Changing faces: mergers hit the real estate industry

Not since the beginning of this decade when the Resolution Trust Corp. and distraught financial institutions began offering large portfolios of real estate at profoundly discounted prices have there been so many large blocks of real estate changing possession. Private capital, which took a two-year hiatus from the market when the capitalization rates on portfolios went up while the quality of the underlying real estate nosedived, returned to the market with a vengeance last year.

About $7 billion to $8 billion in commercial real estate changed hands last year through private placement transactions, and those numbers are expected to increase another 20 to 30 percent this year. Among the many investors coming back to the market are wealthy individuals, foreign players, and pension plans. The target for all this capital has not only been large single assets, but real estate operating companies as well. Increasingly, however, shrewd investors are turning a covetous eye to the largest segment of real estate operating companies in the United States--the real estate investment trusts--which last year raised about $9 billion in new equity down from $16 billion the year before.

"Investment bankers will be merging the same REITs they created over the last three years," predicts Michael Evans, national director of the E&Y Kenneth Leventhal Real Estate Group.

In the meantime, big money is being funneled into the recapitalization of real estate operating companies, most of which have been Canadian since real estate operating companies in the United States find it more tax advantageous to use a REIT structure. Canada, on the other hand, does not allow a financial structure similar to REITs.

One of the few publicly traded real estate companies in the United States was Koll Management Services, Inc. in Newport Beach, Calif., which was spun off from The Koll Company and went public in 1991. This past November, Freeman Spogli & Co., a Los Angeles-based investment banking firm, agreed to acquire all of the publicly held shares of this management services company and half of The Koll Company's interest.

The new corporate structure makes the company more attractive to lenders, says William Rothe, Koll's president. The company recently received a $50 million line of credit and has continued to be an acquirer of regional real estate services companies. In addition, Koll also intends to be an investor and has recently made some aggressive moves in that direction. At the end of last year, Koll made a counter tender offer for 51 percent of two limited partnerships managed by Consolidated Capital Properties. That effort ended successfully as Koll put together a structure where the general partner sold its controlling interest in 13 of ConCap's partnerships to Insignia Financial Group of Greenville., S.C. Koll then ended up with a 40 percent minority interest in the entity that bought the tendered shares in two partnerships originally sought by Koll.

Koll has bigger plans for the $250 million opportunity fund it put together last year with the Bren Co. The fund is already fully invested, with about $125 million worth of real estate and $125 million in loans. "We will be putting together another fund this year that will be larger than last year's, and it will pursue similar types of assets," says Chuck Schreiber, chief executive officer of Koll/ Bren Realty Advisors. Although there were no investments in operating companies, Koll/Bren is not averse to moving in that direction.

As noted, outside of REITs, many of the big real estate companies that are basically owners and managers of real estate operations have been Canadian, and since Canada's real estate recession appears even lengthier and deeper than that experienced in the United States, almost all these companies have suffered financial difficulties. Probably the most well known of the problematic Canadian property companies has been Olympia York, which actually fell into deep difficulties betting wrongly in international real estate markets such as London and New York in addition to taking a beating in its home base of Toronto.

As noted by Stan Ross, managing partner of the E&Y Kenneth Leventhal Real Estate Group, "A large number of publicly traded Canadian real estate companies have been or are undergoing massive restructuring as U.S. capital sources have zoomed in on these ailing entities. The pure size of their U.S. and Canadian real estate holdings coupled with the Canadian banks' desire to solve thereal estate problem' made them ripe opportunities for acquisition and restructuring." As further explained by Mark Hopkins, a partner in Ernst & Young's Financial Advisory Services Group, "An important catalyst for a number of restructurings has been the investment, primarily by U.S. investors, in pre-restructuring debt securities at distressed prices. Such investors have had the opportunity to earn a good investment return while influencing the adjustment of capital structure so that fresh capital can be attracted."

The first to change ownership structure was Calgary-based Trizec Corp. In July, 1994, Argo Partnership LP, a J.P. Morgan/J.W. O'Conner fund, and Horsham Corp. of Canada invested C$ 1.1 billion to acquire 24 percent and 44.5 percent, respectively, of Trizec's outstanding equity.

Then in February, 1995, a group of international investors led by U.S. real estate financier Steven Green announced it would attempt to acquire 40 percent of Bramalea Ltd., the big Toronto real estate company. Green's investment vehicle, International Realty Investors LLC, offered to dish out $23 1.1 million for secured debt bearing interest at eight percent per annum that could be converted into Bramalea common shares at $3 per share at any time during the term of the debt. The investment was conditional on the completion of definitive agreements between the company, the investor group, and lenders by February 28. The deal wasn't consummated and Bramalea was forced to seek reorganization protection.

There also has been a lot of activity surrounding Toronto's other big property company, Cadillac Fairview. Last summer, Goldman Sachs' Whitehall Street real estate limited partnership bought 28 percent of the company's $1.1 billion debt for $165 million, then nudged the company to seek protection under the Canadian bankruptcy courts.

Among the companies reportedly looking to take a piece, if not all, of Cadillac Fairview is another Toronto company, Cambridge Shopping Centers. The most recent bid came from New York-based Blackstone Group, with backing from the C$25 billion Ontario Teachers' Pension Plan Board. Under Blackstone's offer, C$1 billion of new capital would be invested into a "new" Cadillac Fairview. This amount would come from four sources: C$312 million to be invested by a limited partnership of investors managed by the Blackstone Group and Ontario Teachers'; C$200 million from a rights offering made to holders of Cadillac Fairview's existing subordinated debentures; C$188 million from the purchase by Blackstone and Ontario Teachers' of 75 percent of the company's holdings in two Toronto real estate ventures; and C$300 million provided through a new secured credit facility.

