The robust M&A market has helped boost returns for investors in the real estate sector in recent months, and it is a trend likely to continue into 2022.
Looking back 12 months, real estate companies – particularly in the retail subsector – were trading at discounts that seemed unsustainable. During the course of the year, this changed and public markets started to deliver strong returns.
One of the key benefits of listed real estate companies is there is a large liquid alternative market for their assets. And if prices move too far away from fair market value for too long, shareholders can instead benefit from this other avenue for pricing.
As a result, there has also been a shift in the M&A market, albeit in a cyclically atypical way.
M&A cycle
The typical pattern for the M&A market is activity peaks as a recession hits and then falls to near zero. It then slowly rebuilds momentum as capital markets open back up and fundamentals start to establish momentum once again.
During the course of 2021 however, M&A markets continued to thrive, beyond that's been seen in previous traditional market cycles. To put it in perspective, following the tech bubble recession in the early 2000s, we saw US$10 billion of deals in the US in the real estate space, and a similar figure after the global financial crisis in 2008-09. However, in 2021, there was over US$60 billion in deals.
The drivers of this are twofold – accelerated early cycle fundamentals, coupled with late cycle capital availability, meaning cheap debt is readily available.
Of course, not all deals are worth taking part in. Some of the key factors for investors in REITs to consider – many of these unique to the sector – include:
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Is management supportive? Hostile deals are rarely successful in REITs, so a willing management team is arguably more important than discounts or willing buyers.
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Is there a discount to private market values? This is a warning sign of possible mismanagement.
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Does the buyer want the assets or the company? Buyers that want just the real estate will have a differentiated cost of capital, use a different capital structure (i.e. more leverage), and have a different view of value, to those who are interested in the entire operating platform (management, asset managers, sales, operations, etc).
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Is there a risk of activism? Activism is a challenge in the REIT sector due to corporate charters that limit ownership, the fact that values don’t stray too far from the private market and REIT investors typically don’t want companies to go away.
Economic outlook
The positive economic outlook is also providing a favourable tailwind for REITs. The economic recovery continues in most of the developed world, despite resurgent fears of the impact of new variants of COVID-19. While the recovery may moderate from peak levels, it’s likely to remain resilient as vaccine efficacy levels outweigh the more recent rise in global cases.
This is further supported by ongoing policy support from the world’s central banks. Overall, financial conditions remain supportive and largely better than pre-COVID levels.
As a result, real estate fundamental outlooks continue to improve, evidenced by the ongoing strength of earnings and operating results. Furthermore, REITs remain fairly to attractively priced compared to equities and corporate bonds. REITs will likely enjoy attractive relative returns to these asset classes as highly valued sectors of the equity market contend with a move higher in interest rates and the increased likelihood of higher US corporate tax rates, while bonds contend with higher and more sustained levels of inflation.
From a valuation perspective, global real estate securities currently offer attractive valuation compared to other asset classes.
Overall, in 2022, we believe both the private equity and M&A market trends are set to continue and investors should position their portfolios to take best advantage of this thematic, while adjusting for the headwinds evident in some subsectors of the market.
Steve Ralff, managing director at LaSalle Securities.
