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American Realty Capital Properties acquired American RealtyCapital Trust IV for $3.1 billion, CapLease for $2.2 billion andCole Real Estate Investments for $6.85 billion. Essex PropertyTrust acquired BRE Properties for $4.34 billion. Thomas PropertiesGroup merged with Parkway Properties in a $1.2-billion deal. W. P.Carey forged a $4-billion merger with Corporate PropertyAssociates:16—Global, its non-traded REIT affiliate—and those arejust a few of the megadeals from 2013.

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After a flurry of merger and acquisition activity in the lastdays of 2013—Thompson Reuters reports M&A activity rose 69.2%to $65.3 billion in the commercial real estate sector last year—thedealmaking momentum has not slowed. If anything, the deal flow haspicked up.

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McMillian Commercial Real Estate merged with Keyser in May justafter Keyser merged with Catalyst in April. Also in April, EntergyTransfer partners spent $1.8 billion on Susser Holdings. PMCCommercial Trust merged with CIM Urban REIT in a $2.4-billion dealin April. Brookdale and Emeritus inked a $2.8-billion merger inFebruary just after Kite Realty Group Trust acquired InlandDiversified Realty Trust in a $1.2-billion deal. And Ventas Inc.announced earlier this month that it would buy American RealtyCapital Healthcare Trust for $2.6 billion.

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The list goes on and on. In fact, even commercial real estatebrokerages are merging. Although the deals are smaller—NewmarkGrubb Knight Frank acquired Cornish & Carey Commercial for $135million, London-based Savills completed a $260-million merger withStudley earlier this month and Avison Young continues grabbingsmaller firms as it expands across US markets—it's nevertheless asignal of a changing industry.

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Where do we go from here? Industry watchers say M&A activityis not likely to stop. Any attempt at predicting the volume ofM&A activity in the second half of 2014 and beyond demandsunderstanding the market factors driving the uptick, the positiveand negative impacts of M&A on the industry and how thosedrivers may change in a consolidated landscape.

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Why So Much M&A?

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The commercial real estate industry has seen waves ofconsolidation in the past, but 2013 and 2014 will go down inhistory books as a flurry of activity. So what's driving all theconsolidation?

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“REITs were rocked on share prices last year, and M&A mightbe the salve,” says Joseph Pasquarella, a senior managing directorat Integra Realty Resources. “While the S&P 500 grew 32.4% in2013, the average REIT return was just 2.7%. The jump in interestrates last May triggered the cold snap and since then REITs havehad to pursue alternative strategies to demonstrate their worth toinvestors.”

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Stuart Eisenberg, partner and real estate practice leader atprofessional services firm BDO, has a similar take. He says thelack of quality assets and competition for these assets is a majorfactor driving M&A activity in the commercial real estateindustry.

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“In fact, according to the 2014 BDO RiskFactor Report for REITs,94% of REITs cite strong competition for lessees and prime realestate as a top concern, ranking it the third risk overall for asecond consecutive year,” Eisenberg says. “Many real estatecompanies may see merging with and acquiring other firms as a wayto navigate around the competition.”

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Commercial real estate prices and values that follow economicactivity are key drivers, according to Jerry Hansen, a forensicaccountant at consulting firm Berkeley Research Group. As the USeconomy has recovered, real estate prices are recovering and evenexceeding pre-financial crisis levels in some areas. And that maybe influencing some of the mega moves REITs are making to merge forbuying scale.

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“The market is not overheated yet, but investors are looking totake advantage of the low interest rates, higher occupancy ratesand a rise in values to potentially realize significant returns inthe short term,” Hansen says. “In addition, buyers such as privateequity and hedge funds, as well as international sovereign wealthfunds, have been sitting on huge sums of cash waiting for anopportunity to invest. The available cash, improving bank lending,low interest rates, high occupancy and potential returns aredriving this increased M&A activity.”

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Big Deal Makers Speak Out

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What is the positive impact of the flood of M&A on thecommercial real estate industry? From the REIT perspective, it'sthe economy of scale operations.

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“Bigger is better, and REITs held to high standards for growthcan get a boost through M&A,” says Pasquarella. “Throughroll-ups and acquisitions, REITs are growing their silhouettes inbursts rather than property by property. By acquiring moreproperties, REITs can reduce operating expenses and better poolhuman resources.”

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That's the view from the outside, but is there a running themeamong those participating in the M&A deals? Consider statementsfrom some of the CEOs involved in megadeals and you'll see variousreasons for big buys:

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“With the scale and advantages that come with being a$21.5-billion investment grade credit rated company, we expect toenjoy a significant cost of capital advantage,” says NicholasSchorsch, chairman and CEO of ARCP about the $6.85-billion Coleacquisition. The combined company is now the world's largest netlease REIT.

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Brookdale CEO Andy Smith on the $2.8-billion Emeritusacquisition: “This combination will improve our ability to deliverthe best high-quality solutions for the growing demographic ofaging seniors and their families. With still only 10% market sharepost-merger, we are confident of our prospects for driving furtherlong-term revenue growth.” Brookdale's portfolio grows to 112,694units across 46 states to create what the company says is “the onlynationwide network of senior living communities” providingend-to-end care.

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Trevor Bond, WPC's president and CEO, says this about the$2.4-billion CPA:16 acquisition: “We believe that the positivebalance sheet, earnings and AFFO impact of the merger withCPA:16—Global, along with the additional liquidity provided by theincreased size of our credit facility, will continue to supportWPC's position as the leading global net lease REIT.” The mergerbrings WPC's portfolio to over 85 million square feet of corporatereal estate leased to over 230 companies around the world.

