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Is the Public REIT Market Losing Its Luster?

Change appears to be threatening the public real estate investment trust (REIT) market. Just five years ago, the total value of public REIT mergers and acquisitions was only $10 billion — with less than $2 billion coming from private equity firms. In contrast, last year the total value of public REIT mergers and acquisitions exceeded $85 billion — with more than two-thirds of this money coming from private equity firms.

The attraction of public REITs to the private equity industry is clear. REITs have experienced substantial capital inflow since 2003, and private firms can gain efficiencies by buying large pools of assets or public REITs.

But why are public REITs choosing to go private, and why now? What does it say about the future prospects of the public REIT market when companies like Equity Office Properties (EOP) — the nation's largest publicly traded office building owner and manager, with a portfolio of more than 590 buildings — go private?

Some analysts say that EOP's departure from the public REIT market may be a signal that its best days are over. After all, when markets get pricey, investors tend to smell a downturn and head for the exits.

Others see the sale of EOP to the Blackstone Group as a signal that public companies are not suitable for the real estate industry, where competition tends to be local and market information is difficult and costly to collect. Ironically, EOP spent years as the poster child for public REITs after moving from private to public ownership in 1997.

Why REITs will endure

Going private gives companies access to private capital and reduces the cost of complying with federal regulations that public companies must observe. But the benefit of being a public REIT is greater access to lower-cost capital and investor liquidity. Public REITs are attractive for investors looking to own real estate through retirement plans or directly through taxable mutual funds.

Market signs also indicate that the public REIT market is far from collapse. First and foremost, fundamentals are strong. We are seeing strengthening demand as well as higher occupancy rates and increasing rental rates for most property types nationally. Excess supply does not seem to be a problem. Also, given the rise in construction costs and land prices, building activity in most U.S. markets has been declining since 2005.

Strong fundamentals don't completely insulate a market from financial crisis. Markets can become vulnerable when prices move too far above reality and are no longer linked to market fundamentals. But there is little evidence that prices of public REITs are heading in that direction.

A smart deal for Blackstone

There is still reasonable pricing of public REITs, as in the case of the EOP buyout. The $55.50 per share offer for EOP from Blackstone implies a property cap rate (after adjusting for the book value of vacant land, cash and cash equivalents, and investments in unconsolidated joint ventures) of 5.25%. That's a 19x multiple of adjusted net operating income.

In contrast, the real return on a 10-year Treasury Inflation-Protected Security (TIPS) is 2.44%. TIPS are bonds backed by the full faith and credit of the U.S. government that pay interest semi-annually on an inflation-adjusted basis.

The difference between these two returns is 2.81%, a large risk premium for investing in real estate, especially since real estate is a proven inflation hedge. The dramatic investment implications of this large risk premium can easily be seen when considering the terminal value of $1 invested over a 10-year period. A dollar invested in real estate earning an inflation-protected return of 5.25% yields an ending value of $1.67 vs. $1.32, in real terms, for $1 invested in a 10-year TIPS. So, it's no surprise that private equity firms are investing in public REITs.

Note the end game

Private equity firms do not take companies private and keep them under private ownership indefinitely. Instead, most private deals are executed with a goal of returning the reconfigured company or assets to the public market within three to five years, which is consistent with a forecast of improving market fundamentals and lower property cap rates. In the case of the EOP buyout, Blackstone has already negotiated sales of EOP buildings in Washington, D.C. and Seattle to Beacon Capital Partners, and has completed similar deals in other markets

So, while the tide of public REITs going private has resembled something of a tsunami of late, it would be rash to conclude that public REITs must go private to make economic sense.

James Shilling is the Michael J. Horne Chair of Real Estate Studies at DePaul University in Chicago. He is an expert on REITs as well as finance and investment activity.

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