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Investment Climate Highly Favorable for REITs

Flush with New and Excess Capital, REITs Are Increasing Their Buying Activity
November 3, 2010
REITs have been some of the most active players in the CRE investment market in 2010. What's more, REITs also make up a substantial portion of the widely discussed "capital on the sideline" ready to pounce on commercial real estate investment opportunities as they arise -- seemingly enjoying the best of both worlds.

In their third quarter earnings conference calls, REIT executives spent a lot of time discussing the investment climate and answering analysts' questions on their strategies. Several common themes were evident in those calls:
  • Deal flow is growing as more product is coming to market;

  • Money is cheap from an interest-rate perspective, and hence the ability to raise new equity in the capital markets is strong as investors look to REITs for growth;

  • The current price of properties on the market represents a deep discount to replacement costs; and

  • Core markets are generating the most interest while international markets are also becoming attractive.

According to CoStar Debt Strategist Mark Fitzgerald, REITs are primed to increase their acquisition activity in the current environment.

"REIT capital raised in 2009 was primarily used to fortify balance sheets," Fitzgerald wrote in a recent daily update to clients, "whereas recent capital raises are being deployed for acquisitions. In 2009, public REITs raised almost $35 billion via the public markets, yet net acquisitions were negative $2.6 billion. However, in 2010 (through September), REITs raised another $32.5 billion in the public markets, with net acquisitions of almost $15 billion."

Fitzgerald said REITs' ability to raise cheap capital in the public markets also allows them to bid aggressively on certain assets.

"Of course, capital raised in the current year is not necessarily the best indicator of the capacity of these firms to make further acquisitions," Fitzgerald added. "For example, it doesn't capture excess capital already held on the balance sheet and also ignores increased purchasing power via leverage."

Even if they don't refinance their debt maturing in 2011, REITs have about $16 billion available for acquisitions in the near term, Fitzgerald calculates. And if they are able to refinance half of their maturing debt, the amount of cash available for acquisitions would balloon to more than $25 billion.

"Additional capital raises could increase these numbers significantly, as could leverage," Fitzgerald said, "For example, net retail acquisitions by REITs are just under $4 billion in 2010; in the 50% refinance scenario, the capacity exists for almost twice this activity in the short term, and using 50% leverage, we could see REITs doing four times as many acquisitions."

Of the five major property types, the retail and hotel sectors should benefit the most from public REIT capital, Fitzgerald said.

Of course, while many REITs are ramping up acquisitions, others are taking the opportunity to sell assets in a pricing environment that has improved significantly over the past year -- for example, ProLogis recently sold $1 billion of assets to Blackstone, Fitzgerald noted.

For REITs such as ProLogis, the selling of properties is a prelude to more acquisitions, as Walt Rakowich, ProLogis CEO, explained in his earnings conference call this past week. Here are comments from a variety of recent REIT earnings conference calls regarding the current investment climate and strategies.

ProLogis: Recycling

"Our strategy has been to recycle out of non-strategic assets in predominantly secondary U.S. markets," Rakowich said. "This transaction [with Blackstone] moves us forward in the accomplishment of that objective. Of the direct-owned sale portfolio, 72% of the assets are outside of the major logistics corridors in which we have chosen to concentrate our investment."

"In addition, the average tenant size of 44,000 square feet is about 40% smaller than our average across the company and only 8% of the square footage in the portfolio is leased by our global customers," Rakowich added. "So after the completion of the transaction, we’ll have an additional $2 billion to $2.5 billion of non-strategic industrial assets that we’ll target for distributions in future years. By recycling proceeds from these sales into new development, we believe we will substantially increase the [net asset value] of the company."

"In addition, we’re going to look to exit our remaining investment in non-industrial properties, which primarily consists of retail and other assets we acquired during the Catellus merger," Rakowich said. "Historically, there were tax consequences to selling these assets before 2014 given the 10-year tax prohibition of selling assets that were once held in a C corporation. However, the recent Jobs Bill recently passed changed that provision for 2010 and 2011, and we now have a window to sell these assets sooner without C Corp tax consequences."

As for future acquisitions, Rakowich said ProLogis strategy "will be more concentrated in the major markets from a long-term, capital investment perspective, which we believe will serve ourselves better in the years ahead."

