Even in a scorching hot condo market, a $350 million development pipeline basically didn't add a dime to the value of Gables Residential Trust's stock where Wall Street was concerned.
"There's a dividend machine and the measurement of success happens every quarter," says David Fitch, CEO of the Atlanta-based company, one of a handful of public apartment REITs that turned private last year. "One of the measurements of a public [apartment] company is FFO [funds from operations]. The gains generated from the sale of operating properties is not recognizedin the FFO calculation. If you go make $20 million in development, that $20 million does not directly show up in the dividend machines. We went through a period where valuations were ascending, and we were unable to realize that value in a meaningful way."
It was a frustrating situation for the CEO and his colleagues at Gables, which also owned 20,500 units in 2005. They had both properties and a development pipeline with product that was highly appealing to condo converters, but as a public company, they couldn't truly capitalize on the value of either.
So Gables put itself on the block, eventually selling for $2.8 billion in cash to a joint venture of ING Clarion and Lehman Brothers.
It wasn't the only public apartment REIT to make such a decision in 2005. AMLI Residential did the same thing, opting out of public life for ownership by Morgan Stanley Real Estate in a $2.1 billion cash deal. Town and Country Trust, a small public apartment REIT, also accepted a $1.5 billion cash offer from a joint venture of Morgan Stanley Real Estate and other investors. And, rumors swirl about the other public companies that could follow these firms' lead. (See "Who's Next?," p. 53.)
What's driving this latest public-to-private trend? The answer is twofold. First, REIT regulations and public market values are limiting the options available to public apartment REITs striving to stay competitive in a hot real estate market, and the flood of capital pouring into the private market is providing serious enticement for leaving Wall Street behind. But the tide may now be turning.
"The privatization deals reflect the flood of capital looking for a home in real estate," says Craig Leupold, a principal with San Diego-based Green Street Advisors, an independent research and consulting firm concentrating on publicly traded real estate. "Premiums are being paid for portfolio transactions versus one-off deals given the efficiency of putting out large sums of capital in a single transaction. As result of the privatizations, apartment REIT prices have increased, and the REITs no longer trade at the large discounts to NAV [net asset value] that were pervasive just six to nine months ago."
Public Limitations
Being public certainly has its advantages. Publicly listed firms generally have broader access to capital, for one. But that wasn't much help to AMLI Residential in the last year or so.
Entrenched in its core Midwestern and Southern markets (and their corresponding lackluster rental markets), AMLI needed to diversify its 28,659-unit portfolio, and CEO Gregory Mutz knew it. "AMLI had the challenge that its properties were in markets that had underperformed and been lower growth for the last three to four years," Mutz says. "Our markets weren't growing like the coastal markets. We wanted to sell Indianapolis and take all of that money and go buy properties in Southern California, but the dilution would have been too painful and costly."
He cast many envious glances toward those higher barrier-to-entry coastal markets where many of AMLI's public competitors owned properties. But Mutz also knew he was basically window-shopping. "Our earnings would have gone down a lot," Mutz says. "You could receive a six [percent cap rate] on the sale of an Indianapolis property and only a four [percent cap rate], say in Los Angeles. That's a big difference. Two points on $200 million is $4 million bucks. If AMLI's earnings dropped by $4 million, our stock price would most likely have under immense pressure."
Being public also not only affects a company's ability to buy existing properties, it also affects their capacity to construct–and sell–new apartment buildings. Analysts tend to get a little nervous when a REIT's development pipeline gets too large for their liking. They think it adds risk. And, just as leverage limitations make it difficult for public firms to buy increasingly expensive properties, they also make it hard for such companies to buy entitled land, whose value has also skyrocketed. This forces firms to pursue parcels that must be zoned or rezoned, which takes time and also adds risk. "For the public guys, it's hard for them to justify paying these prices when they can't ramp up their leverage," says Stephen Swett, an analyst and managing director at Wachovia.
