By Steve Bergsman

Can REIT capital market activity match the flurry of 2003?

For over a year, the REIT industry has undergone its own version of "Let's Make a Deal." Investors desperate for yield vehicles have crowded into REITs—despite the fact that the operational performance levels for a number of REIT sectors such as office, industrial and multifamily have been persistently weak.

"The market has been dying for yield products so the REIT shares have performed very well," observes Steven Kantor, a managing director and head of the real estate group for Credit Suisse First Boston. "Investors want good quality yield right now. You can't get yield in the bond market. However, this could change in the near future."

IPOs, debt issuance, equity and preferred—whatever the market tossed up last year, REIT investors bought it all. And the good run continued into the first quarter 2004, although REIT share prices fell as Portfolio went to press. Unless there is some dramatic unforeseen bad news like an international credit crunch, not even a slight rise in interest rates is expected to slow things down for an extended period of time.

Last year was the comeback for REITs in regards to capital markets. A total of 228 offerings made it to market in 2003, raising $25.6 billion, according to the National Association of Real Estate Investment Trusts. Those kinds of numbers haven't been seen since 1998 when the REIT world experienced a record 474 offerings and raised $38.4 billion.

It was the kind of year to make investment bankers smile. "After the boom years in the mid-1990s, investment banks staffed up through 1999 and 2000 and then had to cut staff in the years 2001 through 2003," observes Ron Sturzenegger, Bank of America's managing director and head of real estate and lodging investment banking. "Although 2003 wasn't a record year, profitability per person (investment banker) was probably a record because we all did well with fewer people."

At the end of the first quarter of 2004, Sturzenegger, like many in the industry, was optimistic that the good times would continue. However, the reversal of fund flows into REITs in April tempered that enthusiasm.

"There was more money put into REIT funds in January and February alone than almost all of 2003," Sturzenegger says. "Then the April market correction slowed the industry's momentum and substantially lowered stock values. There remains great strength for yield-oriented stocks, but with the anticipated rise in interest rates, we are likely to remain in a choppy equity market for a while."

However, Lawrence Gray, managing director and head of real estate corporate finance for Wachovia Securities, says there is a silver lining to the volatile trading activity in April.

"The last major REIT correction in 1998 occurred when both the real estate fundamentals and equity pricing were at or near a cyclical peak," Gray says. "This go round, while REIT equities were somewhat overbought, the fundamentals are arguably in a cyclical trough and will benefit from the rebounding economy thereby providing some support level for REIT equities."

Top Gun in the IPO Market

What made 2003 such an incredible year was the return of the IPO market. Last year, there were eight REIT IPOs, the most since 1998 when 17 were launched. However, the startling statistic in all of this was that the eight IPOs raised $2.7 billion, which was more than the $2.2 billion raised in 1998. This was mainly due to a pair of substantial offerings. In 2003, the largest IPO was American Financial Realty Trust (NYSE: AFR). AFR, which mainly invests in bank properties, raised over $804 million in its IPO. Just behind that in rankings was the IPO of office REIT, Maguire Properties Inc. (NYSE: MPG), which took in over $700 million.

The REIT IPO market has the potential to be even busier in 2004 as the investment banks dust off their delivery skills.

"My guess is that there is a bunch of people with capital starting to think about buying hotels." —DAVID DOYLE

Last year, Morgan Stanley didn't lead manage any REIT IPOs. When 2004 unfurled it had three in its pipeline. Given the kind of valuation levels REITs were trading at in the beginning of the year, it was very attractive for owners of portfolios to go public, says a Morgan Stanley investment banker. "In 2004 you will see a continuation of last year's IPO activity depending on valuations—if they remain steady through the remainder of the year," the banker says.

Judging from last year's activity and the early 2004 IPOs, it appears the hot sectors to come public are financial and sale-leaseback companies, aggregators with unusual stories (such as American Financial Realty which boasted a specific expertise) and lodging firms.

