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Do private firms have the REIT stuff?

By Kevin Kenyon

With a flourishing economy and an abundance of capital ready for the taking, it might seem like the perfect time for some of the shopping center industry's remaining private companies to make the leap into the public arena.

But while today's internal operating environment may be positive, mainly due to rising occupancy levels and fewer retail bankruptcies, experts say the stifling outlook for external growth could make it difficult for private developers who are considering an initial public offering (IPO).

However, with rapid consolidation among today's real estate investment trusts (REITs), some experts believe private firms may be forced to consider an IPO in order to survive in the competitive regional mall sector.

Consolidation could also be a catalyst, experts say, in prompting private companies to put themselves up for sale to combine with larger REITs.

According to Andrew Jones, retail REIT analyst for New York-based Morgan Stanley Dean Witter, there is both good news and bad news on the retail front that could influence an IPO decision.

On the positive side, the shopping center industry as a whole is experiencing good internal growth, he said, noting that two-thirds of the companies he follows are showing occupancy increases, and retail bankruptcies are down significantly.

In addition, Mr. Jones said, big box retailers will soon saturate all of their planned markets, leaving malls with "less to worry about in the future.

"The other nonmall retail venues have already taken their pound of flesh from the malls, and I think, by and large, we're in a fairly stable market share environment," he explained.

On the negative side, asset prices, a driver of external growth, have gone up significantly recently, making it difficult for developers to play the spread acquisition game, he added.

"That makes it harder for them to tell the story that they could be good acquisitors of real estate," he said. "Investors pay for growth, so if they feel like half of your growth story is handicapped, they're going to get less excited about the story."

But while today's operating environment may not be ideal for an IPO, Mr. Jones said the trend of rapid shopping center industry consolidation may push some private developers to make a decision regarding their status.

"With some of the public companies growing so quickly, I think you may find some of the private mall companies having to consider an IPO more seriously, because to be competitive in that business they need to get bigger. But that means they're going to consider selling their assets a lot more seriously.

"The consolidation we're seeing is going to force action, whether it's more companies going public or more companies putting themselves up for sale to combine with other larger REITs," Mr. Jones said.

David Fick, vice president and retail REIT analyst with Legg Mason Wood Walker, a Baltimore-based real estate research firm, said the daunting task of competing with some of the larger mall REITs may deter private developers from going public.

"There's so much consolidation going on in the mall business right now, and a perception that you can only be a player if you're a big player, so I don't think you're going to see any IPOs on the mall side any time soon -- if ever again," he said.

With REITs raising the competitive stakes to a new level, Mr. Fick said, it would be difficult for a private developer to make the leap successfully.

"There aren't enough large private portfolios for anybody to be able to come in and dominate that sector. You've got a real perception right now that only two or three players are going to be left standing at the end of the day, and the other guys are going to be consolidated," he said.

Another factor is that there is little opportunity for external growth, because with cap rates below 7% it's dilutive to buy malls, Mr. Fick explained.

But while prices may be overheated on the mall side, the situation is more favorable for community center developers considering going public, he added.

"You need to have a growth story, and that's why a lot of neighborhood and community shopping center developers are thinking about doing IPOs -- many of them have growth stories," Mr. Fick said.

As an example, he said a community center developer could come out at $200 million, which would allow it to buy 10 centers and still have $50 million left -- a potential growth rate of 33%. Even after issuing new shares as required, it would still have a potential gross funds from operations (FFO) of 15%.

"To do the same in the regional mall sector would require a couple of billion dollars worth of real estate, because $200 million would only get you one regional mall. It's just so much harder because the denominator is larger," Mr. Fick said.

"It's now at a point where it's harder for some of the big guys to sustain their growth. That's why we're looking at smaller companies as being better growth opportunities over the next couple of years."

Kevin Comer, group head, real estate securities research at Baltimore-based BT Alex. Brown's New York office, also said that private developers have their work cut out for them.

"The environment we have today makes it increasingly difficult for companies to go public successfully -- unless they've got either a fairly competitive market capitalization out of the box, or if they have a niche that isn't being served at all by the existing public companies," he said.

The most compelling reason for a private developer to go public, according to Mr. Comer, is to compete with public companies in terms of cost of capital. This was a major factor in the REIT boom earlier in the decade, he added.

Because many REITs have established enough of a track record in the public markets, their cost of debt is fairly inexpensive and they have abundant access to capital, he explained.

"[For] the private mall companies that are still out there, their cost of capital is still property level. It is secured financing for the most part, and they're competing with REITs with credit lines that are much more favorable," he said.

Like Mr. Fick, Mr. Comer believes the more likely candidates to go public are the grocery-anchored community center developers.

"The positive to being a smaller company coming out today is that if you have a very solid, conservative type of strategy, which the neighborhood grocery-anchored strips seem to have, you are able to grow your earnings faster because you're growing off a smaller base."

That is offset, however, by the fact that small companies don't have liquidity in their common stock, which helps reduce the cost of equity capital, he said. This is one of the factors influencing the drive for size among today's REITs.

All things considered, Mr. Comer said, the question will ultimately come down to the economics of making an IPO work.

"I would imagine that a significant number of the companies that are still private would love to go public. The question is, how many of them can actually do it successfully?" he said.

As far as Morgan Stanley's Mr. Jones is concerned, it's also a question that should be on the minds of every private company these days.

"I think that because of the consolidation, everybody's got to be thinking about what they're going to do," he said. "I don't think people can just sit around and be content to be a middle or smaller-sized private mall company.

"There is a strong catalyst for action. My bet is that most of these companies end up selling, rather than becoming their own public companies."