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The long road to consolidation

Discussions are spirited and ongoing, but activity in the mergers and acquisitions (M&A) arena has slowed over the past year as the multifamily industry pauses to consider its recent consolidations and examine future integrations. Players still agree that the industry's 27 public REITs will continue to narrow to fewer than 10, but now believe that consolidation will take longer than expected. A closer scrutiny of the M&A process and end results, current capital constraints and a reluctance to sell at below net asset value are just a few of the factors curbing today's M&A momentum.

"Consolidations are taking longer than expected because they're much harder to accomplish than people ever dreamed," asserts Richard Michaux, president and CEO of AvalonBay Communities in Alexandria, Va. "Boards and senior management are being much more cautious now that a few mergers and acquisitions have been completed," he continues. "Discussions are taking place, but in truth activity is down. It will take longer than we all thought just one year ago for the market to rationalize itself to six or eight REITs."

Ron Terwilliger, national managing partner of Atlanta-based Trammell Crow Residential, agrees. "Consolidations have lost momentum, contrary to what everyone believed," says Terwilliger. "Many REITs believe their stocks are undervalued, trading at below net asset value, anywhere from a small percentage to as much as 20%, and are reluctant to sell their companies at current prices. We think there will be future consolidation, but not until the market recovers and people feel better about the prices at which they will merge."

Despite the current lull in activity, there are several motivators that are expected to fuel activity after this period. Among the forces driving consolidation are an increase in size (thus better economies of scale, as well as improved access to capital); geographic dispersion; a structured management succession; a specific expertise (such as development); and new product arenas.

Size matters Some major players in the apartment industry are striving to own a large number of apartments to create operating efficiencies. They believe they can achieve this more efficiently through M&A activity than development or other more customary ways of growing a company.

"A lot of people finally saw that size and scale do make a big difference, and obtaining that mass has driven much of the industry's mergers and acquisitions," states Doug Crocker, CEO of Equity Residential Properties (EQR) of Chicago. "In addition, Wall Street wants companies that have liquidity, and the bigger you are, the easier it is to issue stock and debt."

Scot Sellers, chairman of Archstone Communities Trust in Denver, also notes the importance of critical mass. "There's a general consensus in the apartment industry that if you don't have at least $1 billion in equity market capitalization, you won't be large enough to survive in the public arena," says Sellers. "Smaller companies are feeling the pressure to either buy another firm over the next three years and get larger, or be purchased by someone else."

Dean Henry, president of Legacy Partners Residential Inc., in Foster City, Calif., agrees. "It appears to me that in order to be successful in this industry you either have to be a very big public company or a very small private one," he says. "The big public firms do well because of their size. Then there are the successful local guys in a limited number of markets, who know those markets intimately, have probably been building for a long time and are most likely private.

"Smaller companies that went public were once the darlings of Wall Street but then fell out of favor," he continues. "Today, the small public companies can't be successful because that's not what Wall Street is looking for anymore, and they're getting acquired by the bigger ones."

Henry says that the intent of a public company is to get bigger, improve the FFO and enhance shareholder value. By creating size and scale, better efficiencies are produced. "However, due to capital constraints, it is difficult for these public companies to grow through consolidation right now," says Henry. "The larger companies have a better opportunity of maximizing internal operations by focusing on the reduction of operating expenses."

Geographic dispersion Companies grow in accordance with their strategic plans, which for some in the apartment industry, consists of geographic dispersion through M&A. For example, AvalonBay Communities' consolidation in June 1998 was propelled by the opportunity for both parties to enter into several high-barrier geographic markets of the country. "Bay Apartment Communities had a penetration in high-barrier areas of the West Coast and wanted to expand into the east, while Avalon Properties had a concentration in high-barrier areas of the east, with a desire to expand in the west," explains Michaux. "The consolidation fulfilled a strategic objective for both of us."

Three of EQR's acquisitions in the last three years had a core geographic strategy. Crocker says the $1.1 billion acquisition of Wellsford in May 1997 was completed to gain Wellsford's assets in several geographic regions including Seattle, which Crocker says is poised for significant turnaround. In December 1997, EQR acquired Phoenix-based Evans Withycombe Residential, also for $1.1 billion. The third acquisition was Merry Land & Investment Co. Inc., a $2.2 billion transaction concluded in October 1998. "We were underweighted in the southeast," says Crocker. "The Merry Land merger finished balancing our portfolio."

>From a generic standpoint, the EQR acquisitions delivered scale and >geographic dispersion quickly in a rising real estate market. "With >one-stop shopping, we purchased 30,000 apartments," says Crocker. "That >could have taken a whole year with an internal acquisitions department."

Furthermore, Crocker says EQR was acquiring about $1.5 billion worth of real estate a year internally - and that's fast - "but with an acquisition the size of Merry Land, we were able to achieve that in four months." Speed was key, he adds, since properties were rising in value at a rate of about 1.5% per month in the previous period. The faster the assets were acquired, the greater the upside potential.

