CBL and Associates Prope... (NYSE:CBL)
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The recent rally in shares of real estate investment trusts has amplified the disconnect between equity- and debt-market valuations in the sector, which has in turn opened back-door merger-and-acquisition opportunities to the more well-capitalized players in the space.

REIT shares have rallied between 30% and 60% over the last month despite continued weak retail sales, rising vacancies, structural overcapacity in the sector, staggering debt loads and significant refinancing risk at some of these companies.

Consider the debt/market equity ratios of these REITs, whose shares have more than doubled from recent lows: CBL & Associates Properties Inc. (CBL), 18.3x; Developers Diversified Realty Corp. (DDR), 13.3x; Macerich Co. (MAC), 5.5x; Duke Realty Corp. (DRE), 3.1x.

In addition to high debt loads, each of these companies also faces significant, near-term refinancing risks with anywhere between 40% and 60% of their debt maturing within the next three years. Understandably, therefore, the enthusiasm of the equity markets hasn't been shared by the debt markets.

The pricing of credit default swaps, which insure against the default of a company's underlying bonds, have remained at elevated levels for most REITs, with bonds of these companies continuing to trade at significant discounts to face value (for example, Developers Diversified Realty's 3.75% October 2012 senior bonds are currently trading around 44% of face value).

This obvious disconnect between the equity and debt markets presents a lucrative opportunity for large, diversified companies in the sector with strong balance sheets to consolidate their weaker counterparts.

Leading REITs such as Simon Property Group Inc. (SPG), Public Storage (PSA) and Vornado Realty Trust (VNO) can acquire the senior secured debt, or the mortgage notes securing assets, of their weaker competitors at their current discounted prices and then simply wait for these companies to sink under the weight of their own debt. This could prove a unique win-win strategy for well-capitalized companies looking to acquire others.

If the target company does default, it would give the acquirer a strong negotiating position and make it the leading contender to take possession of the assets of the defaulting company.

The worst that would happen is that the target company would actually make good on its obligations, providing a handsome return to the investor. The bottom line is that there are more than 130 publicly-listed REITs in the U.S., many of which are unlikely to survive, given accelerating deterioration in commercial property fundamentals, increasing funding costs, higher capitalization rates and a tough refinancing environment.

This was recently reflected in the bankruptcy filing of General Growth Properties, which was unable to refinance its principal loans and mortgages as banks and other financing sources reduced their appetite for such loans.

So far, this strategy has been successfully executed by few companies. One example, albeit in a different sector, is American Greetings Corp.'s (AM) recent acquisition of Recycled Paper Greetings. American Greetings bought a sizable chunk of Recycled Paper's debt in July 2008. After Recycled Paper defaulted, American Greetings bought it out in a prepackaged Chapter 11 reorganization transaction earlier this year.

Given the increasing chatter about consolidation among REITs, the potential consolidators in the sector would do well to take a page out of American Greetings' play book and draw up a list of weaker competitors whose debt they can acquire on the cheap without having to pay full price for the equity of these companies.

(Sameer Bhatia is a columnist with Dow Jones Newswires. He can be reached at 201-938-5863 or by email at sameer.bhatia@dowjones.com. Dow Jones Newswires is enhancing its news, commentary and analysis for the investment banking community, and is providing it on this service temporarily. Stay tuned for information on continued access to the best of Dow Jones news and opinion on companies, sectors and deals for bankers and research analysts.)

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