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The big get bigger

A year ago, Dennis J. Hiffman, chairman and CEO of Oak-brook Terrace, Ill.-based NAI Hiffman, had the clear sense that something was missing. He was in the process of building his brokerage firm, but with the economy turning bad, Hiffman figured he needed a stronger foundation to support the company. Revenues from brokerage work, as everybody knows, tend to evaporate in a recession.

In the current consolidation-happy business environment, the lesson has become: when in doubt, merge. Hiffman found a willing partner nearby: Chicago-based Scribcor Inc., a century-old property management and consulting firm overseeing a portfolio of 3 million sq. ft., including such prestigious Chicago office addresses as the Wrigley Building and the Marquette Building. Hiffman acquired Scribcor in April and in the ensuing months added another 4.5 million sq. ft. worth of management contracts to the portfolio.

The deal made good strategic sense for both parties in an industry where clients are increasingly expecting a full smorgasbord of services from their real estate advisors.

“We could have built a property management division from scratch in-house. But that would have taken years and would have been expensive for us,” says Hiffman, who won't divulge the price he paid for Scribcor.

“With one acquisition we were into property management, and we had instant credibility with clients,” Hiffman adds. “Our ambition is to grow our firm, and an acquisition like Scribcor helps us achieve our goals much faster.”

A year of less activity

As it turns out, the Scribcor deal unfolded against the backdrop of declining overall property sales activity. There appears to be no definitive statistics regarding the annual number of mergers between commercial real estate companies. According to the Washington, D.C.-based National Association of Real Estate Investment Trusts (NAREIT), the number of REIT-to-REIT mergers increased from one in 1999 to three in 2000 and five in 2001. The trade organization does not track mergers involving REITs and private companies, and there appear to be no statistics detailing the number of mergers involving private real estate companies.

However, property sales declined in 2001. The number of transactions for office properties in the nation's 38 largest markets declined 16% from 2000 to 2001, from 3,828 deals to 3,211 deals, according to Encino, Calif.-based Marcus & Millichap Real Estate Brokerage Co.

Retail transactions also were down 16%, falling to 3,418 transactions from 4,064. The rental apartment sector held up best, with transactions slipping 6% from 2000 to 2001, dropping from 6,973 to 6,526.

According to Real Capital Analytics Inc., a New York-based research firm, the total value of central business district office transactions declined 40% in the first six months of 2001 compared with the same period in 2000, while suburban office deals dropped 26%.

In terms of transaction activity, most industry members predict that 2002 is going to be roughly the same or slightly depressed compared with 2001. “This is going to be a down year for transactions,” says Lou Taylor, a REIT analyst at Deutsche Banc Alex. Brown in New York.

“I think transaction volume, as measured by dollars, will be down another 10% to 15% in 2002,” Taylor adds. The total could go even lower if the recession lasts longer than people think and the Federal Reserve cuts interest rates further, which would give owners more opportunity to refinance their assets instead of selling them.”

Other industry professionals are a little more optimistic. “We expect 2002 to be on par with 2001,” says Hessam Nadji, managing director with Marcus & Millichap. “Interest rates should remain low for most of the year, and that means the environment will be very liquid.

Mega-sized deals

While sales activity was down, many of the transactions that were completed last year were big ones. The blockbuster was the February announcement that Chicago-based Equity Office Properties Trust was acquiring Menlo Park, Calif.-based Spieker Properties Inc. in a mega-deal valued at $7.2 billion.

“That acquisition was a colossal surprise, though strategically the combination of the two companies made all the sense in the world,” Taylor says. “What was so different about the deal was that both companies were quite successful on their own.”

Typically, in a merger deal, one party is significantly weaker than the other and in need of a partner, Taylor notes. “Sam Zell and Equity embarked on a different course: taking a major competitor out of the valuable California market and creating major new market share in the process,” he says.

There were other notable mergers during 2001. Stamford, Conn.-based GE Capital acquired REIT Franchise Finance Corp. of America, headquartered in Scottsdale, Ariz., for $2.1 billion. Denver-based Archstone Communities Trust acquired Arlington, Va.-based Charles E. Smith Residential Realty Inc., creating one of the nation's largest apartment REITs.

Also, CalWest Industrial Properties LLC, a joint venture of Chicago-based RREEF and Sacramento, Calif.-based California Public Employees' Retirement System, spent $2.1 billion to acquire Boston-based Cabot Industrial Trust. The $24-a-share price amounted to a 20% premium over Cabot's stock price at the time the deal was announced in late October.

