Takeout Firms Flock To Office Fundamentals

Another real estate investment trust (REIT) is exiting the public stage. Just yesterday, investment bank Morgan Stanley announced plans to buy San Mateo, Calif.-based office and industrial owner Glenborough Realty Trust Inc. (NYSE: GLB) for roughly $1.9 billion. The offer values GLB shares at $26, an 8.2% premium over Friday’s closing price. GLB owns a portfolio of 45 office, industrial and retail properties scattered the nation.

This latest deal brings the total value of office REIT mergers and acquisitions (M & A) up to nearly $20 billion so far this year, according to SNL Financial. With four full months left to go in 2006, the old annual M&A record of $4.5 billion, set in 2001, has already been exceeded.

So what’s behind this flurry of office deals? Are they simply part of the overall M&A frenzy, which is being driven by the need to deploy huge pools of private equity? Or is there something about the office market (try improving fundamentals and rising rents) that’s driving these deals?

Office REIT mergers and acquisitions since 1999
Buyer/Target Announced Deal value

SL Green/Reckson Assoc

8/06 $3.7 billion
Brookfield Props & Blackstone/Trizec Props 6/06 $4.7 billion
Blackstone/CarrAmerica 3/06 $2.7 billion
LBA Realty/Bedford Property Investors 2/06 $434 million
GE Real Estate/Arden Realty 12/05 $3 billion
Brandywine Realty/Prentiss 10/03 $2.2 billion
DRA Advisors/CRT Properties 6/05 $902 million
Lightstone Group/Prime Group Realty 2/05 $208 million
Transwestern Investment/Great lakes REIT 1 /04 $241 million
Equity Office Props/Spieker Props 2/01 $4.5 billion
Equity Office Props/Cornerstone Properties 2/00 $2.7 billion
Ocwen Financial Corp/Ocwen Asset Mgmt 7/99 $200 million
Total: $40.1 billion
*when announced | source: SNL Financial

If you ask investors like Morgan Stanley and Blackstone Group, which have plowed billions into office portfolios, it’s about riding favorable occupancy and rental trends. But, Stifel Nicolaus Managing Director John Guinee stresses that the rosy scenario is only apparent in some markets. “Office recovery is multifaceted--anywhere from extraordinarily strong and long-term in nature in places such as midtown Manhattan to relatively anemic and almost non-existent in older Midwest markets,” said Guinee during an exclusive interview with SNL Financial on Aug. 18.

With Glenborough Realty, Morgan Stanley is buying into a company positioned to benefit from strong demand in key markets. During the 12 months between midyear 2005 and 2006, for example, heavy leasing absorption helped GLB boost portfolio-wide occupancy from 88.3% to 94.1%. Owning assets in several key markets, including Washington, D.C and Southern California helped. The single largest chunk of GLB-owned properties (27% of the portfolio) is located in the plum Washington, D.C. market. Office vacancy in the D.C. metro area was just 4% at the end of July

Another enticement for Morgan Stanley: Nearly half (or 45%) of GLB’s 2006 lease expirations will occur in either Washington, D.C and Southern California, two of the strongest office markets in the nation. Office tenants renewing or re-upping their leases in these markets are likely to spend more on rent over the next six to 18 months, too.

Improving fundamentals are “absolutely making it to the bottom line” of several office REITs, says Guinee. He cites SL Green (which bought New York office REIT Reckson two weeks ago) and Corporate Office Properties Trust as two examples. But he also sees plenty of office REITs that aren’t benefiting from improving fundamentals, including Brandywine Realty Trust and Mack-Cali Realty Corp. Brandywine and Mack-Cali both own assets in the mid-

Atlantic region; Brandywine also owns office properties in Texas. “In markets where gross rental rates are only increasing by 1% to 3% annually, those gross rent increases are offset by higher operating expense increases, increasing tenant improvement costs and the ever-increasing corporate G & A,” he says.

At this point, Guinee is predicting a slowdown in M & A activity. His reasoning: Because many of the REITs with portfolios of good, institutional-quality office properties in high-growth markets have already changed hands. Even with billions of private equity sloshing around, he says, “the privatization community” doesn’t want to buy bad real estate in slow growth markets.

The office REITs with the highest quality real estate that remain public are Equity Office Properties Trust, Boston Properties, SL Green, Maguire Properties, Highwoods Properties and Corporate Office Property Trust, he says.

Guinee remains bullish on office REITS, predicting that they will continue to outperform the broader REIT market: “Office and apartment have far exceeded other subsector because of the privatization and take-out activities,” he says. “We clearly see office total returns as not being sustainable relative to other sectors.”

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