Seen as most likely option if other exit choices don’t prove viable

Market experts are bracing for a possible wave of initial public offerings to hit the real estate world in the next two to five years as many speculate that private-equity firms may use IPOs as exit visas.

Such firms have been on a tear over the past five years, snapping up commercial properties and taking private a record number of real estate investment trusts. And observers speculate that many of these firms may opt to do IPOs to exit the transaction at the end of the five- to seven-year investment window, especially if the credit markets remain in turmoil.

“I’m one of them,” said Ettore Santucci, a partner and chairman of securities and corporate finance with Boston-based Goodwin Procter LLP, referring to those anticipating a surge in REIT IPOs.

“I think we are likely to see companies come public again,” agrees David Loeb, an analyst at Robert W. Baird & Co. Inc. in Milwaukee. “Some of them may be similar to portfolios that went private in the last several years.”

For investors wondering when to jump into real estate, an IPO wave would signal that the sector is in growth mode, because savvy private-equity players would not sell at the bottom, Mr. Loeb said.

In the United States alone, there were 26 going-private real estate transactions, valued at $87.85 billion, in 2006, up from 18 transactions, valued at $34.19 billion, in 2005 and 18 transactions, worth $29.27 billion, in 2004, according to Dealogic Ltd., a market research firm based in London. The flurry of transactions continued in the first half of 2007 until the meltdown in the credit markets caused private equity to dry up and deals to grind to a halt.

So far in 2008, there have been only four public-to-private real estate transactions valued at $4.86 billion, down from 12 transactions valued at $55.31 billion during the comparable period a year ago, Dealogic reported.

Historic low interest rates, easy lending standards and a flood of capital, which included hedge funds and private-equity firms, led to the surge in mergers and acquisitions activity in the real estate universe over the past five years. Going-private transactions, in particular, made headlines in 2004 and 2005 when The Blackstone Group in New York went on a buying binge, snapping up a flurry of hotel companies, including MeriStar Hospitality Corp., Extended Stay America, Prime Hospitality Corp., Boca Resorts Inc., Wyndham International and La Quinta Corp.

The wave gained momentum through early 2007 when it peaked with the takeout of the country’s largest REIT, Equity Office Properties Trust of Chicago, in February of that year. Each transaction drove up the values of public REITs as investors would speculate on which might be the next target.

But the subprime debacle, economic downturn and credit crunch caused takeover activity to halt abruptly. Investors dumped REITs along with the financials in late 2007, causing equity REITs to deliver dismal returns for the year of -15.7%, according to the National Association of Real Estate Investment Trusts Inc. in Washington.

Equity REITs have rallied back in 2008, delivering returns, which include dividends, of 6.2% as of the close of business June 16.

Private-equity firms, by nature, tend to hold on to an investment for five to seven years, often refurbishing and re-tenanting the properties to boost values before exiting the transaction. Speculation is now growing over how they plan to exit.

They can either auction off the properties piecemeal to different entities, sell the entire portfolio to a larger entity, hold on to it by rolling the fund into an open-ended fund or do an IPO to exit, said Stephen Cordes, managing director and head of portfolio management at ING Clarion Partners LLC in New York.

The IPO scenario would be the most likely option if the debt markets remain in turmoil, interest rates rise, inflation spikes up and the public markets start valuing real estate higher than the private one.

If credit becomes easy and cheap again, “it would be more attractive to do portfolio sales than to do IPOs,” Mr. Santucci said. However, he said, it is unlikely that credit will become cheap when inflation and rates are rising.

Those who do IPOs will likely be middle-market in size — between $800 million and $1.3 billion — and bring savvy management teams and development expertise with them, Mr. Santucci said. “It is so difficult to outperform if you start off with a big asset footprint” in a huge IPO, he said.

Valuation is also key. If public REITs are trading at a healthy premium to their net asset value, then private-equity firms will likely favor IPOs as an exit strategy, Mr. Cordes said. Currently, equity REITs are trading at about a 5% discount to NAV on average, with hotels trading at the steepest discounts at about 25%, making IPOs less likely in the near term.

Some experts see some eerie similarities between today’s credit environment and the savings and loan crisis of the late ’80s and early ’90s that led to a surge in REIT IPOs. Vulture funds and others swooped in to purchase properties at bargain-basement prices through the government-owned Resolution Trust Corp. back in the early ’90s, with many of them bundling up the properties and taking them public as REITs.

“There was a big shakeout because the banks contracted like they’re doing now,” said Chip MacDonald, an Atlanta-based partner in Jones Day, a Cleveland-based law firm. “I don’t think we’re quite at that point in time yet for a repeat of that, but it could happen again.”

Mr. MacDonald said the number of IPOs will likely depend on how the public markets value real estate, the number of distressed properties doing fire sales and the number of foreclosures. A few real estate moguls, such as New York’s Harry Macklowe, already are facing financial troubles and starting to sell properties, such as the landmark General Motors Building, to keep creditors at bay. A deeper or more prolonged recession would likely cause even more distressed sales, Mr. MacDonald said.

Still, a surge in IPOs is likely a couple of years off.

“The REIT market, although it’s been pretty strong, hasn’t gotten to the pricing where it’s more attractive than selling to private buyers,” said Kent Richey, a partner in the New York office of Jones Day.

Philip Blumberg, founder of American Ventures, a real estate investment management company based in Coral Gables, Fla., speculates troubled property owners needing access to capital likely will resort to IPOs first.

Mr. Santucci predicts that the IPO wave likely will begin in 2010 or 2011. “It’s difficult to imagine IPOs sooner than 24 months from now because there is too much volatility and too much nervousness out there,” he said.