When an apartment REIT does manage to build, it's often difficult for them to flip a new property, despite the undeniable financial appeal of doing so in today's market. "The REIT structure has limits on unlocking value," Swett says. "It's harder to sell. You can't just build to flip it unless you build within a specific-purpose entity."
And then there's Sarbanes-Oxley. Popularly known as SOX, these regulations place more financial and accounting requirements–and compliance costs–on public firms. For some, the additional costs just don't make financial sense. According to Mutz, the law added about $2 million in overhead for AMLI; Fitch estimates SOX costs at $1.7 million for Gables.
Gables must comply with many aspects of the law as part of ING Clarion. But it's nowhere near the amount of cost and effort involved when the company was on its own. "The absolute cost of Sarbanes-Oxley is out of scale for companies of our size," Fitch says. "What they ask you to do is a little silly as you move deeper into operations."
It's also extremely time-consuming. "The cost and fun of public of being public is not what it once was," agrees Simon Wadsworth, CFO for Mid-America Apartment Communities, a Memphis-based firm that is one of the smaller apartment REITs. "Instead of wheeling and dealing at meetings, you're doing 404 documentations. It's very tedious."
Private Plays
For formerly public firms, going private has opened up a host of new opportunities. At AMLI, the Morgan Stanley deal provided the freedom and funding to finally enter new (and expensive) markets. It also gave the Chicago-based company a chance to capture its true value for stockholders. "Our problem was that we were trading at around $30 per share," Mutz recalls. "Our net asset value was substantially greater. If you want to grow and get larger, you have to sell stock and increase your equity base. However, selling stock at $30 per share when your true value is 20 percent greater results in unacceptable dilution to the current shareholders.
"No one on our board, management included, wanted to sell stock at this great a discount to NAV," Mutz says. "So we were, in effect, trapped–too small for SOX operating in underperforming markets and trading at too great a discount to NAV to grow our way out of the box we were in."
Fortunately for acquisition-friendly REITs, private capital is definitely interested in large portfolios, Leupold says. "There's an abundance of capital in the private market that's looking to be placed as efficiently as possible," he says. "There are big premiums for portfolio transactions. A lot of that capital is looking at the REITs."
This capital comes from a number of places: pension funds (though some of those are divesting themselves of U.S. assets and looking overseas), life insurance companies, and foreign investors. Overseas money, in fact, comprises about a third of the Gables fund. "The Middle Easterners are interested in multifamily," says Stephen Cordes, managing director of ING Clarion. "We're going to see more of them."
And big investors expect to stay interested in the apartment industry. "We see multifamily as an area where, on risk-adjusted basis, we will able to achieve extremely aggressive returns," says Cordes.
Such returns are highly appealing to large funds and investors, which pay close attention to the NCREIF Property Index and adjust their real estate holdings accordingly. (This index, produced by the Chicago-based National Council of Real Estate Investment Fiduciaries, shows real estate performance and provides investors with industry averages for benchmarking their own returns.)
John Kessler, managing director for Morgan Stanley Real Estate, also sees multifamily as an attractive bet. "Because of demographics and other reasons, we thought multifamily would be one of the better-performing asset classes," says Kessler, whose company now counts AMLI among its investments. "We thought we shouldn't be underweight in it. We should be equal or overweight."
Capital Cycle
With so much money chasing multifamily at the same time as being private offers big advantages, will more MFE Top 50 public apartment REITs go private in 2006? Maybe, maybe not. It all depends on how large–or small–the difference is between the public and the private markets and the value they assign to multifamily firms.
Some, such as Leupold, think there are more deals to come. "I still see the REITs trading at a discount to their underlying value, which has been the impetus to these transactions to date," he says from his analyst's perch. "As we continue to see cap rates decline, the private market is a little more astute [than the public market] when it comes to where cap rates are currently. It has been willing to pay the price to take these companies private and efficiently deploy large buckets of capital."
