Portfolio transformation propels robust M&A activity as real estate, hospitality and construction executives address unprecedented disruption
In our outlook six months ago, we anticipated that an overwhelmingly positive economic landscape, supported by strong fundamentals, would propel vigorous M&A activity into 2018. The results of our most recent mergers and acquisitions report, the Global Capital Confidence Barometer suggest that this prediction has been accurate. At the time, we detected a cresting of real estate values and a recognition that the market was starting to price in rising interest rates, which had a corresponding effect of driving down real estate values. This created a gap in valuations between public and private markets.
Consequently, almost half (46%) of real estate, hospitality and construction (RHC) executives are expecting to pursue deals in the next 12 months, and more than two-thirds (68%) expect the M&A market to improve within the sector.
The real estate industry is impacted by supply and demand as much as any rise and fall of the economy. Consequently, the continued strength in the US economy has operated as a tailwind for the sector. As a result, the business cycle has fueled more development and the addition of new supply to the market. However, the undisciplined nature and quantity of the new supply has meant that some owners and operators have been limited in their ability to push rents up the way they had been able to in prior years. After all, new robust supply inevitably leads to shadow inventory. This may explain the enduring, though more tempered, confidence in the economic outlook within the sector as RHC executives shift their attitude slightly from improving to stable (55% see the sector economy as improving vs. 66% six months ago).
Divestment plays a key role in portfolio optimization for RHC companies
The additional supply, combined with disruptive trends across the sector, is dramatically altering the RHC landscape. Hospitality executives are having to contend with the exponential rise in popularity of accommodation sharing sites. E-commerce is having a material impact on the retail space market. Meanwhile, the coworking model, which is substantially altering how organizations use office space, is disrupting the demand for traditional office space.
In response, RHC companies are reviewing their portfolio mix; 69% of RHC executives acknowledge that portfolio transformation is the most prominent issue on the boardroom agenda. The paramount need to reshape portfolios in an era of accelerating change means a shift to an almost continuous assessment of current operations, risks and opportunities. Threats from digitally enabled competitors and startups, combined with changing customer behaviors, has led one-third of RHC companies to review their portfolios more frequently than they did three years ago. As a result of these reviews, 65% say their companies have identified underperforming or assets at risk of disruption that are ripe for divestment, something 44% of RHC executives think activist shareholders will be agitating for, and something 71% of respondents say they intend to execute within the coming year.
Rising interest rates — the elephant in the room
Although the overall optimism RHC executives share both at a macroeconomic level and in terms of the M&A outlook is robust, the elephant in the room is rising interest rates. Yet, only 10% of RHC respondents saw this as the biggest risk to their current investment plans.
The RHC industry is in its ninth year of expansion. This is almost unprecedented for a real estate cycle. In this time, interest rates have remained low, while values have reached an all-time high. Given the late cycle, veterans are carefully watching how things unfold and analyzing their portfolio and lease duration to determine which may fare better in an inflationary environment. For the short to medium term, investors are sending some cautionary signals. We'll see which way the wind is blowing when we survey RHC executives again six months from now.