Friedman, Billings, Ramsey Group Inc. would probably agree with that assessment as it was the lead manager on three REIT IPOs last year: American Financial Realty (co-lead with Banc of America Securities) and two lodging companies, Ashford Hospitality Trust Inc. (NYSE: AHT) and Highland Hospitality Corp. (NYSE: HIH).

While a number of existing hotel firms still have balance sheet issues to work through, newcomers can enjoy a robust market to acquire assets at a time when underlying lodging industry fundamentals seem to be improving. "My guess is that there is a bunch of people with capital starting to think about buying hotels," notes David Doyle, a managing director and group head at FBR.

2003 Common Stock
Rank	Lead Manager	Proceeds Amount (in millions)	Number of Deals
1	Citigroup	$2,319	15
2	Merrill Lynch	$1,221	10
3	Wachovia Securities	$810	10
4	Friedman Billings Ramsey	$1,820	9
5	Goldman Sachs	$657	6
6	Deutsche Bank	$444	5
7	Banc of America Securities	$1,066	4
8	KeyCorp/McDonald	$231	4
9	Credit Suisse First Boston	$919	3
10	UBS	$261	3
Source: Thomson Financial. Data as of 12/31/03. Note: Excludes Mortgage REITs. Full credit to each lead manager.

FBR started 2004 with an IPO plus two more in registration. The first IPO of the year was FBR's deal for Government Properties Trust Inc. (NYSE: GPP), a REIT that acquires office properties leased to the U.S. government. It raised almost $200 million. The next offering was Affordable Residential Communities Inc. (NYSE: ARC), an owner and operator of manufactured housing communities, which raised almost $600 million through a combination of common equity and preferred offering.

"We clearly could have financed this in the private market," says Scott Jackson, Affordable Residential's chief executive officer. "But it was a good time for REITs to come to market. We got a good reception."

The lead managers on the Affordable Residential IPO were Citigroup Global Markets Inc. and Merrill Lynch & Co.

"This year is starting out terrific," says Mark Patterson, Citigroup's global head of real estate investment banking. "The capital markets are excellent for real estate and there is great institutional demand."

Citigroup expects to be very active in the market this year for REIT IPOs and at the beginning of the year had "quite a few" deals in the pipeline.

"IPOs are not property specific now; there's interest in new products," Patterson says. "Last year was very good, but this year can be even better. In North America, it could be the busiest year for IPOs since 1997 (26 IPOs, $6.3 billion raised)."

That doesn't mean that any random portfolio of assets can be tossed into the IPO grinder. UBS Investment Bank reports it looked at 15 potential IPO situations before sifting down to just a handful. "A lot of these don't make sense," says Jackson Hsieh, managing director and global head of real estate for UBS Investment Bank. "It's not necessarily that they can't be priced, but it's not worth the sponsor doing it."

The Urge to Merge

Affordable Residential's IPO had a lot to do with one of the more interesting mergers last year. After Manufactured Home Communities Inc. (NYSE: MHC) made a bid to buy Chateau Communities, Inc. (NYSE: CPJ), the latter company was put into play and eventually ended up in the welcoming arms of Hometown American LLC, a private company majority owned by the state of Washington public employees pension system. The total price of the deal, including assumption of debt, was $2.2 billion.

"Interest rates remain at historic levels and business fundamentals are improving so issuers have legitimate reasons to access the capital markets." —DOUG RUBENSTEIN

One of the other losing bidders for Chateau Communities was Affordable Residential, which then turned around and made a deal with Hometown to buy 90 of the properties acquired from Chateau. As Jackson notes, an IPO seemed like a good way to finance its part of the Hometown-Chateau transaction.

"Within our platform there is a fair amount of upside that is built around our historical operating results," Jackson explains. "We bought a lot of vacancy in this transaction so our IPO was a little bit different than traditional REIT buyers are used to seeing. But, we got a good reception by institutional buyers that often don't buy REITs."

