10-23-06                                                                                           Vol. 9: No. 5 RealtyStocks' Observer If you're not receiving this free monthly e-newsletter, please register. Monthly Feature: PRIVATIZATION OF REITS ESCALATES WITH EQUITY OFFICE BUY-OUT FOR $36 BILLION REITs Rise in the Third Quarter and Continue Strong A. REIT Buy-Out Mania B. Equity Office Properties (EOP) Turning Private C. Equity REIT Performance D. Large Cap REIT Performance E. Mortgage REIT Performance F. Realty Corporations G. Real Estate Mutual Funds A. REIT BUY-OUT MANIA The privatization of REITs has been a trend for over two years that seems to be picking up steam with the most recent announcement of the Equity Office Properties (EOP) takeover on November 21st. (Please see B. below.) Public REITs that have disappeared include Shurgard, CarrAmerica, Arden Realty, Trizec, et al. Thus far in 2006, including EOP, REITs have been taken private in transactions valued at $66 billion compared to only $9.1 billion in 2005 and just $252 million in 2004, although total REIT M&A activity in 2005 was over $20 billion. In addition, there have also been various real estate mergers in the last couple of years. Recently, SL Green (SLG) has announced it's acquisition of Reckson (RA). However, contrary to nearly all other similar announcements already completed, this may encounter some difficulty. Of course, the M&A activity in the public real estate sector is not limited to just REITs, it also involves other entities. For example, the CB Richard Ellis (CBG) acquisition was recently approved for Trammel Crow (TCC) providing considerable consolidation among the commercial real estate service sector. Real estate transaction activity has been slightly up this year with 2,200 real estate deals so far in 2006, compared to 2,100 deals last year. However, the amount of the deals is significantly higher this year totaling $367 billion, up from $249.1 billion in 2005. REITs are experiencing their seventh straight year of increases and it looks as though 2006 could be one of the best years for gains. (Please see C Below.) The EOP announcement has lifted nearly all REITs a few percent this past week, especially those in office REITs - the same property group as EOP. Regardless, most major indices did not advance on a rash of mergers and acquisitions announced for various industries, besides real estate. Unlike the equities market in general, which currently seems to have difficulty setting new highs, the immediate prospects for REITs seem more bullish with last week's aquisition announcements, and more expected. Another reason for higher REIT prices, especially in the Office REIT group, is that the disappearance of EOP will reduce the market cap and shares of Office REITs by over 20%. If investors maintain similar positions in Office REITs, but there is a smaller supply of such stocks available, it should cause the remaining shares of Office REITs to rise. Unfortunately, the market has been very quick to react and such quick and easy gains may already have been made. However, there may be other groups or sectors that will provide more opportunity than Office REITs. Of course, with only an 8% premium to the EOP deal, similar increases among other REITs could start to price REITs at a level that would ultimately slow down M&A activity. Top B. EQUITY OFFICE IS TURNING PRIVATE Before the Thanksgiving Holiday last week, the Blackstone Group announced it's aquisition of one the nation's biggest REITs, Equity Office Properties (EOP), for $20 billion plus $16 billion in debt. The acquisition of the nation's largest office landlord with some 109 million square feet makes it the largest of any buyout thus far and the biggest real estate deal in history. The offering price per share of $48.50 provided a one-day jump in EOP's price by about 8% and the week before the stock drifted up each day closing the week for a gain of 4.5% prior to the announcement. Since the beginning of the year, the stock has increased about 60%, and at the end of last week, the stock even moved slightly higher than the offering price. This dispels prior notions that the largest REITs were too big to be taken private. (However, in our last newsletter, we mentioned that there was some speculation that one of the largest REITs could be acquired.) The news buoyed REITs for an increase of a few percent last week, largely due to future takeover expectations. Despite EOP's current yield of only 2.7% (excluding any special dividends), Blackstone reportedly expects net operating income in its first year of operations to