Extra Space Storage made a big splash with its recent announcement that it was buying Life Storage Inc. for $16 billion. The Life Storage deal marks the fifth real estate mergers and acquisition transaction since the start of 2022 to top $10 billion, according to S&P Global’s M&A Deal Tracker. However, such megadeals—or any M&A activity for that matter—have been scarce in the current market.
Real estate M&A activity likely to remain relatively quiet through the rest of the year with obstacles impeding deals among both public and private real estate companies. The cost of capital and uncertainty around valuations are the two biggest hurdles. For any participants that require leverage, the cost to get a deal done is more expensive, and in certain cases, access to debt is more difficult as well.
“The interest rate environment plus the uncertainty around where the economy is going and the inflationary pressures being managed by the Fed are creating a valuation gap between what sellers might have expected to get a year ago to where they are valued now,” says Jonathan Keith, managing director, risk and financial advisory at Deloitte. In addition, uncertainty around remote work and how workplace models are going to look over the next two, three and four years is weighing on valuations and M&A activity in the office sector in particular.
M&A activity among U.S. public and private REITs totaled $83 billion in 2022—the second-highest annual figure since 2007, according to Deloitte’s 2023 Commercial Real Estate M&A Outlook. Several mega deals closed in the first half of last year, with the largest transaction being Prologis’ acquisition of Duke Realty Corp. for $26 billion. However, the level M&A activity both in dollar volume and number of deals dropped in the second half of 2022, and that slower pace has continued in the first half of 2023.
Challenging financing climate
Uncertainty around valuations and where interest rates are going to settle is inhibiting M&A activity. That being said, there is a trickle of public-to-public M&A deals getting done. In the retail space, Regency Centers Corp. and Urstadt Biddle Properties Inc. announced in May that the two companies had entered into a definitive merger agreement in a transaction valued at approximately $1.4 billion.
“The reason that is still viable is because those are relative value trades,” notes James Scott, managing principal of Capital Advisors and head of investment banking in the Americas for CBRE. As one public REIT merges with another, both share prices are off and it is not as impactful because it is a share-for-share deal. On a relative value basis, the two parties can still reach an agreement on valuation. That presents an opportunity for a larger player to continue to consolidate their sector, he says.
In addition, there have been a couple of non-traded REITs that have consolidated with affiliates. In a previously announced deal, Global Net Lease announced plans to merge with the Necessity Retail REIT with a new combined value of $9.6 billion.
What the market hasn’t seen, and is unlikely to see until there is greater certainty around pricing and a constructive debt market, is the go-private activity that has symbolized prior cycles, notes Scott. The large loan market is still quite challenged. Without the debt markets constructively providing a large piece of that debt capital stack, it’s difficult for private buyers to take REITs private. “Secondarily, if you are a REIT and your share price is trading below NAV, you certainly don’t want to sell at those levels. And we haven’t seen the type of distress that would cause people to be forced sellers in this market,” he says.
REIT take-private activity is usually driven by favorable debt markets that provide high leverage at low rates. Take-private activity also is typically driven by a healthy supply of private equity, such as non-traded REIT equity, looking for core and core-plus returns. “Neither of those conditions exist now, and it is hard to see that those conditions will change in the near term,” says Steve Hentschel, head of the M&A and corporate advisory platform, JLL Capital Markets. The recent REIT M&A activity has been centered around strategic mergers between public REITs combining in stock for stock transactions that don’t need to raise new debt or equity capital, he says. “There are deals being considered but they are either taking much longer than usual, or struggling, to get done,” adds Hentschel.
Dry powder waits for opportunities
Deloitte does expect M&A activity to start picking up, possibly as early as the second half of the year. Some owners may be motivated to sell due to impending debt maturities or the opportunity to monetize existing holdings. In addition, there is a large amount of dry powder on the sidelines waiting for opportunities to emerge, which could create a flurry of activity due to pent-up demand.
Many private equity firms have capital that they want, and need, to deploy. Although private equity fundraising slowed in 2022 to $115 billion from $153 billion the previous year, private equity firms still have more than $400 billion in cash reserves to invest, according to Deloitte. Getting some stability in the interest rates would be helpful in valuations, which could fuel more M&A deals, notes Keith. The other thing that will be helpful is a better sense of where the economy is headed. “If those two things calm the waters a little bit, I think you'll see a significant uptick in M&A, although it is tough to speculate on when that will happen,” he says.
Given the amount of private equity on the sidelines, it could create some good momentum once the market stabilizes. However, it may take longer for deals to hit the market. Given the lead time of putting transactions together and still uncertainty around interest rate increases, it’s likely that M&A activity would push out to 2024 or beyond.
Most of that dry powder is held in private equity vehicles that are looking for opportunistic returns, and that capital generally believes that real estate prices will be lower in the future. “Therefore that capital is more focused on investing in debt and safer portions of the capital structure that provide attractive risk-adjusted returns,” says Hentschel. Those deals that do occur this year will likely be more focused on strategic mergers, he adds.