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Monday, June 4, 2007

Property Prices a Barrier to More REIT Buyouts?

I recently wrote a post that discussed the potential for another round of buyouts in the REIT market. In that post, I came to the conclusion that there was a good chance we are now witnessing the beginnings of another burst of buyout activity.

There are indications, however, that we may be closer to the end of this cycle of buyouts than the beginning. The Wall Street Journal recently published an article that looked at property prices and how they are affecting dealmaking.

Commercial property, the kind that REITs typically invest in, used to be valued for the stream of payments that could be derived from rents over future years. The ability to raise rents or sell the property at a premium price was looked at as added, but uncertain, value.

Now, deals are being structured that assume both rents and property prices will rise significantly. Therefore, the prices for these deals are much higher than they would be otherwise. It now appears that property prices are reaching levels that are not supported by historical trends in rent increases or property appreciation. Prices per square foot have become so rich, some investors are backing out of deals.

Previously, the ever escalating property market had been aided by the thriving commercial mortgage-backed securities (CMBS) market. The loans that are made to fund these property purchases are bundled into pools and sold to investors who are hungry for yield.

Now CMBS investors are demanding higher yields on these securities. To make matters worse, this is coming at a time when lenders are demanding higher rates for funding these deals in the first place and requiring more equity be put into the deals by the purchasers.

With respect to rates, the 10-year Treasury note, currently trading just shy of 5%, is at its highest level since last August.

Borrowing costs going up, prices for deals going up, risk increasing, investors demonstrating caution. These are not the ingredients for a strong, long-lived buyout cycle. Nevertheless, with strong bullishness in worldwide stock markets and private equity firms sloshing cash all over the place, we will surely see a few more major REIT buyouts before we're through.

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