be 5.5% of the purchase price. Such a capitalization (or "cap") rate is the lowest of any recent REIT acquisitions. With 10-year treasuries currently slightly over 4.5%, the spread between the EOP portfolio and treasuries is less than a full point, or 100 BP. Historically, the eight year average for such spreads has been about 3 points higher, and is therefore causing some raised eyebrows among many real estate veterans. Granted, such spreads have narrowed considerably over the past few years, and a spread slightly under 2 points between cap rates and 10-year Ts has not been uncommon. Still, to justify such a low cap rate, it would seem there would be an anticipation that Treasuries are softening and staying relatively low, that savings can be created from private versus public operations and that a higher debt to equity load at favorable rates and higher rental rates will increase cash flow. (It is reported that Blackstone will have a new debt load of about 85%; far higher than the 30% to 40% most REITs carry.) Further, certain operating efficiencies might be obtained by divesting assets in certain less lucrative markets. Another factor that drives such transactions, seldom openly discussed in the public media, is the enormous fees that the principles and key personnel could receive. Of course, as a private entity, such fees would not need to be reported and made public. As previously mentioned in our past newsletters, the global abundance of large sums of capital and the difficulty of finding investments with yields that are attractive, dependable, hedge against inflation and have the potential to increase, has made large portfolios of real estate very appealing. After all, the cost and time involved in building such large portfolios in today's competitive landscape are daunting. This has boosted the prices made for large and desirable commercial properties to all time highs. However, as experienced real estate professionals know, there can be significant extraordinary costs in operating commercial properties. With office buildings, for example, older properties may need retrofitting to meet ADA, safety and building codes and to just stay competitive, remodeling a lobby and hallways or providing a face lift is also often necessary. In addition, as properties age, their obsolescence increases, which may be difficult to cure. For instance, if the number of parking spaces in an office building is inadequate, it may be virtually impossible to overcome. As the average office space per person shrank in the last decade, it created more workers in an office building, making it almost impossible to obtain full building occupancy if there is insufficient parking, unless exceptional public transportation is nearby. Since the average age of a building in the EOP portfolio is probably a couple decades old, there is undoubtedly certain obsolescence in many of their buildings. Unless rents and occupancies improve significantly, the thin spread between treasuries and the cap rate for EOP, and a relatively high purchase price of about $330/s.f., may be insufficient to offset the extraordinary costs required. The biggest beneficiary of the EOP deal would be it's founder & CEO real estate tycoon, Sam Zell. Even though his stock would be worth about $92 million, it appears that his options and partnership interests could reap the multi-billionaire around $800 million. Zell joins other well known and successful founders of REITs, such as Richard Ziman of Arden and Tom Carr of CarrAmerica, who are all selling out to private equity firms. Possibly these shrewd real estate execs know when it's time to leave the real estate party. However, don't expect Zell to completely disappear from real estate. He is still the largest shareholder of Equity Residential (EQR), the nation's largest multi-family REIT. Of course, it begs the question that if the timing is right to sell EOP, could EQR be next? Apparently, such speculation may have helped drive EQR up about 6% last week, and when the EOP deal was announced last Monday, there apparently was some confusion between these two REITs, as EQR was initially up over 20% from its close the week before.   