Another big acquisition is scheduled to close in the first quarter of this year. Denver-based Apartment Investment and Management Co. (AIMCO) is paying $1.5 billion for Casden Properties, a privately-held REIT that has an interest in some 58,000 apartment units, many of them around the company's base in Los Angeles. AIMCO projects that the new assets will boost the value of its portfolio from $12.5 billion to $15 billion.

Also, Los Angeles-based Westfield America, Indianapolis-based Simon Property Group and The Rouse Co. in Columbia, Md., agreed in January to purchase the North American assets of Netherlands-based real estate giant Rodamco for $5.3 billion. Under the terms of the sale, which is expected to close this spring, Westfield will get 43% of the assets, Simon approximately 30% and Rouse approximately 27%. The assets include 35 shopping malls.

The big deals were no surprise to bankers. “You might expect consolidation between smaller players trying to get larger,” says Brian O'Flanagan, a vice president with Mercury Partners LLC, an investment bank in Greenwich, Conn. “But it is large companies, like Equity Office and AIMCO, that have the best access to capital. That gives them the firepower to do deals. The smaller players can't raise capital as easily.”

Some deals last year unraveled in the wake of the Sept. 11 terrorist tragedies. Exhibit A was the planned $2.7 billion merger of Irving, Texas-based FelCor Lodging Trust Inc. and Washington, D.C.-based Meristar Hospitality Corp. The two hotel chains called off the transaction only days after the Sept. 11 terrorist attacks, as vacancies sprouted and hotel valuations suddenly became difficult to pin down.

“We had lots of banks willing to make us a loan initially to finance the transaction,” says Thomas J. Corcoran Jr., president and CEO of FelCor. “Then after Sept. 11, the capital markets were turned upside down. Suddenly you couldn't borrow money for hotels.” With valuations on hotel assets down 10% and more, “this is a terrible time to be a seller into the market,” Corcoran adds.

Some experts have been predicting that the REIT sector is poised to undergo more consolidation, though others aren't so sure. “I don't think REIT consolidation is going to happen very fast,” says Ralph Block, a portfolio manager at Bay Isle Financial Corp., an investment advisory firm in West Lake Village, Calif. “A REIT buying another REIT has to get assets at substantial discount to the net asset value to gain any real advantage.

“That hasn't been possible for the past year. Most REITs today run pretty tight ships,” Block adds. “If two companies merge, it's hard to see where the value-added is.”

The new Archstone-Smith Trust in Denver has identified a modest $8 million in cost savings as a result of its merger. “We've eliminated redundant accounts-payable departments and things like that,” says Jack R. Callison Jr., group vice president of capital markets at Archstone-Smith.

The acquisition of Charles E. Smith was valued at $3.5 billion, but the new company emerges with a clean balance sheet, a priority for many acquirers lately. At the end of the year, Archstone-Smith had some $150 million in cash and a credit facility of $800 million.

A slew of fire sales?

The consensus around the real estate industry is that the current recession is likely to result in few fire-sale divestitures, which were ubiquitous in the 1990 collapse of commercial real estate. Most owners of assets have been far more prudent in taking on debt in recent years, and with low interest rates they often have refinancing as an option if conditions turn sticky.

But there are exceptions. In Chicago, for instance, Prime Group Realty Trust fell into default on a $62 million loan from New York-based Vornado Realty Trust and then stumbled into bankruptcy when a deal to sell the company to a partnership between founder Michael W. Reschke and Montreal-based CDP Capital Inc. was torpedoed. Just before a scheduled Nov. 19 auction of Prime's shares, the company began a legal fight to stay out of the clutches of Vornado.

A decade ago, half-empty office towers went on the block and changed hands for as little as 40% of their replacement cost. Gregory Vorwaller, president of investment properties at Los Angeles-based CB Richard Ellis Inc., figures that some office assets are now available for 80% of replacement. “Two years ago, you couldn't get a building for less than 90% of replacement, so prices have come down some. But I don't expect prices to go much lower,” Vorwaller says.

Why aren't there more transactions in the office sector? Vorwaller points to a yawning gap between buyers' and sellers' expectations. “The gap is 5% to 15% between the bid and asking price on office product,” he says. “That's higher than the gap that exists in the industrial and multifamily markets.”

There is ample capital in the marketplace to buy office properties, but buyers are waiting for a sign that the economy is recovering and leasing trends will become positive again, Vorwaller says.

The buyer-seller pricing gap is something that has frustrated Howard Seeman, president of New York-based Pharus Realty Investments Inc. “For the better part of 2001, when a buyer announced the price he wanted to pay for a property, the seller said, ‘See you later.’ It was the widest gap in expectations in recent memory,” Seeman says.