UBS Investment Bank advised Hometown on the acquisition of Chateau and then got this year off to a flashy start by advising CNL Hospitality Properties, Inc. on its acquisition of KSL Recreation Corp., an owner and operator of luxurious destination resorts. Including the assumption of debt, the deal priced out at $2.16 billion.

"If you look at what's been happening in regard to M&A, it's been more public to private or private to public," Hsieh says. "A lot of assets acquired by private equity funds in past years are now starting to come back into the market. We should see an increased level of activity compared to 2003."

That should be an easily accomplished goal. The biggest deal of last year didn't happen. Taubman Centers, Inc. (NYSE: TCO) turned back a hostile takeover attempt by Simon Property Group (NYSE: SPG), which means the biggest transaction involving a REIT was the final closing of Developers Diversified Realty Corporation's (NYSE: DDR) $1.02 billion merger with JDN Realty Corporation—a transaction that had gotten underway in October 2002.

"Last year was a quiet one for M&A," observes Hoke Slaughter, Morgan Stanley managing director and head of its U.S. real estate investment banking group. "On a fundamental level, M&A has been slow because the market hasn't been differentiating between the haves and the have-nots from a valuation perspective. A high-quality company could love its share price and would desire to use its stock as an acquisition currency, but it doesn't want to buy a lesser-quality company in its space at 20 percent more than the underlying value of the assets."

In other words, with REIT share prices having been so high, someone would likely have had to pay a premium to accomplish a merger.

The Three Amigos: Debt, Equity & Preferred

The busiest work for investment banks in regard to REITs continues to be straightforward finance deals, either debt or some kind of common or preferred share equity offering.

"The year started off strongly," notes Doug Rubenstein, managing director and head of the real estate group for A.G. Edwards. "Interest rates remain at historic levels and business fundamentals are improving so issuers have legitimate reasons to access the capital markets."

However, Rubenstein does caution, "while I do foresee a relatively strong capital raising market, as evidenced already by the first couple months of this calendar year, and the anticipated continuing flow of funds into the industry, last year's activity will be difficult to exceed."

As the capital markets for REITs began to lift about two years ago, the first phase was concentrated in debt offerings. In 2001 and 2002, a large number of debt deals got done because interest rates were so low and everyone refinanced, recalls Banc of America's Sturzenegger, "but in 2003 the equity market opened up and so a lot of companies issued equity."

High-grade REIT debt issuance in 2003 totaled $7.7 billion, down about 20 percent from $9.8 billion in 2003, says Wachovia's Gray. Gray predicts debt issuance may slide to $6.5 billion in 2004.

The debt side remains diametrical to the equity numbers, which rose to over $6 billion in 2003, up from $4.5 billion the year before, Gray says.

The maintenance of debt-to-equity relationships will keep both flowing in 2004, adds Citigroup's Patterson. "As companies raise equity, they will try to raise debt in tandem to keep their capital structure constant. There will be regular offerings as companies make property acquisitions."

Still not everyone gets to go to the party. Already this year, there were some bumps in the road, in particular Pennsylvania Real Estate Investment Trust (NYSE: PEI) had to withdraw a 4.35 million share offering ($37.08 per share) due to an apparent administrative error. Pennsylvania REIT determined that it inadvertently did not elect to treat as a taxable REIT subsidiary a corporation in which it owned more than 10 percent of the stock. The ownership of this corporation would have prevented Pennsylvania REIT from qualifying as a REIT for the taxable years 2001 through 2003. The matter is now resolved and the company's REIT status is no longer in question.

2003 Preferred Equity
Rank	Lead Manager	Proceeds Amount (in millions)	Number of Deals
1	Wachovia Securities	$1,580	15
2	Morgan Stanley	$928	8
3	Merrill Lynch	$680	5
4	Bear Stearns	$481	5
5	UBS	$445	3
6	Credit Suisse First Boston	$358	4
7	Deutsche Bank	$340	3
8	Citigroup	$330	3
9	A.G. Edwards & Sons	$286	3
10	Banc of America Securities	$210	2
Source: Thomson Financial. Data as of 12/31/03. Note: Preferred and Convertible Preferred equity offerings; Excludes Mortgage REITs. Full credit to each lead manager.