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Michael Schall, president and CEO of Essex, says of his firm's$4.34-billion merger with BRE Properties: “The integration effortis proceeding as planned, which we believe will result in astronger platform for sustainable growth, superior service for ourresidents, and expanded career opportunities for our employees,”says. The combined company has an equity market capitalization ofabout $11.1 billion and a total market capitalization ofapproximately $16.2 billion.

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“Through mergers and acquisitions, REITs aim not only to padtheir property portfolios, but also to expand the geographicaldiversity of their holdings,” says Pasquarella. “Many REITstypically focus on a single area, and by diversifying by location,REITs stand a better chance of maintaining value despite regionalissues, such as Detroit's bankruptcy last summer.”

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The Pros and Cons of Consolidation

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The dealmakers are bullish on their mergers and acquisitions,but how is all this M&A impacting the commercial real estate?Is it good, bad or ugly? Maybe a little bit of all three.

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According to Eisenberg, M&A activity has a number ofpositive effects in today's market. First, he says, it can berelatively less expensive to obtain new assets by means of anacquisition as opposed to doing multiple transactions. “Also,mergers and acquisitions can add fresh talent in addition toproperties,” he says. “Finally, this activity can establish theenterprise value for good operators that may be separable from theunderlying real estate.”

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But it's not all pretty: “The potential downsides to increasedM&A activity include reduced competition in the real estateindustry, which may result in lower pricing,” he says. “It couldalso make it difficult for smaller players with fewer resources tocompete with their larger counterparts.”

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At this point, it's unclear as to what impact the flood ofM&A activity could have on the overall competitive environmentlong-term. Although joining of companies may alter the pricinglandscape and make it harder for smaller firms to compete,Eisenberg says it's too early to tell what the lasting affects willbe. That said, there has been no outcry from industry watchers thatthere is too much consolidation among commercial real estatefirms.

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That may be, in part, because REIT prices have dipped a bit onWall Street. With stock prices failing to reflect a REIT's true netasset value the time seems right for larger, well-capitalized REITsto swoop in and make a deal before stock prices rise again. KiteRealty Group's $2.1-billion acquisition of Inland Diversified RealEstate Trust is a good example.

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The merger brings together two shopping center retail portfolioswith a combined asset base of 131 properties totaling 20.3 millionowned square feet across 26 states. Essentially, Kite doubled itsshopping center holdings—and did so by leveraging favorable caprates while picking up shopping centers in strategic locations.

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“Inland Diversified has assembled a very well located, highquality portfolio,” says John Kite, Kite Realty's chairman and CEO.“The asset and tenant quality and strong demographic profile willbe a great complement to our portfolio. With this transaction, wewill be able to substantially increase the size and scale of ourportfolio in our core markets and enter into attractive newmarkets. This transaction will further strengthen our balance sheetand enhance our cash flow, positioning us favorably for futuregrowth and shareholder value creation.”

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Will This Pace Continue?

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With blockbuster deals happening almost left and right, how muchmore consolidation will the industry see? How much more can ittake? Will this pace of M&A deals continue? Industry watchersdo expect consolidation but there are factors that could slow thedeal flow, perhaps in some sectors before others.

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“Retail and apartment REITs stand to gain the most from thisphenomenon,” says Pasquarella. “Last year apartments hit a 12-yearhigh for occupancy, with rents riding high. Yet Bloomberg'sApartment REIT index slipped 7% in 2013. The result is acquisitionslike Essex Property Trust's recent purchase of BRE Properties,which was trading at 13% below net asset value, amounting to ahefty discount on high-quality assets.”

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Even beyond retail and apartment REITs, most believe M&Aactivity will remain active. However, Eisenberg says a change ininterest rates as well as risk tolerance on the part of buyers mayimpact this current trend. When looking at REITs in particular,BDO's report reveals that 85% of those surveyed consider mergersand acquisitions, joint ventures and partnerships to be a risk totheir business, which underscores that, while there are manyadvantages to such activity, it can be a risky business move.

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As 2014 continues, Pasquarella also expects to see more M&Aas REITs take advantage of discounts in net asset value to add heftto their footprints. As he sees it, it's nearly impossible to meetmany shareholders' expectations by acquiring properties one by one.“Wall Street is looking for strong growth with a healthytrajectory, not to mention that larger acquisitions are moreefficient in terms of transaction and human resources costs,” hesays. “So watch for more billion-dollar deals as REITs show thebulls who's boss.”

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Of course, eventually the M&A run has to end, or at leastslow way down. John Hekman, a principal at Berkeley Research Group,says the strength of M&A in the commercial real estate sectorhas to do with the Federal Reserve policy, namely low interestrates and aggressive purchasing of mortgage backed securities,which has injected a great deal of money into the sector.

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Hekman thinks we're in a slowdown this year, “because thequantitative easing is going away and the Fed is deciding when toraise interest rates. The markets will anticipate the Fed's policychange, and a slowdown will occur.”

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Hekman's colleague Hansen has a slightly different view. He isbetting M&A activity will continue its strong pace until thebest opportunities are snatched up or interest rates and pricesincrease to negatively impact some of the potential upside. “Realestate is typically a longer-term play and for it to pay off, theprice and financing have to be right,” he says. “Companies andinvestors have learned some lessons from the financial crisis andwill be more cautious as the price levels heat up.”

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