Capital Markets Minnows vs. Sharks Are REIT investors better off buying the shares of acquirors or acquirees? by Mike Kirby and Jon Fosheim Photograph by John White

The economic rationale (or lack thereof) for mergers will have large ramifications on the returns that can be expected by REIT investors. Our study's findings call into question two of the basic precepts that appear to be gospel for a number of the participants in this industry: First, the REIT industry should and will be dominated by, say, 20 to 30 mega-REITs. Second, investors would be well-advised to adhere to a "buy the survivors" strategy.

Evidence From the Broad Market
The question of whether merger and acquisition activity makes sense is not unique to the REIT arena. A large body of academic data exists that is largely consistent with the findings to date for REITs. The common methodology to study this issue is to review the total return performance of the stocks involved over a period beginning several weeks before a merger is announced and ending several weeks after. While not perfect, this methodology should at least show the market's reaction to merger announcements through a period stretching long enough after the announcement for market participants to have digested and analyzed the transaction.

This first reaction can, of course, be proven wrong over time, but there is no reason to believe a bias exists that causes investors to systematically view things either too rosily or too negatively. While a longer-term view would be desirable, numerous other factors influence share pricing over the longer haul, thus adding considerable "noise" to any such study.

One of the most current and wide-ranging studies of this topic by Julian Franks, Robert Harris, and Sheridan Titman ("The Postmerger Share-Price Performance of Acquiring Firms," Journal of Financial Economics, March 1991) looked at the performance of acquirors and acquirees in 399 separate M&A deals. The results showed that shareholders of acquirees almost always do very well, with gains averaging 28 percent. Shareholders of acquiring companies, however, experienced a deterioration of value of one percent. A similar study by Michael Jensen and Richard Ruback ("The Market for Corporate Control: The Scientific Evidence," Journal of Financial Economics, April 1983) showed that the shares of the acquiring firm performed particularly poorly on mergers, whereas they did notably better on deals involving tender offers. This presumably suggests that hostile deals provide superior returns for acquirors.

Since the vast majority of the activity in the REIT sector has involved negotiated mergers instead of hostile tenders, the less encouraging results for merger transactions are probably more pertinent for REITs.

Both the Franks, Harris, and Titman study and the Jensen and Ruback study indicate that while significant value is created through M&A activity—the value of the total package typically increases by four percent—it all accrues to the shareholders of the acquiree, while shareholders in the acquiror receive virtually no benefit. Why is this? Is it truly a fruitless endeavor to attempt to grow by acquiring other public companies? There have been many attempts to answer these questions, and some of the more interesting theories follow:

• Acquisition targets are very good at recognizing the value they bring to the table, and by explicitly conducting an auction (or implicitly threatening to), they force buyers to pay for all of the value created by a particular deal.

• Management teams have an incentive to become empire builders, and that may not coincide with the best interests of shareholders. Often, a particular manager will be better rewarded (that is, receive a higher salary and gain more power) if he is in charge of a bigger entity, so he is willing to do deals that add no net present value, solely for the sake of getting bigger.

• Even management teams that entertain no such visions of grandeur often have an incentive to add diversity to their company, so as to diversify what is typically the biggest component of their personal balance sheets (a particularly important issue in the REIT sector). The goal of personal diversification may be powerful enough to incent an otherwise rational management team to do a deal that is modestly destructive to value. Other shareholders can, of course, achieve diversity by buying other stocks.

• The share price of acquiring companies may already reflect a market assumption that value will be created through mergers. For example, in the REIT world it is reasonable to assume that the market expects Equity Residential to acquire more apartment REITs in the future. Even if these deals are expected to be value-additive for EQR, the company's share price may already have been bid up to reflect this expectation. If, instead, EQR abstains from acquisitions, investors may be disappointed, and the share price may suffer. In light of the evidence suggesting acquisitions don't make sense for acquiring companies, this is the argument on which acquirors must hang their hats.

While there is merit to this explanation of why acquirors should continue acquiring, the premise imputes a level of omniscience to investors that is a little hard to swallow. Since the stocks of acquiring companies are not impacted by the announcement of these presumably value-enhancing mergers, it implies that investors are extremely good at forecasting the timing, size, and attractiveness of acquisitions. This seems a bit far-fetched and begs the question: If investors are so good at forecasting the fortunes of acquirors, why are they so poor at spotting acquirees ahead of time?

Evidence From the REIT Market
Although the number of case studies is still somewhat limited, it is interesting that the REIT mergers of recent years have generated results similar to those seen in the broad market. As illustrated by the graph at right, the 29 REIT mergers included in our study have been much better deals for the acquiree than the acquiror. (In our study, a few early, smaller deals were excluded because of difficulties in readily obtaining share price information. We do not believe that their exclusion materially impacted our findings.) The performance of the companies involved is shown after adjusting for any changes in the Morgan Stanley REIT Index (RMS) that occurred over the time period, thus removing any "noise" created by changes in overall REIT prices.

