REITs Join Forces to Weather Office Market Downturn

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Good morning. Two REITs will merge by Q3's end to reduce their exposure to a distressed market. Meanwhile, commercial property insurance costs have skyrocketed, halting transactions and prompting investors to appeal for relief from insurers.

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Two REITs Join Forces to Weather Office Market Downturn

In a move to weather a distressed market, two REITs have decided to merge to reduce their exposure. Office Properties Income Trust (OPI) and Diversified Healthcare Trust (DHC) will join in an all-stock transaction to create a new entity, Diversified Properties Trust. Adam Portnoy’s RMR Group manages both REITs.

A look at the deal: According to OPI President Christopher Bilotto, the merger will provide access to cash flows from DHC's medical office and life science portfolio and growth potential from its senior housing portfolio. The new entity is expected to be a larger, more diversified REIT, better positioned for long-term growth and value creation for OPI shareholders.

• OPI's portfolio consists of 160 single-tenant office properties spanning 21M SF, focused on strong credit tenants like government agencies.

• Merger with DHC adds 105 healthcare, life sciences, and senior housing properties covering 8.8M SF, along with 237 third-party managed senior living properties and 27 triple-net leased senior living properties.

• The combined company will have 529 properties across 40 states, with 42% located in the Sunbelt region.

• The company's gross asset values will be distributed across senior living (40%), office space (35%), medical office buildings (12%), and life sciences (9%).

Securing funds: JPMorgan Chase is providing a $368M bridge loan for the OPI and DHC merger, but other funding options are being considered. The combined company's debt would be around $5B and their market capitalization is currently below $1B. OPI shareholders will own 58% and DHC shareholders will own 42% of the new entity with a ratio of 0.147 shares of OPI per DHC share.

➥ THE TAKEAWAY

Taking cover: Following the announcement, OPI's stock plummeted over 25% while DHC's fell 4%. The combined company will be headquartered in Newton, Massachusetts and trade on Nasdaq. Office REITs have faced a decline in their share prices due to the pandemic and rising interest rates. So far, in 2023, their average value has decreased by 17%, and over the past year, the decline has been over 47%, as per Nareit.

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Private CRE transaction volumes had increased for nearly a decade before the COVID pandemic. Then, between 2020 and 2022, the industry saw wide divergences by property type.

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• It’s no surprise that transaction volumes for office have declined, but Juniper Square shows just how much of an impact that outlier has had on transaction volumes as a whole.

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The Price of Commercial Property Insurance is CRE Sales

After climbing so fast in the last two years, the price of commercial property insurance has reached a crisis point. Real estate investors are now calling for lending reform and hoping for government support to relieve some of the pressure this has created for the market.

Upward spiral: By the end of 2022, premiums for commercial insurance had shot up 9.4% nationwide when compared to the previous year. Regions like TX, FL, and CA saw even sharper increases of 30–50%. Meanwhile, construction price increases have made replacement costs 40% more expensive than in the last four years. Add to that the increased frequency of disastrous weather events and you have a lot of nervous insurers.

Looking for footing: Many developers, owners, and brokers are pleading with insurers, hoping they will adapt their insurance requirements. “We’ve lost out on a number of acquisition opportunities and development opportunities, simply because the insurance premiums have been so high," said Kevin Keane, COO of developer and apartment manager Bainbridge Cos.

Hurricane of horrors: The arrival of Hurricane Ian in September 2022 (and the subsequent $112B in damages) became an inflection point for the insurance industry. Globally, disasters such as Ian have hit insurers hard. In fact, 2022 was the second year in a row where insured losses from natural disasters surpassed $100B. Total global economic losses added up to more than $275B, headlined by Ian and rampant flooding in Australia and South Africa. Over the past 3 decades, increases have averaged 5–7% annually.

Between a rock and a hard place: These days, nearly every lender requires a property to have insurance covering 100% of its replacement cost. But industry insiders claim such requirements are simply not compatible with today’s market. Real estate companies could take on more risk, lowering their limits and increasing deductibles, but typically lenders require high limits as part of loan covenants. Keane proposes state governments create entities similar to Florida’s Citizens Property Insurance Corp., a state-run insurer that supports homeowners as private homeowner insurance also spirals.

➥ THE TAKEAWAY

A new normal nobody wants: Some providers have already stopped providing policies in states like Florida and California, where they’ve concluded they just can’t profit from selling property insurance. Nearly a dozen firms became insolvent in the two years before Ian, with another put into receivership by state regulators this February. As the insurance marketplace shrinks, insurance costs are front and center in any acquisition, rather than the afterthought they used to be.

📖 Read this piece from Fortune detailing Goldman Sachs’ (GS) perspective on three major economic headwinds they’re forecasting for the CRE market.

🖥️ Watch this segment from The Real Deal as they examine newly elected Chicago Mayor Brandon Johnson’s policy proposals and their potential impact on the Chicago real estate market.

🎧 Listen to John C. Coe and Todd Rich, co-founder and partner of Declaration Partners, discuss Todd’s various ventures throughout his career on this episode of Icons of DC Area Real Estate.

• Breathing room: Inflation stood at 5% in March, enjoying its smallest monthly increase since May 2021. But according to the Bureau of Labor Statistics, housing prices will keep it high.

• Say goodbye: Hedge fund Citadel has parted ways with developer Sterling Bay and will take over the development of its new $1B Miami HQ itself.

• We're in the money: Carmel Partners closed their 8th investment fund, raising a cool $1.58B, making it the firm’s largest fund to date.

• Ancient enemies: The battle between SL Green (SLG) and developer Ben Ashkenazy over 625 Madison Ave. has taken a new twist: SLG now demands records proving Ben’s net worth.

• Two sides of a coin: On one hand, rents and occupancy rates have stabilized, while on the other hand, transaction volume and building prices have declined in recent months.

• Once and future king: A Tennessee-based REIT MAA has once again earned its place as the largest US apartment owner after losing the title to Starwood Capital Group (STWD) for six years.

• Big box bonanza: According to data from CBRE, third-party logistics providers were the leading tenants of big-box warehouse space in 2022, accounting for 41% of all transactions.

• Curtain call: After outsized interest during the pandemic, investors who purchased apartment building portfolios now have to contend with stalling rents and growing expenses.

• Crystal ball: Consultant Ronan McMahon believes that investors can anticipate future hotspots with the proper resources and by judging the quality of life in surveyed regions.

• The big picture: According to the IMF’s latest World Economic Outlook, inflation may soon be a footnote—but only because they anticipate global growth to remain weak for some time.

• On the up-and-up: A recent report from ATTOM disclosed that the average annual gross rental yield on 3-BR properties is anticipated to grow 7.5% in 2023, up from 6.7% in 2022.

• Microscope on market distress: The impending threat of a ‘CRE-pocalypse’ could be overblown, according to the Mortgage Bankers Association and Moody’s, which argue the CRE lending market is more diverse than believed.

• Welcome to the family: CBRE Group has named Croft Young as their new chief investment officer. Young will put together M&A deals using the $4.8B left on the company’s balance sheet.

• Slowing to a crawl: NYC is looking at the worst year for commercial property sales since 2009, led by a decline in Manhattan’s investment appeal.

• Stillwater comes to Frisco: Stillwater Capital will be leading a $70M multifamily development in Frisco, TX, which will include 352 units. The project is expected to wrap up by Nov. 2025.

Rent inflation kept climbing in March, up 8.2% (coincidentally an 8.1% increase over February). This marked the biggest monthly rent spike since June 1982.