In the United States, real estate operating companies since the early 1990s have been transformed from private firms into publicly traded REITs. In 1993, the REIT market set record capitalizations of $16 billion. Russell Platt, a principal in Morgan Stanley Realty, guesses as little as $5 billion could be raised this year. There are a number of reasons for this decline. The REIT market has been in a freefall for the past 12 months and mutual funds, big investors in the 1992 through 1993 time period, have gone elsewhere. In addition, with interest rates up, REITs have to go public at a nine percent yield. If one subtracts the cost of going public, investors receive little premium from the investment. Even the premium for risk is gone, as the gap between corporate bond yields and REIT yields has disappeared.

All this makes REITs vulnerable to unwarranted suitors. Admittedly, REITs are encumbered with poison pill provisions and other devices to prevent such actions, but there are a number of troubled REITs that might be looking for a white knight.

"There's an improvement in the appetite of private equity for real estate today," observes Richard Gunthal. managing director at Bankers Trust Real Estate Finance Group. More aggressive capital, he says, will be looking at single-asset sales, while less aggressive capital will be investing in some kind of "organized format" for real estate like REITs.

So far the transactions have been few. but varied. Examples include:

Investments in private REITs

* Alaska Retirement Fund investing in Corporate Property Investors, a large private retail REIT.

One REIT merging with another

* Wellsford Residential Partners taking over Holly Residential Properties Inc.

* Two shopping center REITs--Horizon Outlet Centers and McArthur/Glen Realty Corp.--agreeing to merge through a stock swap valued at $315 million.

REITs buying portfolios from other REITs

* Simon Property Group buying four malls from two private REITs--Corporate Property Investors and Lasalle Street Funds.

* United Dominion acquiring apartments from Epoch Property REIT, which was pulled from the market last year.

REITs buying private companies

* Liberty Property Trust acquiring Lingerfelt Development.

Possible REIT takeover candidates include smaller retail REITs that have not been able to do secondary offerings and smaller apartment REITS that are geographically concentrated. "Troubled REITs are going to be approached," Evans says, "and forced to the negotiation table."

Joint ventures, strategic alliances, mergers, and acquisitions are prevalent in most industries as companies strive for efficiency, growth, and global reach. Even the somewhat parochial and isolated world of homebuilding finds itself in a period of intense consolidation.

The homebuilding industry is being transformed from tens of thousands of small, privately held entrepreneurial firms to an industry made up of larger, structured, professionally run companies. Mergers among small to medium-size regional firms have been quite popular and the industry has seen an evolution of national builders that are expanding into new markets to gain marketshare, diversify their portfolio, and balance losses.

Before Wall Street virtually abandoned the homebuilding industry in early 1994, an unprecedented number of homebuilders went public. Now these public companies have to continue to grow to prevent the value of their companies from dropping. They can either grow internally or through mergers and/or acquisitions.

According to David Traversi of Montgomery Securities, homebuilders are buying or becoming "dominant merger partners" (those who retain control after a merger) because (1) if they are public, they are under constant pressure to grow and an acquisition is a way to achieve instant earnings per share growth, (2) if they are private, they are seeking to increase their size in order to access capital, and/or (3) they want to acquire an existing operation to avoid starting from scratch in a new market.

Traversi also points out that homebuilders are selling or becoming "non-dominant merger partnerss," because either (1) they need capital to grow or just maintain the status quo, or (2) the individuals running the company are seeking retirement and liquidity for the value of their company.

Before a company proceeds down the aisle to bigness and national or regional reach, it should remember timing in life is everything. A few key considerations include:

* Why are we buying this business now? Do we need to acquire local market expertise and local brand name? Would we obtain a valuable asset base? Does it fit our long-term strategy?

* What is motivating the company to sell? Is the seller desperate? Is the price negotiable?

* Where in the current business cycle is this market?

* What are the others doing? But do not fall victim to "sheep thinking." The herd effect of homebuilders is notorious--the same product tends to be built in the same market in the same way. You shouldn't get too enamored with the idea of acquiring or merging just because others are doing it. Sellers should ask a different set of questions:

* Who is the buyer and does it make a difference to me?

* Does the buyer have the wherewithal to deliver on their promises?

* Do we/I want to hold a continuing role in the business?

The trick for any homebuilder is balance--knowing when and how to grow.

The successful, large firms understand that there are some activities in the homebuilding process that aren't necessarily effectively pursued from a centralized regional or national office. Land buying, for example, requires intimate knowledge of the local market, where the good dirt is. and what a fair price is. The same could be said for house design. The design of a home that sells best in one market may not be a success in another. Therefore, having some local talent is advantageous.

Centex of Houston, Texas, is a company that has purchased small, local builders. They acquire them not only for their land holdings but also for their relationships with subcontractors and their familiarity with local bureaucratic systems.

A specific example of a successful marriage where a company merged with a regional firm is Los Angeles-based Pacific Greystone's acquisition of the California division of A&M Homes. Talent, land, and operations were wedded into a much more powerful development company.

When the M&A process is done right, a growing homebuilder with professional management has a better chance to access capital, react quickly to market changes, and successfully diversify its portfolio.

Steven M. Friedman is a member of the E&Y Kenneth Leventhal Real Estate Grolip, Los Angeles, CA, (310) 551-7830.

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