As the year ended, the gap was closing, Seeman adds. “That should mean we'll see a better deal flow in 2002, though it's hard to say when the transactions will start to happen in large numbers.”

Brokers report a rising interest in large-scale dealmaking. Linwood Thompson, national director of Marcus & Millichap's multifamily housing group, reveals that the firm brokered $3.6 billion worth of apartment deals last year, up 10% from the 2000 total. Approximately 35% of the firm's apartment transactions last year were sales worth more than $10 million, he says.

“That's the fastest-growing part of our business,” Thompson says. He adds that 40% of the buyers he found for assets were private syndicators or partnerships — high for the sector.

“Most brokers think the buyer on a $20 million deal has got to be an institution, but I don't accept that,” Thompson says. He currently has a $45 million acquisition under contract on a 400-unit apartment complex in Tampa, Fla., involving a private investor who outbid institutions by $2 million and more for the property.

“This was an investor who sold a retail shopping center at a really good price and had to find another asset to put his money into so he could qualify for a tax-free exchange,” Thompson says. “So he was willing to take a little less yield on the apartments to avoid paying $5 million in [capital gains] taxes on the shopping center.”

What sectors to buy in?

At RREEF, Charles B. Leitner, a principal in New York, reports that the company is focusing its investment efforts on the industrial and apartment sectors during the recession. “Industrial is a good defensive sector, we think, in an economy that is going to be challenged in the short term,” Leitner says. “The outlook is a little murky right now, and 2002 won't be an easy time to do deals.”

That approach led RREEF late last year to the purchase of 830 Third Avenue office building in New York, a 150,000 sq. ft. property that was 97% leased. Leitner won't say what RREEF paid for the building, which was owned by an institution, but he figures that his company bought it for roughly 80% of replacement cost.

“It's a solid Class-B building that had fallen 10% to 15% in value over the past year,” he says. “The seller had done a major rehab and there wasn't much tenant turnover exposure. We think it was an unusually good opportunity for us.”

Many investment groups expect to be net acquirers in the current marketplace. Last year, RREEF made 41 acquisitions, worth $3.5 billion, and divested 60 properties worth nearly $1 billion, according to Leitner. “My expectation is that both acquisitions and dispositions are likely to be down in 2002 for us,” he adds.

Capitalization rates vary widely by market, ranging from 8% for apartments in Southern California to 11% for offices in Boston, Leitner notes. The differences often aren't as great as they seem.

“You have to adjust for risk,” Leitner says. “That apartment property yielding 8% in L.A. might look a lot safer than the office building getting 11% in suburban Boston.”

In the industrial sector, some of the best acquisition opportunities require a buyer willing to commit to additional investment. Indianapolis-based Duke Realty Corp. purchased a 400,000 sq. ft. facility that once belonged to Commonwealth Edison Co. in the Chicago suburb of Bolingbrook for an undisclosed price. It had old sodium vapor lights, low-pressure sprinklers and a mere 15 interior docks. The new owner is spending millions to install metal halide lights, high-flow sprinklers and an additional 45 docks. A lease for a single user is in the final stages of negotiation.

“We were able to make the property work because we bought it at the right price,” says Jim Connor, a senior vice president at Duke. Nearby in Northlake, Ill., he adds, Duke recently acquired an old 250,000 sq. ft. International Paper Co. plant on 23 acres. It is being razed to make way for a new 385,000 sq. ft. distribution facility. “It's a good time to do deals like this if you have the resources to turn properties around,” Connor says.

One of the most active acquirers of late on the retail front has been Inland Group Inc., based in Oak Brook, Ill. In January the company was putting the finishing touches on its $316 million purchase of eight shopping centers in the Southeast from Thomas Enterprises Inc., a Smyrna, Ga.-based developer.

The company owns more than 100 shopping centers around Chicago and other big Midwestern hubs, but it's concentrating its new investment in more dynamic markets in Florida, Georgia and the Carolinas.

“We fully expect the Southeast to be the fastest-growing segment of our business in the future,” says Joe Cosenza, an Inland vice-chairman. Inland has another $200 million in acquisitions on tap that it hopes to close by late winter.

Most other companies, however, are not so bold. “The marketplace looks very challenging,” says Leitner of RREEF. “I think you'll see everybody, us included, becoming very selective in seeking opportunities to do transactions this year.”

H. Lee Murphy is a Geneva, Ill.-based writer.

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