Top C. EQUITY REIT PERFORMANCE Equity REITs had a robust gain of 11.25% in the third quarter of 2006, basically matching their gain in the first quarter, and improving on a negative -5.3% loss in the second quarter. However, October was up 6.63% and November should finish up higher. With only one exception, all property type groups were positive in the 3Q and all were positive in October. Year-to-date (YTD), only one property type group (Retail Malls/Centers) is positive and Equity REITs have gained 19.88% for the year - excluding dividends. The best performers YTD are Offices (up 31.17%) followed by Apartments (up 30.67%) and Retail Factory Outlets (up (29.78%). The best performer for the third quarter was Self-Storage (up 23.81%) and the best performer in October was Regional Malls (up 13.26%). In the 2Q the worst performer was Self Storage, which made a strong turnaround. (Please see Equity Gainers and Losers.)   Top D. LARGE CAP REIT PERFORMANCE Large Cap REITs finished the third quarter weaker than the broader REIT market with a gain of only 7.4%. However, they are scantly higher than the average for all REITs in October, but are substantially ahead for the year through October, with a gain of 32.1%. Out of 25 Large Cap stocks, all but one was positive in the third quarter, but all were positive in October. The best Large Cap REIT in the 3Q was Apartment Investment (AIV) with a gain of over 20.1% for October, the best performer was iStarFinancial (SFI) with a price change of 11.1%. The worst performing Large Cap for the 3Q was Plum Creek Timber (PCL) with a loss of -2.3%. Through October, the leaders are SL Green, leaping 60.1% and Apartment Inv. (AIV) surging 51.4%. The only negative performing REIT YTD is Plum Creek Timber (PCL). Please see Large Cap REITs.)   Top E. MORTGAGE REIT PERFORMANCE Mortgage REITs underperformed Equity REITs in the 3Q with a gain of 4.12%. However, as interest rates softened, they had a better showing in October with a gain of 11.42%. YTD, Mortgage REITs now edge out Equity REITs with a gain of 20.58%. Of course, when the higher dividends with Mortgage REITs are included and total returns are considered, the performance of Mortgage REITs is even better than those in Equities. The best performing group for the third quarter and YTD was Commercial Mortgages. (Please see Mortgage Gainers and Losers.)   Top F. REALTY CORPORATIONS Realty Co's. underperformed REITs in the third quarter with a loss of -0.84%, and have now lagged behind REITs for each quarter of 2006. However, Realty Corps. matched Equity REITs in October with a gain of 6.63%. Gainers and losers were about equal in the 3Q with Developers performing the best (up 12.27%) and Mobile Home Manufacturers losing the most (down -14.04%). For October, all industries were positive with the best performer being Property Services, largely as a result of the acquisition of Trammel by CB Richard Ellis. YTD, Realty Co's. are trailing REITS with a gain of only 8.01%. YTD, the best industries are Tech & Net (up 32.46%) and Property Services (up 30.89%). The worst industries YTD are Mobile Home Mfgs. (off -16.18%) and Home Builders (off -15.83%). Despite a much softer residential market, Home Builders have actually posted gains in September and October, as many investors are thinking that the worst may be over in this industry. (Please see Realty Corp. Gainers and Losers.)   Top G. REAL ESTATE MUTUAL FUNDS (REMFs) REMFs trailed the broader REIT market October with an average overall return of 5.55%. The best performing REMFs for June were ProFunds Ultra Sector with a return of 8.87%, followed by JHancock Real Estate, up 6,88% for the month. YTD, out of 288 funds, the average REMF has had an overall return of 28.98%, which exceeds the broader REIT market - but not Large Cap REITs. The top two funds YTD were ProFunds Ultra Sector and E.I.I Int'l Property with overall returns of 42.06% and 37.66%, respectively. (Please see REMFs.)   Top Note: In reporting group percentage changes, stocks that were under $1 are excluded from our calculations. If a stock is under $1 for more than two months, it is subject to removal from our coverage. All gains or losses regarding Realty Stocks are price changes only; dividends are excluded, and are calculated as of the end of each month. Disclaimer: The material provided herein should not be taken as endorsements or recommendations to invest in a stock, fund, a group of stocks or other securities. No guarantee can be made as to the expected performance of such investments. Investors should consult all available information, including data external to RealtyStocks and associated Web sites, and exercise own best judgment before making any investment decisions. The author may have equity positions in some of the companies covered in RealtyStocks, which may change from time to time, and will divulge such information upon request.   Top InRealty Sponsors Inquire about our special advertising banner promotions! E-MAIL: stocks@inrealty.com Copyright ©2006, WebVisers Inc. All rights reserved .