More Private Real Estate Companies Plan REIT IPOs

Ever since the introduction of modern REIT-enabling legislation in the US in 1960, public ownership of commercial real estate has gone through a series of growth spurts, often followed by slight contractions as real estate owners followed the ebb and flow of the capital markets.

The last major growth spurt for REITs was in the 1990s when access to private capital was limited and the public equity markets provided a greater opportunity for real estate owners to access capital to expand their businesses. Today, similar conditions exist in the real estate capital markets and it appears we may be on the cusp of another era of great REIT formation.

In March of 2009 Simon Property Group succeeded in selling 17 million of its shares at $31.50 a share despite a severe credit crunch and a deep recession. Simon’s offering helped to build confidence that the REIT sector could raise capital and thus paved the way for more REIT IPOs. In total, there were nine other REIT IPOs totaling about $3 billion in 2009. This year, six IPOs totaling about $1.16 billion had been completed as of mid July, including Hudson Pacific Properties’ successful $218 million IPO. Some offerings have been structured as blind pools, with sponsors planning to invest the proceeds in distressed real estate or other assets. Others have been structured as rollups, with a sponsor rolling up assets into an operating partnership owned by a REIT and taking the REIT public in an IPO.

The pace of REIT IPOs is quickening. In late June, Hudson Pacific, a company that invests in office and media and entertainment properties, mainly in California, raised $218 million in a REIT IPO. Concurrently with the completion of the IPO, Hudson Pacific completed a private placement of $20 million of common stock to its chairman and CEO, and certain affiliated investment funds, at the initial public offering price.

To be sure, not all REIT IPOs have been successful. Some were withdrawn due to the choppy stock market or because sponsors could not get the initial offering price they wanted. Other offerings raised less equity than sponsors hoped for. But this has not discouraged sponsors from moving ahead. More REIT IPOs are in the pipeline, including those sponsored by hospitality, health care and office/industrial companies.

Going public can be attractive to private real estate companies for a number of reasons. The public capital markets provide an alternative source of capital, enabling companies to pay down debt, recapitalize their balance sheets and build liquidity. Properly structured, assets can be contributed to a REIT-owned operating partnership in a tax-free transaction.

Another reason for going public is that, according to Green Street Advisors, Wall Street currently values real estate at 15% to 20% more than Main Street. Thus a portfolio of properties owned by a private company might have a value of $500 million, but as a REIT, the value of its properties might be $575 to $600 million. REIT-owned properties command a premium because REITs provide a liquid form of investment, transparency, competitive dividends, professional management and other benefits; and investors apparently expect property markets to recover as the economy gradually improves, with vacancy rates declining and rents starting to increase.

While REITs have accumulated substantial equity through secondary offerings and IPOs, they have been slow to invest that equity in properties even though asset values have fallen as much as 40% from their 2007 peaks. Property acquisitions by public REITs dropped from 6,351 in 2005 to 360 in 2009 and transaction activity has remained subdued this year, for a variety of reasons. Banks have been reluctant to take the writedowns from foreclosing on loans in default and selling the properties collateralizing those loans. Instead, they have worked with owners to extend loans or find other alternatives to foreclosure. This has reduced the incentive for owners to sell properties immediately to pay loans off. Some owners are clearly waiting for property values to increase before putting their properties on the market.

But pressure could be building for banks and owners to start selling properties. About $1.24 trillion of US commercial real estate loans ($1.02 trillion held by banks and $221.5 billion bundled into CMBS) will need to be refinanced over the next four years. Otherwise the properties will have to be sold by banks in foreclosure proceedings or by owners themselves, and this could create more buying opportunities for REITs.

It’s uncertain when the public capital markets will be receptive to more REIT IPOs in the current cycle, but private real estate companies are trying to take advantage of the opportunity while they can. To succeed, they will need to have a powerful story to sell Wall Street: their track record, differentiation from competitors, how they plan to invest equity proceeds, why their management team is well qualified to manage a public REIT, why their balance sheet is healthy, how they plan to manage the risks of investing, and other issues of deep concern to investors. As we’ve seen recently, not every private company can make it through the IPO window, but for those that succeed, long-term opportunities should be available to deploy this capital to grow their businesses.

 Howard Roth is the Global Real Estate Leader and a partner with Ernst & Young LLP’s Real Estate practice. He may be reached at howard.roth@ey.com. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.