Real estate M&A set record pace in H1 but could slow in H2

In the first half of this year, real estate merger and acquisition activity continued the blistering pace set last year. There have been 18 transactions so far this year, matching the amount seen in the entirety of 2020 and setting a pace that, should it continue for the remainder of the year, would eclipse the record 33 transactions completed last year, according to real assets capital advisory firm Hodes Weill’s 2022 Mid-Year M&A Market Review.

Activity has been driven by managers wanting to expand into new markets, sectors, products and adjacent asset classes, the report said.

For example, Host Hotels acquired a 49 percent stake in extended stay and select service hotel specialist manager Noble Investment Group in January to widen its purview beyond resort and leisure-centric hotels. Stockholm-based private equity firm EQT’s planned acquisition of Hong Kong’s Baring Private Equity Asia, announced in March, will expand its footprint in Asia. Under the deal, which is set to close in Q4 2022, BPEA Real Estate will combine with EQT’s real estate platform, EQT Exeter. ICONIQ Investment Management’s purchase of a minority stake in New York-based Madison Realty Capital in June added real estate debt to the San Francisco-based multi-asset manager’s repertoire.

Where activity is differing from last year is that more of the transactions involve minority stakes rather than majority or full interests in firms. The ICONIQ and Host deals are examples of this, as are CNO Financial Group’s purchase of a minority interest in Rialto Capital in April and Almanac Realty Investors taking a 20 percent stake in Chicago-based multifamily specialist Waterton. Around 44 percent of M&A deals so far this year involved a minority stake, up from 33 percent last year.

“For a lot of managers, it is the minority stake that meets their strategic objectives,” David Hodes, founder and co-manager of the firm, told PERE exclusively.

That strategic objective is most commonly a desire for growth capital. Managers looking to sell minority stakes often are seeking additional capital to jumpstart new businesses or help complete first closings in existing fund series, Hodes said. The structure can often benefit the acquirer too, as the management teams of the selling firms still have a significant stake in the business and are therefore more aligned with their investors.

“If you buy 20 percent of a business, you have $1 of exposure but current management has $4 of exposure,” Hodes said. “Once you get to [buying] 40 percent to 50 percent, that’s when you want management focusing on upside and they may lose their focus.” When an external investor owns larger and larger stakes, there is the greater chance that management has ‘cashed out’ and this gives rise to the potential for them to be less focused on the performance of the business, he added.

The impact of uncertainty on deals

In many of the deals this year, a minority stake is the product of an uncertain environment. Future performance is uncertain due to rising rates, poor price visibility and a fluctuating macroeconomic and geopolitical situation. As a result, some deals are being ‘back ended,’ Hodes said, meaning fuller stakes are promised later based on a variety of incentives or targets being met. Host took a 49 percent stake in Noble in January and has the option to increase its stake up to full ownership, as an example.

Another way deals are being ‘back-ended’ is via future fund commitments. CNO committed to invest in future Rialto funds as part of its minority stake deal. The extra alignment of interest can create a comfortability for both parties, Hodes said.

“A new investor is thinking I can potentially benefit if [your firm] experiences substantial new growth as a result of my backing you,” Hodes said.

And while real estate M&A had strong H1 2022 transaction volume, market uncertainty may affect deal activity in the second half, Hodes said. “I’m aware of two specific transactions where the managers were saying, ‘We’re just going to wait till September and let the dust settle,’” he added.

Indeed, public market volatility has made it increasingly difficult to understand what deals are worth, potentially driving many potential participants to the sidelines in the second half. Hodes said he is already seeing a slowdown in activity, particularly from publicly listed buyers as their share prices have taken hits.

While more take-privates could occur as those declines in share prices create a buying opportunity for well-capitalized firms, many market participants are in wait-and-see mode due to the volatility. Many managers are more internally focused on their portfolios rather than thinking about long-term growth plans. Those managers are concluding that now is not the best time to sell given uncertainty about portfolio valuations and future investor capital flows, according to Hodes.

“Some managers who had been considering strategic sales are today taking the view that they should focus solely on portfolio management and preserving or enhancing portfolio value given market volatility,” Hodes said. “They are surmising that their investors would be unhappy if they were more focused on platform realization or sales versus a laser focus on maximizing LP value.”