Pennsylvania REIT was an exception. More typical of the activity this year was the February issuance by Omega Healthcare Investors Inc. (NYSE: OHI), a company that provides financing to the long-term care industry. It sold almost 4.8 million shares of preferred stock at $25 per share. The company used most of the proceeds to repurchase existing preferred shares held by its largest stockholder.

Maguire Properties, which had just gone public in 2003, was back in the financial markets in January tossing up 9 million shares (at $25 per share) of preferred stock. The offering had increased by 50 percent from the original placement of 6 million shares.

Omega and Maguire both came to market with preferred stock—the red hot financing mechanism for REITs in 2003. Preferred stock issuance in 2003 totaled $4.7 billion, double the activity of the year before, reports Wachovia's Gray.

Without actual asset growth by the REITs, "we could be at the end of the refinancing/ recapitalization game fairly soon." —LAWRENCE GRAY

Yet despite the early run at preferred in January and February by select REITs, Gray thinks that market peaked and activity could retract to the $3 billion level this year.

"The market for preferred was very active last year and that was a function of refinancing with a lower coupon than the higher priced preferred that was issued back in 1998," Gray explains. "Companies were taking the preferreds issued with coupons in the 8 percent to 9 percent range and refinancing them in the low 7s and high 6s." That type of preferred refinancing slowed mostly because companies that could refinance had already made their move.

FBR can boast doing five straight preferred deals last year. However, even Doyle notes, "you can't keep the momentum in the market forever. At some point the activity peaks just because you can't or don't want to refinance again. We see less companies issuing preferred to pay off older preferred, but, for a lot of companies still growing it is a great tool to use."

2003 U.S. Public IGD
Rank	Lead Manager	Number of Bookrunning Lead Deals
1	Wachovia Securities	18
2	Banc of America Securities	15
3	Citigroup	10
4	JP Morgan	9
5	UBS	8
6	Credit Suisse First Boston	7
7	Deutsche Bank	5
8	Bank One Corp	5
9	Morgan Stanley	4
10	Lehman Brothers	3
Source: Thomson Financial. Data as of 12/31/03. Note: Excludes Mortgage REITs. Full credit to each lead manager.

On the investment side, what drove the preferred market was the popularity of closed-end funds, which were major buyers of this type of issuance.

"Preferred is not played out," UBS' Hsieh says. "There is no shortage of issuance because the closed-end funds are big buyers, especially of non-rated preferred, mostly because investors are looking for dividend yielding securities. Many of the hybrid closed-end funds are focusing on REIT preferred and common stock."

Hsieh lumps UBS in with Citigroup and Merrill Lynch as the investment banks doing the "lion's share" of the closed-end fund issuances. Those numbers are substantial. Gray estimates through the first two months of 2004, over $9 billion in closed-end funds had been raised in an 18-month period, in total more than in the preceding five years combined.

Ahead of the Game

It is always difficult to forecast the future and any number of hurdles might occur that could derail the REIT industry's momentum—as was evidenced by the quick change in REIT share prices in April. The key to any "foreseen" change would be a rise interest rates, but in an election year no one seems to think rates will rise much—at least not before election day. So that leaves it up to an unforeseen event such as an international debt crisis, another terrorist attack in the U.S. or a large hedge fund going under.

Yet not everyone is so sanguine about what lies ahead for REITs. Gray tosses up the biggest caution, the improving but still weak underlying real estate market. Without actual asset growth by the REITs, he says, "we could be at the end of the refinancing/recapitalization game fairly soon."

The problem is, Gray says, "that once you refinance your debt, refinance your preferred and recapitalize your balance sheet then you've completed the work on the right side of the balance sheet. You need to balance that with the left side. We need these companies to start growing their asset bases in order to maintain the financing momentum."