As long as the stock market continues its robust march to 6,000 and beyond, and glamour high-tech IPOs reap the lion's share of attention, REIT stocks will remain undervalued. The good: real estate fundamentals can't be ignored forever...
When the [illegible text] Association of Real Estate [illegible text] Trusts (NAREIT) came to Atlanta last [illegible text], the pre-Olympic build-up was just starting, but already the REIT industry's major players were preparing to battle for investors' attention in an already blazing-hot stock market rally.
Here are the Olympics and the competition on the athletic field ever more closely resembles the battle playing out in the financial markets, as REITs continue to tap into new capital arsenals to level the competitive playing field in the years ahead.
REITs had their IPO days in the sun in 1993 and 1994. Last year, there were only a handful of new public REIT offerings (but the Patriot American hotel REIT IPO was one of the industry's largest to date, at $260 million). REITs were most active in going back to the market for secondary stock offerings. The biggest second was by Meditrust, which saw its offering jump from 3 million shares up to 8.75 million. And if the numbers for first quarter seconds is any indication, 1996 will be a record year for the industry.
Recently, NATIONAL REAL ESTATE INVESTOR cosponsored a combined CMBS/REIT conference with Frank J. Fabozzi and Information Management Network in New York City over four days. In attendance were some of the REIT industry's major managers, investors and analysts. And since it best pinpointed some of the industry's hottest topics, we thought you might like to hear what some of the participants had to say.
One of the first orders of business is to address a few of the historical perspectives on the REIT industry. As we sit in mid-1996, real estate's share of the total stock market is only about 1% to 2%. Still, that has grown considerably over just the last few years and continues at a good clip.
During the conference, Mark Decker, president and CEO of NAREIT, told attendees that the commercial real estate industry "is still five to 10 years away from a full recovery."
Decker also predicted that in the next 10 years, the market capitalization for all REITs will be $500 billion, and the REITs will possess some $700 billion to $800 billion in total real estate assets.
He also made it clear that there is a need to dispel at least four primary myths that are circulating in the commercial real estate industry, those being:
1. Technology will make real estate obsolete
2. Real estate investments are bad
3. Wall Street doesn't understand real estate
4. Declining real estate demand will result in less space use
The bottom line is that REITs in recent years have been instrumental in the increasing institutionalization of the commercial real estate markets, and while the shape and form of this industry may change over time, the fundamentals of the value inherent in REIT real estate assets might only improve with age.
Overstretched to keep up
Overall, the size and depth of the REIT market has created unique opportunities and problems at the same time.
"There were 25 REITs before 1993, with 8-10 high-flyers. We're almost over-stretched to keep up with these companies" in today's REIT market, said Sam Lieber, portfolio manager at Evergreen Real Estate Funds. "We look to companies that have a loan payout ratio, and the capacity to do private placements is also attractive."
With increased size comes a natural division between the haves and the have-nots. "The market is putting a higher multiple on management companies over REITs. If this continues, there may be some pressures to spin off the management companies. Many investors want long-term dividend performance, not short-term management contracts. We could see this dichotomy exploited," said Lieber.
But ultimately, how do REITs stack up against other industries?
"There will be a consolidation of existing companies as well as new companies coming public. It's a competitive market for returns, REITs will be quiet as long as the market is active. REITs don't have the sizzle or sex-appeal to capture instutitional investors. As the market slows down, brokers will focus on REITs," said Lieber.
Frederick Carr, principal of the Penobscott Group, sees fewer, but larger companies in the future. "There will be more consolidation of private entities into public REITs. The average size of the investment-grade REIT is bigger today," said Carr.
John Gates, president and CEO of Centerpoint Properties in Chicago, said those REITS with the highest FFO growth will be winners, and internal growth will be king. "Ultimately everything comes back to the real estate," said Gates.
Centerpoint has developed a strategy to "recycle" capital, by selling property portfolios to institutions. Centerpoint closed its first portfolio sale of industrial properties on May 21, 1996. "It's the closest thing to self-funding, and delays going back to the market," said Gates.
According to Gates, there are types of REITs: The "asset collectors" (which stay REITs), and the "value-addeds" (which are proactive). Of the two, Gates sees the latter coming out on top, and might be successful enough to be tempted to convert to C Corps.
Both Lieber and Gates agree that C Corps are doing well (witness the success of Wyndham Hotels' IPO in May), and more C Corps will be forming.
Also down the road, Carr suggests the possibility of future government intervention, since Washington bureaucrats almost never overlook an opportunity to collect more taxes. REITs' prime tax-advantaged status might just come under review, so stay tuned.
Public vs. private
Why should institutions stake a claim in the public real estate market at all, versus going with private investments? This has become a major question of late, as real estate values nationwide continue to shake out.
