Consolidation in the real estate investment trust (REIT) industry has become more prevalent in recent years, a trend that is likely to continue. There are a variety of factors contributing to the accelerated consolidation of firms in the industry – from favorable current economic conditions that are generating increased economies of scale to optimization opportunities created through continued growth and acquisitions. Although financial incentives are the primary factor influencing merger and acquisition (M&A) activity, many strategic factors such as achieving economies of scale have also played a significant role (W. Ambrose, Highfield & Linneman, 2005). Evaluating the underlying factors that have contributed to recent M&A activity can offer valuable insight into expected long-term investment performance of the commercial real estate asset class and real estate securities.
REIT Market Overview
The recent M&A activity in the REIT sector is not unprecedented. REITs went through large-scale consolidation between 1990 and 1997, resulting in significant growth in the total REIT market capitalization. During this same period, the number of overall firms declined. This phenomenon can be traced to fundamental shifts that occurred in the real estate industry in the early 1990s.
A brief history of the US REIT market is useful to explain and analyze these fundamental shifts. REITs were first introduced in 1960 by Congress, providing tax treatment for commercial real estate investments similar to mutual funds. REITs became “quasi-exempt” from corporate taxation, which enabled shareholders to avoid double taxation from corporate taxes and personal income taxes. As such, REIT earnings and capital gains were only taxed when realized by individual shareholders. However, this preferential tax treatment designated by Congress came at a high price. Regulations governing the corporate structure of REITs limited their ability to retain earnings and generate supplementary operating income compared to the traditional corporate structure (W. Ambrose & Linneman, 1998).
Prior to 1990, REITs were mainly considered passive long-term investments. Existing regulations made it difficult for REITs to access capital and utilize cash flows necessary to support potential acquisition and growth opportunities. In the early 1990s, removal of certain restrictive tax laws and the introduction of more flexible REIT corporate structures led to the modern REIT era. These regulatory changes stimulated overall growth of the REIT market and encouraged industry consolidation as firms had the ability and capital to pursue acquisition opportunities (Wilshire, 2016).
Recent Mergers & Acquisitions — Contributing Factors
There are many factors to be considered in the context of recent consolidation in the REIT industry. The accelerated pace of M&A is only expected to rise among industry players. REIT stock underperformance has encouraged M&A activity as REITs view consolidation as an opportunity to generate shareholder value and improve stock performance. Pebblebrook Hotel Trust’s impending $5.2 billion acquisition of Lasalle Hotel Properties is evidence of this sentiment (Borchersen-Keto, 2018). Pebblebrook believes the acquisition is a value-maximizing opportunity for its shareholders.
Increasing economies of scale has also been a major driver in the recent wave of M&A activity. REIT managers believe they can achieve efficiency in management and operations through increasing firm size and owning larger portfolios. This was the case in Prologis Inc.’s recent acquisition of DCT Industrial Trust. “This high level of strategic fit will allow us to capture significant scale economies immediately,” said Prologis Chairman and CEO Hamid R. Moghadam (Prologis, Inc., 2018).
REIT Sector Outlook
As a relatively new asset class, REITs have little empirical evidence validating increased performance metrics as a consequence of industry wide consolidation. REITs have been known to provide portfolio diversification, as they are not always highly correlated with stocks and bonds. A recent rise in correlation between REITs and the S&P 500 raises concern among investors who view REITs as a reliable source of diversification (Engle, 2018). With over 220 public REITs, it will be interesting to see how recent consolidation impacts overall returns and the performance of REITs.
References
Borchersen-Keto, S. (2018). Pebblebrook, LaSalle to Merge in $5.2 Billion Transaction. Retrieved from https://www.reit.com/news/articles/pebblebrook-lasalle-merge-52-billion-transaction
Engle, J. (2018). Retrieved from https://seekingalpha.com/amp/article/4121471-outlook-reit-sector-2018
FTSE Nareit Real Estate Index Historical Market Capitalization, 1972 – 2017.
Prologis, Inc. (2018). Prologis to Acquire DCT Industrial Trust for $8.4 Billion. Retrieved from http://ir.prologis.com/press-releases/2018/04-29-2018-204333658
W. Ambrose, B., Highfield, M., & Linneman, P. (2005). Real Estate and Economies of Scale: The Case of REITs. Real Estate Economics, 33(2), 323-350.
W. Ambrose, B., & Linneman, P. (1998).Old REITs and New REITs. Retrieved from http://realestate.wharton.upenn.edu/wp-content/uploads/2017/03/300.pdf
Wilshire. (2016). The Role of REITs and Listed Real Estate Equities in Target Date Fund Asset Allocations.