Fitch, however, believes the deal-making environment has changed. He says companies like ING Clarion and Morgan Stanley took advantage of the spread between public and private values, and, afterward, the public markets closed the gap as apartment REIT stock prices rose. "The markets are efficient," he says. "Those players that got in were able to take advantage of a disparity in values. In our case, one could infer that we were able to get the $5 to $10 per share for our development machine. That was the premium that the public market was not giving us."
That shifted in the last quarter of 2005, when apartment fundamentals changed. "The fourth quarter of last year was scorching hot," Wadsworth says. "Same store NOI [net operating income] was at 6.5 percent. We were up over 8 percent. Nobody forecasted that. [Companies] who were kind of rocky before that are less rocky. I think that took some pressure off people. They're less vulnerable."
Of course, markets and real estate do tend to be cyclical.
"In 1997 and 1998, everyone felt that the REITs would have a lower cost of capital," Swett says. "They had access to secured non-recourse financing they also had the ability to raise unsecured debt, which the private guys hadn't done. Everybody thought that the REITs would be constantly acquiring assets, and you would have assets moving into public markets. That has not been the case in multifamily."
The rise of the private dollar kept REITs from dominating. But that does not mean that being public won't again become fashionable. For some multifamily executives, going public still retains its allure, even if it's not the right choice at the moment. "For different times, there are different reasons to be public," says Bruce Ward, president of Phoenix-based Alliance Residential, who admits he's harbored thoughts of taking his growing company public one day. (Alliance, a private MFE Top 50 firm, managed 37,423 units in 2005.) "When capital markets are tight, they have more consistent capital than private guys. Right now, private guys have virtually unlimited capital."
Who's Next?
Analysts and executives ponder which public companies could turn private.
Talk to industry insiders about the most likely candidates for going private, and you'll often hear the same names over and over again. Post Properties. BRE Properties. Home Properties or Mid-America Apartment Communities.
What's the reason so many people speculate about these particular REITs? Their size. Most people agree that a REIT needs to be in the $2 billion to $3 billion market capitalization range to be candidates for acquisition. "To buy a company like AvalonBay or Equity Residential takes $10 [billion] to $15 billion," says Simon Wadsworth, CFO for Mid-America, which is based in Memphis. "You need to get two to three funds coming together. It's quite a bit of money."
This limits the number of companies that can realistically compete to buy apartment REITs. "There are more players at smaller dollar price points," says Craig Leupold, a principal with Green Street Advisors, a San Diego-based independent research and consulting firm concentrating on publicly traded real estate. "When groups are looking at deals, you start to whittle away as you get to a $5 billion to $10 billion type of company. The number of players who play in that arena are smaller."
Public apartment execs are aware of the interest in their firms. Each year, Wadsworth says, Mid-America's management talks with its board and discusses whether or not staying public is the best way to increase the company's value. So far, the answer has been yes. But that doesn't mean the Mid-America CFO would hang up if he got a call from an interested buyer. "We would never say never," Wadsworth says. "We're definitely not for sale. But if someone comes in and makes an attractive offer, we'd take that to the board and we'd look at it in-depth."
No Escape
Going private provides relief from SOX regulations, but investors still want plenty of information.
When Gables CEO David Fitch hears that his life is easier without oversight of the public markets and analysts, he shakes his head. While the process may be different, it's certainly not easier.
"As a public company there's a uniformity that's mind-boggling," Fitch says. "There's a wide, vast group of investors and analysts."
The idea that things get easier when a REIT goes private is a misconception.
"There's a level of involvement and scrutiny that is more in depth in a private setting than was required in a public setting," Fitch says. "There's a different level of scrutiny and involvement in the private setting that's not necessarily required in a public setting."
Long after the sale, Gables is still learning how to educate its investors. "We're learning what they want to know, which is not what we needed to share before," Fitch says. "It's reengineering the information flow and expectations."