Contrary to the findings of our prior study of REIT mergers ("M&A Activity in the REIT Sector: Is it Better to Own the Hunted or the Hunter?" December 1997), there is now no evidence that material trading based on insider information takes place. Neither the acquiror's shares nor the acquiree's show any statistically significant signs of performing differently from the RMS in the days preceding the announcement of a deal. However, at the close of the first trading day subsequent to the announcement of a deal, the shares of the acquirors had underperformed the RMS by 1.5 percent, while the acquirees had outperformed by 3.7 percent. By the time 20 trading days had elapsed, the acquirees retained their abnormal return of 3.7 percent (statistically significant at 99 percent), while the acquirors continued to underperform, ultimately showing a 2.7 percent decline in relative value (statistically significant at 99 percent) over the period.

It is interesting to note that while the direction of our findings is similar to that found in our 1997 study, the magnitude of the over/underperformance has shrunk, implying that more recent deals have been a better—but still bad— deal for the acquirors and only a good—but not great—deal for the acquirees. In a departure from the finding that in corporate America M&A activity resulted in aggregate gains for the shareholders of the two companies involved, the early evidence on REITs is that the transactions have resulted in no net change in wealth. In other words, 1 + 1 has equaled about 2, but nothing more. The fact that the 3.7 percent overperformance by acquirees is greater in magnitude than the 2.7 percent underperformance by acquirors is offset by the fact that the acquirors have, on average, been larger companies. However, we would expect that in the long run, REIT M&A activity will prove to be value-additive in the aggregate, just as it appears to be elsewhere.

The data contained in the graph on this page reviews the performance over a 20-trading-day period subsequent to a merger announcement. While it seems logical that the management teams of the companies involved would have had ample opportunity to explain the merits of their deals to investors during this period, a potential criticism of our methodology is that this is too short a study period. If, as some suggest, risk arbitrageurs skew the pricing in the period immediately following a deal's announcement, perhaps a longer study period is warranted. While we believe the methodology we used provides the most meaningful results (apologists for the acquirors often forget that risk-arb players sometimes buy the acquiror and sell the acquiree), it is interesting to note that even six months after a merger's announcement, the acquiror's shares have historically underperformed the RMS.

As can be seen in the graph on page 38, the magnitude of the underperformance is 3.3 percent (although this finding is not statistically significant). Further evidence that the negative impact on the acquiror's shares is more than just a short-lived downward blip comes from a recent study by Barry Ziering and Willard McIntosh at Prudential Real Estate Investors ("REIT M&A Outcomes: When to Hold, When to Fold," April 1999).

When Ziering and McIntosh looked at performance around the time that REIT M&A deals closed (as opposed to our study of the time period surrounding the announcement of the deals), they found that the shares of acquirors generally underperformed in the months immediately following a deal's closing. Their findings held true during rising REIT markets in 1996 and 1997 as well as during the bear market of 1998. Since the vast majority of new information is disseminated on a deal's announcement, we have trouble buying into the argument that the acquirors should perform differently from their peer group after a deal closes. Nevertheless, this is what has happened, and Ziering and McIntosh's findings do nothing to bolster the case for the acquisitive REITs.

Their findings also shoot another hole in the argument that initial returns on the acquirors' stocks are skewed downward by risk arbitrageurs. If these players have the effect of depressing the share price of the acquirors' stock due to short selling after the announcement, shouldn't we expect the opposite as they cover their short positions once the deal closes? The rather obvious implication of all this is that most of the acquiring REITs would likely have been better off not doing their mergers.

Several caveats are necessary, however, before reaching a firm conclusion. First, this is a relatively small sample and the time period is limited. Several acquirors—for instance, Bradley, Apartment Investment & Management Co., and Prime Retail—actually benefited from their mergers. Put simply, it can be misleading to read too much into the results from a sample of this size, and additional REIT mergers may be necessary before one can reach meaningful conclusions. Second, this study does not examine the long-term (more than six months) performance of the companies involved. While the market presumably does a pretty good job of understanding and pricing the pluses and minuses involved in most deals, the potential exists that the initial reaction is not always the correct one. Of course, there is no reason to assume that any potential systematic bias works against acquiring companies, as it is just as likely to work in the opposite direction. Third, as noted, it could be that investors do a particularly good job of anticipating the benefits that may arise through future mergers by ascribing higher multiples to the shares of consolidators. If true, the actual merger announcement merely confirms investors' expectations, and if no merger is announced, investors may be disappointed. Finally, the rationale for the M&A activity may change as time passes. If deals predicated on size, efficiencies, and improved economies (for example, Equity Office Properties and Beacon Properties; Duke Realty Investors and Weeks Corp.; and Avalon Properties and Bay Apartment Communities) eventually take the place of the marriages of "have not" REITs, perhaps the results will differ. Whether these deals will be better or worse is not clear, although, as noted, the recent results have been more encouraging than the earlier results.

Conclusion
As the "bigger is better" mantra is chanted by more and more companies, it is likely that REITs will continue to experience trends that have been in place in other industries for many years. Specifically, some mergers will be justified by sound economic rationale, while others will amount to little more than empire building. As consolidation in the REIT sector continues, acquirors will continue to justify their deals based on what are sure to be meaningful cost savings and other efficiencies. However, it is also likely that they will continue to pay top dollar to gain access to those synergies, and the actual value of those benefits will likely flow to shareholders of the acquiree. As always, investors should view each deal on its own merits. Nevertheless, as underscored by our data, the burden of proof must fall on the acquiring company.