Private Capital and Valuations Driving Commercial Real Estate M&A Activity

Rising interest rates have not derailed a steady pipeline of merger and acquisition (M&A) activity in commercial real estate—at least not yet.

The real estate sector has seen several mega-mergers announced this year. The biggest deal to date is the acquisition by Prologis of Duke Realty in an all-stock transaction valued at $23 billion. More recently, STORE Capital announced that it was being acquired by Singapore’s GIC and Oak Street in an all-cash transaction valued at about $14 billion.

“What we’re seeing is a continuation of robust activity,” says Tim Bodner, real estate deals leader at PwC. Deal-making includes strategic buys where a public real estate investment trust (REIT) is acquiring or merging with another public or private REIT, private firms acquiring another private entity, and take-private acquisitions where private capital is acquiring a public REIT or company. Many public REITs are attractive as they are trading at a discount to net asset value (NAV).

One of the key drivers behind much of the recent activity is abundant capital raised in private equity vehicles, including funds and non-traded REITs, that needs to be put to work. “There is still a significant amount of private capital that is being pointed at real estate,” says Bodner.

According to Robert A Stanger & Co., alternative investment fundraising year-to-date through August totaled $77.1 billion, a 56 percent increase over the same period of 2021. Fundraising was led by NAV REITs at $26.0 billion, non-traded business development companies (BDCs) at $18.7 billion, interval funds at $18.0 billion, and Delaware Statutory Trusts at $6.8 billion. “That capital needs to be deployed at scale, and there are great opportunities to invest that equity into buying public REITs right now,” says Steve Hentschel, senior managing director and head of the M&A and corporate advisory group, capital markets, at JLL.

Blackstone is one entity that has been successful in raising capital through its various structures and has been “leading the charge” on M&A and strategic transactions activity. Stanger has reported that Blackstone has raised $25.0 billion in the alternative investment space year-to-date, including BREIT with $15.4 billion and its perpetual-life BDC, Blackstone Private Credit Fund, with $9.6 billion. According to JLL, Blackstone (NYSE: BX) acquired PS Business Barks (NYSE: PSB) in an all-cash deal valued at $7.6 billion. Blackstone affiliates BREIT and BPP also acquired American Campus Communities in an all-cash deal valued at $13 billion.

In addition to non-traded REITs, sponsors are raising very large opportunistic real estate funds, and there also is a lot of activity around family offices, high net-worth individuals, and sovereign wealth funds most of which are allocating a significant amount of capital to real estate. “The private capital dynamic in those three constituent parts is a significant driver of M&A and it’s why we think we’re going to continue to see activity,” says Bodner.

REITs Trading at a Discount

As the broader stock market has fallen over recent months, some public REITs that are trading at a discount to NAV create an attractive buying opportunity. According to Green Street data from Sept. 21, few sectors are trading at or above NAV. Those sectors that are trading at the biggest discount to NAV are office at -27.3 percent; apartments at -23.2 percent and lodging at -17.6 percent.

A rise in investor activism over the past decade also has been a contributing factor to M&A activity in the public REIT space. “Activists have contributed to the flow of good real estate assets from the hands of O.K. managers to better managers,” notes Dave Bragg, co-head of strategic research at Green Street.

However, Green Street’s research also indicates that the recent uptick in M&A activity involving public REITs has been relatively modest. Going back to 2000, the percentage of REITs that have been involved in M&A, including take-private deals or mergers between public REITs, has typically averaged about 4 percent of the REIT market cap per year. In 2021 and thus far in 2022, that percentage ticked slightly higher to about 5 percent. The research firm is predicting that M&A deals will drop back to that 4 percent level over the next 12 months. So, despite the big announcements that have occurred this year, activity is fairly close to the historical average, notes Bragg.

Private Entities Have Buying Power

The flurry of M&A deals in recent years is stirring debate around public versus private investment opportunities. Going back to 2018, there has only been $5 billion in equity raised by REIT IPOs, with the majority of that raised in 2018, according to JLL. During the same period, REIT take the private activity from 2018 through June of 2022 (not including STORE Capital) was roughly $64 billion. “Assets are leaving the public sector and new companies aren’t coming in to fill the void,” says Hentschel.

Public REITs have been challenged by the fact that many have been trading below NAV. “That situation is very frustrating to a public REIT because you can’t issue equity to grow your business,” says Hentschel. In addition, REITs are trading with a near-perfect correlation to the S&P 500. That dynamic is viewed as a negative by investors who are looking to real estate to diversify and stabilize investment portfolios. That correlation could make it very difficult for the public REIT sector to thrive, he adds.

The shift in favor of private capital in the real estate sector aligns with a bigger mega-trend or “shift in power” towards private equity occurring more broadly across industries, says Bodner. “The importance of private capital across industry sectors is going to have a significant impact on the public markets,” he says. The biggest byproduct of that power shift is that a disproportionate amount of capital is being raised by private vehicles, and in turn, private capital is likely going to drive a disproportionate level of deal-making across all sectors of real estate. Over time, the public REIT universe could span a smaller pool of companies that are much larger in size. “There will always be a role for public real estate companies, but those who are able to stay in the public market will likely be the ones with significant scale and a differentiated business plan,” he adds.

Public REITs continue to offer advantages, such as liquidity, as well as buying opportunities. “When REITs trade at big discounts to NAV as is the case now, one can achieve superior returns by buying REITs,” says Bragg. In that regard, investors with a dual mandate for investing in both public and private vehicles could benefit investors, he adds.

Debt Market Could Slow M&A

Despite tailwinds fueling M&A activity, there are near-term challenges that could slow transactions, including debt financing that has become both less available and more costly. “Once that volatility stabilizes, the private equity firms are very well-positioned to be on their front foot to deploy capital, and we think that’s going to happen,” says Bodner. PwC anticipates that there will continue to be additional M&A deals announced through the end of 2022, particularly from private pools of capital that have both a lot of cash and a longer-term investment horizon.

If the goal is to maximize shareholder value, then exiting through a private transaction likely makes more sense than trying to stay in the public markets for those firms that are trading below their NAV, notes Bodner. In addition, he says that some of the older vintage “lifecycle” REITs are perceived very differently than the new perpetual NAV REITs, which likely will drive more consolidation and M&A deals around that particular part of the industry.

There are forces on each side, which could present both headwinds and tailwinds to M&A deals, adds Bragg. “So, it is a bit of a tug of war right now in terms of what direction M&A will head in. For those reasons, we expect the pace to be pretty consistent with what we have seen historically,” he says.