In addition to size and geographic dispersion, Crocker says the three mergers also brought buying power, management to bear in certain marketplaces and "increased diversification, which basically is spreading the risk - something we've preached for a long time."

Management succession Also behind the industry's M&A discussions, especially in apartment companies without an internal management succession plan, is whether to go outside the industry in order to find the appropriate management for a multifamily company, or merge to acquire that talent.

"I believe the issue of management succession is on the minds of several CEOs and boards in the REIT world today, and in some cases is driving M&A discussions," says Michaux, adding that the modern era of apartment REITs is only about 6 years old. Many of the people running these REITs came from private companies, may not be enjoying the public spotlight and some are nearing retirement. According to Michaux, several were entrepreneurs who made all of the company's decisions, without hiring, training and mentoring people below them to run the company.

As companies get larger, they require more professional management, more sophisticated information technology, and a different type of manager to run those systems. The real estate industry and its management - not known for its high-tech expertise - will need to become fully computer literate to manage its growing, more sophisticated companies.

"The world of the Internet has arrived," says Michaux. "If you don't have an Internet strategy, you'll be left behind. As this industry consolidates and companies grow, they can afford better and more professional talent - not only at the CEO level but in the IT, marketing and branding areas. For the industry as a whole, this is a good thing as its larger players begin to encompass all the aspects of what makes a public company an ongoing entity."

Sellers also sees the evolution of more professional management in the multifamily industry. "M&A transactions tend to focus attention on the new management, and whether those managers are 'validating' the transaction by running the new company more professionally," says Sellers. "Every time the industry completes a transaction, it helps push management to better levels of professionalism."

Expertise and product diversification In an industry where full integration has also gained significance, purchasing a company to obtain its expertise in a major area is also driving M&A activity in the apartment industry. Forexample, a firm without development expertise that commits to growing a development arm inhouse can be faced with huge risks. Among them: Will the developers like the company? Its culture? How quickly can they get out into the market? Will they be good developers? When buying a company with proven expertise in development, the risk is reduced to: Do they like the company's culture?

Gaining a development expertise was also behind EQR's merger with Evans Withycombe Residential. "The development expertise we secured allowed us to go into the development business and build properties in high-barrier markets, where it's difficult to acquire assets," says Crocker. "Now we get a new product at a price usually equal to or less than what we would have paid for certain existing properties in specific markets.

"For example, we have had tremendous success building in infill locations in high-barrier areas of Atlanta," he continues. "For one property, we anticipated a 9.5% yield, but after nine months, it's looking like 10.5%. In California, where we wouldn't have been able to acquire a property, we developed one slated for an 8.5% yield, and it is now well over 9%. We've had the same success in Boston, which is a difficult market in which to build."

Similar to acquiring a development expertise, it may be more desirable for a company to acquire a firm and its particular product line than to pursue that segment on its own. Jonathan L. Kempner, president of the National Multi Housing Council (NMHC), notes, "Just as most leading car manufacturers have a high-end product as well as a basic car, some apartment companies want to offer both products. For example, EQR's purchase of Lexford Residential delivered diversification by adding Lexford's mid-market, basic portfolio product to Equity's A/B offering," he says. "Lexford's product may not be as sexy, but that's not to say there isn't money to be made in that market."

Crocker adds that the Lexford purchase was beneficial to both companies. "Lexford is a different asset type for us, with a quality some notches below ours," he says. "But we saw an ability to use our balance sheet and operating techniques to improve Lexford's performance, first by replacing their high costs of debt by our lower cost of debt. When we finish paying off their obligations, we will make an additional $5.5 million to $6 million in cash flow.

"From an operating standpoint, we should be able to reduce their cost of operations through better buying and, since they were capital restricted, we will be able to make improvements to selected properties and get good returns on those investment dollars," Crocker adds.

Going private While many players in the apartment industry are reaping the benefits of consolidation, the current high cost and reduced access to capital are turning lots of attention to private enterprise. In addition to having more access to capital, private enterprise also faces less market criticism in terms of high financial leverage.

At San Francisco-based BRE Properties Inc., president and CEO Frank McDowell says the driving force behind some of the most recent M&A transactions - such as Lexford's sale to EQR and Walden Residential Properties Inc.'s sale to a private group - was a lack of attractively priced capital. "In both these cases, it appeared that the acquired companies did not see a way to deliver as good returns to shareholders in the near to intermediate term as independent, public companies," he says. "Overall, the primary effect on the industry of its recent M&A activities has been the slowdown or possible reversal of the public securitization of real estate."

Trammell Crow's Terwilliger says it might be a case of the grass being greener on the other side. "Public apartment companies frustrated, with their current stock prices are beginning to wonder if they might be better off going private, since they are not being valued fairly as public companies," says Terwilliger. "Some feel that their stock prices have to go somewhat lower before there is enough difference between the private values of their assets and the total market capitalization for them to afford to go private."

