A shakeup may be in store for the office REIT sector with firms likely to change hands as interest rates rise and investors—private equity funds, other REITs and foreign investors—seek opportunities for placing large amounts of available capital.
Steve Pumper, executive managing partner at Transwestern, has predicted that private equity funds would begin taking over REITs for some time.
“This started to happen last fall, because REITs are trading at discounts, and private equity funds need to put large amounts of capital work,” he says, noting that this is hard to do in meaning way with one-off transactions. REITs are willing to sell whole portfolios rather than sell off assets one-by-one, Plumper says, because it costs less in transaction fees and involves a shorter timeframe to sell.
There has been some mergers and acquisitions REIT activity throughout 2018, but that largely has involved companies specializing in other property sectors besides offices. LaSalle Hotel Properties is the subject of a bidding war between Blackstone Group and Pebblebrook Hotel Trust—a battle that Pebblebrook appears to have won. Meanwhile, Brookfield Asset Management Inc. agreed to acquire Forest City Realty Trust Inc. in early August in a deal valued at $11.4 billion. And another Brookfield entity, Brookfield Property Partners, bought GGP Inc. for $15 billion.
But office REITs may have their moment soon. Bloomberg recently reported that Columbia Property Trust, an office REIT with $2.8 billion in class-A and -B-plus assets that are mostly located in gateway markets, might go on the block. The REIT hired Morgan Stanley as an advisor after several investors had shown interest in acquiring the REIT, but offers were deemed too low to consider. In addition, activist investor Jonathan Litt reportedly increased his position in Mack-Cali Realty Corp., which owns office and apartments. Litt is believed to be pushing for changes at the firm, including a possible sale of all or parts of the company.
When it comes to Columbia, which owned 9.2 million sq. ft. of office space as of Dec. 31, 2017, the majority of its assets are in New York, San Francisco and Washington, D.C., according to Eric Enloe, managing director for JLL’s Valuation and & Advisory Services platform, so it is likely to attract significant buyer interest. “Given the still favorable debt market and the quality and location of Columbia’s assets, I expect a large pool of buyers to submit bids, including private equity, other REITs and international buyers, which focus on gateway cities,” he notes.
In an interview with NREI in June, Columbia President and CEO Nelson Mills discussed the robust performance of the firm’s portfolio in those core markets.
“The demand is perpetually strong in these markets. Supply tends to be constrained; that dynamic is always good. They’re very liquid markets, and capital from all over the world seeks investments in these markets, so you always have liquidity options there,” Mills said.
Like with any other publicly-traded company, Enloe says that REIT pricing is cyclical is cyclical and is based on both the value of underlying assets and the public’s perception of its worth or stock price.
“With interest rates rising, in many cases REIT stock prices have declined, but this does not necessarily mean that the values of the underlying real estate assets in the REIT are less valuable,” he says. “This can create a scenario where the stock price has a disconnect relative to the true net asset value (NAV) of the assets in the REIT. This serves as a potential buying opportunity for an investor.”
Private equity funds are under constant pressure from limited partners to put their capital to work quickly, notes real estate attorney Eric Rubenfeld, a partner at Los Angeles-based Fragner Seifert Pace & Winograd LLP and a former real estate private equity fund principal.
With high prices for class-A office space in core cities, he says that REIT transactions are one place where there is still an opportunity for the right investors to acquire attractive assets at a discount, particularly if a REIT’s stock is trading below NAV.
“REITs are attractive to the small number of big public equity funds that have the capital needed to buy a REIT and thereby acquire a whole portfolio of assets in one transaction, rather than compete with every other investor that is trying to buy class-A assets in core markets on a property-by-property basis,” Rubenfeld explains.
He notes that investors in private equity funds and REITs look at the value of a real estate portfolio differently. “Private equity investors are looking for total returns over a three- to five-year time horizon,” he says. “They look at both current income and capital appreciation and are ok purchasing low yielding assets so long as the asset can be improved and sold at a profit.
“REIT investors, on the other hand, are investing primarily for the quarterly dividend yield, which is based on the free cash flow generated by the portfolio. Every asset has to generate an attractive yield or the stock price suffers,” Rubenfeld continues. “Accordingly, private equity investors can look at a REIT’s portfolio and see opportunities for capital returns that REIT investors miss.”
Danny Ismail, an analyst at Orange County, Calif.-based Green Street Advisors who analyzes office REITs, such as Boston Properties and Vornado, suggests that discounted REIT portfolios may be attractive to private equity funds and other investors, but not necessarily office REITs. He notes that even with office REITs discounted significantly in core markets like New York, “there seems to be a lack of appetite by investors.”
“Office is a tough business,” he says, noting that acquiring most gateway office REITs requires “someone with deep pockets to write a substantial check.” But office assets provide relatively low returns compared to say industrial REITs, in part because of uninspiring fundamentals and capitalization expenditures for this product type, which are up across the board. This is due primarily to growth in concessions and the cost of tenant improvements and maintenance.
Other barriers to selling office REITs include reluctance to sell by office REIT managers, as well as corporate governance, taxes and transaction fees, Ismail adds.
Pumper also points out that office assets are riskier investment than industrial assets because tenants are using office space more efficiently and are leasing less space.
He notes that the move open floor plans, along with flexibility in workplace that allows employees to work from home, hotels and other venues, requires less office space per employee. Law firms, which are now using online law libraries, also are downsizing space because they no longer need a large in-house law library.