As Confidence Peaks, so Does Deal Making

By Michael Fishbin, Global Hospitality Leader, Ernst & Young: Global economic confidence continues to improve as credit availability expands, industry fundamentals strengthen and companies focus on growth.

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There’s no question that stubbornly high global unemployment, the ongoing crisis in Europe, decelerating growth in key emerging markets and fiscal challenges in the U.S. are causing global real estate owners, investors and corporate occupiers to step back and re-evaluate. However, there are many positive developments worth highlighting as some real estate sectors start to show visible signs of improvement.

Global real estate transaction volume totaled US$214b in the first quarter of 2013, up 23 percent from last year. The increase was across all property types. Across the global regions, EMEA results were the weakest, while transaction volumes in Asia were up 31 percent from last year. Impressively, China and the U.S. accounted for about 63 percent of the total transaction volume, according to Real Capital Analytics.

As our latest Global Capital Confidence Barometer survey points out, companies are looking to invest and their appetite for making acquisitions is increasing. Also, it shows that the gap between the price a buyer and seller are willing to transact is decreasing and that 71 percent of RHC respondents expect global M&A volume to improve in the next 12 months.

Global economic confidence has significantly rebounded, as indicated by 85 percent of RHC respondents saying that the economy is either improving or stable, compared with 53 percent a year ago. This confidence is attributable to positive sentiments surrounding economic growth, credit availability, employment growth and short-term market stability. Nonetheless, industry participants will likely continue to monitor a number of global economic factors that may limit momentum, such as waning emerging market growth; dampening economic indicators in key eurozone countries, particularly Germany; the prolonged eurozone crisis, including the Cyprus bailout; and uncertainty regarding the long-term impact of the United States sequester.

Forty-nine percent of the RHC respondents point to cash as their primary source of deal financing over the next 12 months. Only 30 percent indicated that they plan to use debt as their primary source of deal financing, despite many reporting improved credit availability.  The predominant use of cash to finance deals may be indicative of companies’ ongoing cautionary mindset, and evidence of their need to deploy cash, which is currently earning a low return.

Investors in Search of Yield Look to REITs

Companies have been largely focused on lower-risk, lower-yielding growth strategies and more cautious approaches than one would expect, given increased confidence and better credit availability. Additionally, because interest rates have been low for an extended period of time, global investors are in search of higher yields, stronger valuations and inflation protection for income stocks. One result of this is that a number of companies have recently announced that they are exploring converting to real estate investment trusts (REITs).

Due to strong fundamentals and growing confidence in the global economy, the appetite for acquisitions has increased. Seventy-one percent of RHC respondents expect improvement in global M&A and deal volumes over the next 12 months. Thirty-four percent of RHC respondents expect their company will pursue an acquisition in the next 12 months, an improvement from 25 percent in October 2012. The improvement in acquisition plans is partially driven by an increasing number of opportunities (55 percent) vs. 46 percent in October 2012.

Additionally, RHC respondents surveyed indicate that the valuation gap has narrowed, with 80 percent of respondents stating that the gap is 20 percent or less, as opposed to only 49 percent saying this in April 2012. Further, 24 percent of respondents said that the valuation gap will contract over the next 12 months, compared with only 10 percent in October 2012.

Expectations for higher valuations are now at their highest level in the history of our Global Capital Confidence Barometer: 46 percent of RHC respondents expect prices/valuations to rise in the next year, up from 37 percent in April 2012. Only 9 percent expect valuations to decline, compared with 34 percent one year ago, indicating that the market has stabilized.

A majority of the RHC respondents (64 percent) indicate that the most common deal size in the next 12 months will range from $51 million to $500 million. This is consistent with what we saw earlier this year. Furthermore, during the same period, 97 percent of all single assets that transacted within the commercial real estate sector were under $500 million, with an average sale price of $136 million.

A contributing cause to the ongoing slowdown in deal making is a valuation gap between buyers and sellers. Sellers have been seeking high valuations, while potential buyers wanted discounts, and were reluctant to pay a premium.

However, we may now be nearing equilibrium between what buyers will pay and what sellers will accept. This equilibrium should help spur additional transaction activity. The pendulum is primed to swing the other way — toward stronger valuations from buyers and more profitability for sellers.