Glimcher: Blackstone Also Figures In

In the third quarter, Glimcher Realty Trust entered into an agreement along with the Blackstone Group to purchase Pearlridge Center in Honolulu for $245 million. The center will be acquired by joint venture, which is owned 80% by Blackstone and 20% by Glimcher.

"Without the emergence of robust acquisition environment, it is extremely important to be able to take advantage of the limited quality opportunities that become available," said Michael Glimcher, chairman and CEO of the retail REIT. "Accordingly, we are pleased to be directly involved with the acquisition of this high quality mall. We are also excited to be able to expand our strategic relationship with Blackstone through this investment. We believe this partnership [puts us in] in the best position to pursue future opportunities that present themselves within the market place."

"We do recognize that there is more work to be done on the delivering front but we now have more flexibility in time to execute on our strategy," Glimcher said. "We will also continue to focus on finding additional growth opportunities and would like to be in a position to not only raise capital to continue the delivering process, but to able to pair up with strategic investments in acquisitions as well. Finding the right opportunities that not only make sense from a pricing perspective but which also enhance the overall quality of the portfolio continues to be one of our major areas of focus. We are working hard and being creative in order to make this happen, and we are actively in the market today looking for potential opportunities."

Host Hotels: Looking Around the World

"This is a unique period of time in the acquisition market as the spread between unlevered return and our cost of capital has rarely been higher and the discount to replacement cost for an acquisition has seldom been more attractive," said Ed Walter, president and CEO of Host Hotels & Resorts Inc. "We will continue to look for additional acquisition opportunity that meet our investment criteria. Overall we continue to have a solid pipeline."

For Host, a lot of that opportunity lies overseas.

"As you look around the world and focus on market like Brazil, India, China, you certainly see a lot better economic growth to what we are projecting to see in the U.S. and we know that economic growth ultimately translates into hotel demand growth. And that's the most fundamental reason why we felt it was important to explore our opportunities internationally," Walter said.

Boston Properties: Exploring International, but There's No Place Like Home

"We’re also open to investing outside the United States," Mort Zuckerman, chairman and CEO of Boston Properties, said. "We haven’t found -- shall we say -- opportunities that we think are comparatively more attractive than staying in the United States. We don’t have a problem in terms of investing in some other countries. I mean I would say that given the fact that I once used to speak French, I still would limit myself to the English-speaking markets."

"As I say, it’s a matter of communication, it’s a matter of understanding the political systems, it’s a matter of understanding the legal system, and to some extent to have a better understanding of the way business works," Zuckerman said. "So, I think this is something that we wouldn’t preclude forever. I mean, we’re going to be a very, very large factor as a company in this country and perhaps in other countries, but we’re going to move very carefully. We still believe and I think a lot of other people believe that far and away our best opportunities still are within the United States."

On the U.S. front, Doug Linde, president and director of Boston Properties, said a lot of the properties for sale and being sold currently have come about because of the aggressive financial structure that was used to purchase them during the last cycle.

"There is however an abundance of capital seeking high-quality investments in our markets and it’s resulting in pricing that some may perceive as exceeding expectations from either a value per square foot or cap rate basis," Linde said. "We haven’t changed our view on what we are anticipating for the types of returns we’re looking for. We never expected to see double-digit unlevered yields on the kind of assets, the high-quality buildings in sub-markets that we are looking for."

Kilroy Realty: Simple and Straightforward

"Our investment strategy is simple and straightforward. We aim to take advantage of certain inflection points as the real estate cycle progresses," said John Kilroy, CEO of Kilroy Realty. "In the early stages where we're right now, our strategy is to buy high-quality, irreplaceable core assets in top tier markets at discounts to replacement cost. We seek well-leased properties with sufficient term to get us to a better point in the cycle. This should generate good stabilized yields with the ability to grow them over time."

"As the recovery begins to gain steam and job growth occurs, we will move further out on the risk curve to purchase more value-added acquisitions with more lease-up opportunity," Kilroy added. "Finally, when we reach a strong recovery that includes significant tenant demand, lower vacancies and higher rent growth, we anticipate that we will once again focus more of our investment attention on development."

"Our buying criterion is disciplined," Kilroy said. "We stick to what we know, for pursuing opportunities in key West Coast's locations, where we have deep market knowledge and experience. We buy properties at prices below replacement cost, and include significant amenities, and great access to transportation and infrastructure. We look for properties where we can increase rents, as well as those that are well leased to provide current cash flow."

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