for the same period in 2005. September 2006 issuances reached $23.34 billion, compared to $11.89 billion in September 2005, according to data from Commercial Real Estate Direct.

Another emerging trend is the significant interest office REITs are receiving, as opposed to other property types. Of the top 10 deals of the year, four have been the acquisition of office REITs.

Blackstone has been the biggest player so far this year, accounting for more than $17 billion in three of the year's top 10 deals. Those deals include the acquisition of Trizec with Brookfield, the acquisition of CarrAmerica and the $2.6 billion acquisition of MeriStar Hospitality Corp.

Many experts predict this steady stream of REIT privatizations is likely to continue, a trend fueled by two separate factors on the buy side. In certain cases, many value-added and opportunistic funds are looking to take advantage of REITs' development pipelines, and are willing to pay premium prices to gain control of their real estate assets. Secondly, many investors are eager to acquire a group of properties in a single, large transaction. At the same time, some REIT managers consider privatization because it eliminates the pressure to accommodate the demands of shareholders.

Although the trend toward private equity funds acquiring public REITs continues, some companies are moving in the other direction, by forming their own private equity funds that potentially could go public at a later date. This strategy identifies public markets as a possible exit route for privately held real estate companies -- a strategy that might emerge from the big REIT acquisitions of 2005 and 2006, particularly if market conditions change.

What is the outlook for 2007?

Some industry experts warn that a cooling trend could be taking place. Factors that might cause a pullback in REIT M&A activity include: rising interest rates, rising capitalization rates and the softening of the residential real estate market, which some fear could spill over to the commercial market.

As 2006 comes to an end, however, many industry experts continue to expect more sophisticated and complex transactions of larger magnitude to continue as entities take advantage of abundant capital and increasing worldwide opportunities.

Rosen is managing director of KPMG LLP Real Estate Economic & Valuation Services.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

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