The Next Wave of REIT Privatizations

NEW YORK CITY—The REIT industry could be on the cusp of a new wave of privatizations, says Fitch Ratings. The Blackstone Group's commitment to buy Excel Trust and Brookfield Asset Management's agreement to acquire Associated Estates Realty Corp. may be harbingers of deal flow comparable to what the industry saw between 2005 and 2007.

“Debt and equity capital are in ample supply, low-cost and less-discerning,” says director Britton Costa. “Since REITs do not need to trade as wide of a discount or have as much growth for returns to pencil out in a low yield world, the number of candidates increases; more capital and more targets should mean more transactions.” Costa sees as many as 40 such deals taking place over the next few years, comparable to the 30 privatizations worth a combined $123 billion at the peak of the last cycle.

A report from Fitch notes that the stars are aligning. “Capital formation via private equity fundraising, sovereign wealth funds' increasing real estate allocations and a rebounding CMBS market provides ample funding for privatizations,” the report states. “Capital formation looks similar to the preceding wave of privatizations. Fitch views the presence of SWFs and Chinese insurance companies as a key source of incremental capital.”

Not only are low all-in debt capital costs enabling investors to achieve targeted return thresholds, but underwriting standards are declining, as well—another similarity to the last privatization wave, says Fitch. The ratings agency assumes investors' return expectations are lower for recent vintage private equity funds, given global yield compression when compared to the funds that led the last wave.

Fitch also sees pricing and the aging of the cycle as incentivizing deals. “Issuers may be more willing to entertain an offer given the length of the rally in fundamentals (i.e. the longer the rally to date, the less growth being 'left on the table'),” the report states. “Moreover, with REIT share prices approaching all-time highs and FFO multiples above their long-term average (19.7x currently versus 17.3x average from 2004 to the present), current share prices reflect both the growth and premium valuations.”

Additionally, the cap rate spread between public and private market values is narrowing, another aspect that's reminiscent of the last privatization wave. The spread averaged 154 basis points in 2014, narrowing from 184 bps in 2011 and comparing with the respective 117-bp and 78-bp spreads seen in 2006 and 2007. Fitch says the directional move in the relationship as more meaningful than actual levels, given differences in asset quality and liquidity—“i.e. REITs should trade at a lower implied yield in exchange for the liquidity of a listed security, all else equal.”

Britton sees mixed implications for REIT bondholders in all of this. Possible ramifications could include bond tenders, consent payments, and in the most extreme instance, credit downgrades. That being said, REIT bonds do enjoy some key structural attributes, thanks to covenants in bond indentures.

“To achieve targeted returns via the use of leverage, private equity firms have little choice other than to negotiate with bondholders to tender for the bonds,” Costa says. “These provisions have shielded many REIT bondholders from the fate of fixed-income investors in other corporate sectors.”