He adds that his firm, a private enterprise, has the opportunity to sell selected properties to public organizations, but has every intention of staying private. "This provides the flexibility and wealth creation opportunities that don't exist in public markets."

Shekar Narasimhan is chairman & CEO of Vienna, Va.-based WMF Group, a public commercial markets finance firm managing about $12.5 billion in loans. "The benefits of remaining public have changed, and several companies are opting to be taken private because of that," says Narasimhan. "Over the past 18 months, private capital sources for real estate have become at least as competitive as public funding. In the case of small- to mid-sized public companies, private capital has become even more competitive, accessible and flexible."

Narasimhan reports that there is a strategy between remaining public and being an acquirer, and simply going the private route. It requires moving the assets off-balance-sheet into joint ventures, and then bringing back capital to the public company; maintaining the management of the assets taken off-balance-sheet, then bringing them back in the future - assuming the public market will provide the capital.

"While there is activity and motion in the M&A area, it's all being driven by the attitude of the public market toward REIT stocks," asserts Narasimhan. "I don't see anything in the near term that convinces me that that will change fast enough or dramatically enough to require a rethinking."

At Post Properties Inc. of Atlanta, chief investment officer Byron Carlock Jr., says there are benefits to a company going private. "Valuations are frustrating in today's capital market, where they're being capped artificially for the industry at net asset value," says Carlock. "Some companies are trading at liquidation because there's nothing special about them. But branded companies with outstanding management, strategies and products, that deliver something special to customers besides just bricks and mortar, justify trading at valuations significantly above net asset value. Right now there's no differential between the two types; we're all being painted with the same brush.

"This may sound harsh, but companies that behave as they did when they were private development or ownership companies should seriously look at going private," Carlock adds. "They can then increase leverage, tailor their strategies to suit their personal preferences, and not be subject to public scrutiny. Those that choose to stay public need to build and maintain investor confidence by having a product, strategy, management and balance sheet that are appropriate for a public company."

In the meantime, Post Properties plans to keep its head down and "do what we've always done, which is to develop our growth consistently and profitably," says Carlock. "I believe we have a balance sheet that will afford us continued access to the capital markets. We have a product and strategy that will serve us well many years into the future. We have no current plans to acquire or go private."

NMHC's Kempner does see some light at the end of the REIT tunnel. "Our chief economists say that although private players are buying portfolios, REITs have been the big acquirers in the industry's M&A activities to date," says Kempner. "At the beginning of 1999, we estimated that public REITs owned about 8% of the nation's apartment stock. REIT stocks have softened and the tempo of M&A activity slowed over last year. However, apartment REITs have still outperformed all other REITs so far this year, with a total return through September of positive 8.2%, compared to a loss of negative 4.8% for all REITs."

Advice and lessons learned Companies that have completed M&A transactions in the apartment industry admit that the entire process is much more challenging and emotionally draining than they had anticipated. Integration of two companys' cultures is one of the most demanding aspects.

"The cultural aspects of people coming together from different backgrounds, geography and ways of doing business can be very challenging," says Michaux of AvalonBay. "If both companies don't have a depth of talent and management, the merger can be a huge diversion from the new company's day-to-day operations."

To enhance the integration of cultures, Michaux advises the CEOs of the merging companies to explore the cultural issue, and not be blinded by opportunities of earnings, geographic diversification and other incentives. "All the strategic reasons for a merger can be diluted dramatically if the cultures don't work, the people can't get along and key employees start to leave," he says. "Suddenly all the strategic gains you thought you'd enjoy are fading."

Sellers of Archstone Communities says that preparation is key in a merger. "Talk to anyone who has completed a merger and they'll say the integration of two companies' cultures was more challenging than they ever thought," says Sellers. "My advice is to prepare yourself thoroughly for what lies ahead by gaining a good understanding of the other company's culture, and identifying which elements of your own culture are critical and non-negotiable. Talk through these issues up front to assure you have a match."

"The industry has learned that to survive as we move forward, the REITs must have a strategy that is different from the other REITs and is understood in the investment community," maintains Terwilliger. "The most successful REITs have a clear geographic, product or size strategy that separates them from the others, and have demonstrated an ability and willingness to stick to those strategies and carry them out."

At WMF Group, Narasimhan notes that too many companies right now are simply treading water. "People should be more aggressive with their business plans," he says. "Pick a strategy and aggressively pursue it. Run your company like it will be there forever and stop worrying about the market."

Crocker of EQR says that in five years the multifamily industry will see only a handful of public REITs, which will be advantageous. "There will be less confusion, more predictability and stronger companies with better management, without a 'Whoops!' factor," he says. "There will be less volatility of company earnings and greater liquidity, which will attract more share-holders."

Crocker says that with fewer companies in the market, analysts will do a better job of covering the remaining firms, which will improve the credibility of those companies and draw more investors into the industry.

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