Most real estate investment trusts inched higher in Monday's otherwise anemic market on
news that the
California Public Employee Retirement System
, or Calpers, was adding to its industrial real estate portfolio with its purchase of
Cabot Industrial Trust
opined that Calpers' play for Cabot was likely an isolated event, it hasn't stopped analysts from highlighting the next possible acquisition targets if the Cabot purchase sets a trend.
"This acquisition supports our belief that public real estate companies are generally attractively valued relative to private market valuations," notes David Kostin, senior real estate analyst at Goldman Sachs. "We believe that this transaction, with a pension fund buying a public real estate company highlights the current attractive valuation of many REITs, even in an uncertain economy and broader market."
According to Kostin's estimates, the average REIT trades at a 15% discount to its net asset value, the value of the property in its portfolio. Before Monday's offer, Cabot traded at nearly a 25% discount to its net asset value.
After a market-leading performance in the first half of the year, REITs peaked in August as economic fears mounted. The
Morgan Stanley REIT Index
, or RMS, has dropped nearly 11% since its August high, and some analysts think the disparity between market value and the underlying value of property in many REITs' portfolios makes the sector ripe for consolidation or additional transactions like the Calpers deal, where a private suitor bids for a REIT.
That valuation disparity may provide opportunities for pension funds and other private investors who are looking to purchase real estate on the cheap. If that happens, investors could find rewards in the especially undervalued names.
However, playing the takeover game has its downside. The variables that contribute to successful deals are both inconsistent and disparate: Management must want to sell; the combination of property portfolios has to make strategic sense; the corporate cultures of the combined entities have to mesh; and so on. Just because a deal creates value doesn't mean it will happen. Last year's
botched deal between
shows how easily a deal can fail.
As Charles Fitzgerald, co-portfolio manager at JP Morgan Fleming Asset Management,
noted Monday, the current economic landscape doesn't create a favorable environment for real estate deals. There's simply too much uncertainty regarding occupancy, rental rates and market strength to assess the appropriate price for many transactions.
Still, buying REITs and real estate companies that have solid property portfolios with a market value well below their property value and that pay a solid dividend can be a conservative way to put money to work in uncertain times. In that case, the list above can serve as a good starting point for those looking for asset value, regardless of any merger trend.
Looking at Value
In his evaluation of Calpers' bid, Kostin finds the price it paid for Cabot to be in line with similar deals. "The transaction price premium of 20% compares with a 10% median premium for the 60 real estate transactions we have tracked during the past seven years and a 23% median premium for the 12 public-private buyouts we have observed during the last three years," he says.
He also notes that the $24-per-share bid suggests a price-to-funds-from-operations, or FFO, multiple of 10 times for 2001 and a multiple of 9.6 times for 2002 for Cabot. (FFO is a REIT's measure of cash flow.) Comparatively, the average REIT currently trades at about 9 times 2001 FFO estimates and 8.4 times 2002 estimates.
Some might interpret the data to mean that REITs are undervalued. But once you consider the typical premium paid in a merger and the economic environment, REITs are much closer to fair value. While the discount to net asset value appears attractive in some cases, the average spread between market value and property value was considerably greater during the REIT bear market in 1998 and 1999. Similarly, while the current 7.2% average dividend yield is also enticing, the average yield pushed 9% at the trough.
While Kostin makes a strong case for companies that could benefit if value players come calling, it's important to put the potential for merger fever in a broader context.
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds' firm had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to