It comes down to price versus liquidity, but in the end, you can't ignore the growth in REITs.
"From 1985 to 1995, compounded annual rates of returns on REIT stocks averaged 9.1% versus 31.2%, respectively," said Jay Willoughby, director at Aldrich Eastman & Waltch. "By 2005, the markets will grow to $600 billion in assets."
Now that level should be large enough to draw more institutional interest. And though the much-anticipated increased investment by pension funds into the real estate markets has been slow to materialize, pension plan managers do control some 10% of the REIT market, said William Ramseyer, chairman and CEO of Heitman/PRA Securities Advisors Inc. "Our view is that substantial REIT ownership will come from the 401(k) market."
The public versus private investment debate will rage on for many years, even as unique structures like UPREITs and DOWNREITs continue to evolve. Still, capital will always seek its own level.
"Capital looks backwards at where it has been and where it wants to go. It looks for returns and good structure/format," said Willoughby.
Talk of the day: M&A
One of the other most important major trends in the REIT industry is the recent flurry of mergers and acquisitions activity.
How do investors feel about the new wave of m&a? "Investors will take a wait and see approach, because you don't have big material discounts to value," said Robert Lieber, managing director at Lehman Brothers.
Of particular note was the recently announced merger agreement between Simon Property Group and DeBartolo Realty Group, two of the largest regional mall REITs in existence.
Peter Henkel, vice president at Morgan Stanley & Co., worked on the merger agreement, and thinks that as more merger announcements are made, stocks will run up and industry sectors will be spot-lighted.
"Investors have a generally negative outlook on regional malls. As that story (Simon/DeBartolo) gets out, the stock will run up. Highwoods was up 1 1/2 on the day of its(with Crocker Realty Trust). It won the benefit of the doubt as a company, and the sector gets a good ride," said Henkel.
One of the most-asked questions by analysts when the subject of mergers arises is the notion of accretion -- is the deal accretive?
"We spent a lot of time talking about accretion (on Simon/DeBartolo), but the market had a greater focus on the strategic rationale (of the deal)," said Henkel.
"The dynamics changed dramatically after DeBartolo Sr. passed away. While both companies have been fierce competitors, they've always had respect for each other's business. They have no overlapping markets. When you put them together, there is a lot of good complimentary synergy," said Henkel.
The whole notion is, does the deal make strategic sense, and is it positioning the companies for the future. "It's a market of haves and have-nots," said Henkel. "The market is rewarding companies for doing strategic transactions. Ego is still a significant issue. But more CEOs are starting to think that managing a public company isn't what they thought it would be. They can make a lot of money in a merger situation and go do their own thing. They can realize a +/-20% premium on the stock price, and some walk away rick."
Lieber agrees. "Being a public company isn't the panacea that a lot of people thought it would be. There is something to be said for taking your chips and going back to being an entrepreneur. We are first and foremost a service business, and there is tremendous pressure to provide the best service at the lowest fee level. We'll see a continued trend as entrepreneurs grow up and move out and size becomes more important."
So, how long and how deep does the m&a trend run?
Fred Caven, managing director at Paine Webber Inc., said, "The fair market value issue could become an issue that accelerates the takeover process." In other words, more boards of directors will look to how the market is valuing their companies and judge if the time is right to partner with others or if merger offers are fair and adequate.
Henkel thinks the trend has a ways to run. "The fundamentals are so compelling, once the social issues get broken down, they've got to continue to happen."
Joe Johnson, with Goodwin, Proctor & Hoar said, "Simon/DeBartolo got everyone's attention and people are thinking of deals they wouldn't have thought of a year ago."
One investment group that seems to be catching on the REIT wave is retirement systems. The consensus seems to be they've arrived, both domestic and foreign funds.
According to Jon Zehner, managing director at J.P. Morgan, OhioPERS, OhioSTERS, GM and CalPERS are among the most active domestic pension fund investors.
Zehner also notes the impact of international funds on the domestic REIT scene. "Europeans in general are not as deal-oriented as Americans. They value long-term, personal relationships, particularly the Dutch. The real estate people get to keep their involvement in indirect real estate investments rather than turning it over to their stock brethren," said Zehner.
Raymond Bottorf, who since 1990 has held the title of president and sole director of U.S. Alpha Inc., a wholly-owned subsidiary of Algemeen Burgerlijk Pensionfonds (ABP), which is one of the largest pension funds in the world, said ABP will start a REIT with Rodamco with an initial market cap of $350 million. Presently, ABP holds significant stakes in retail REIT stocks, including CBL, DeBartolo, Federal Realty, Macerich, New Plan, Rouse Co., Simon, and Taubman.
ABP has more than $125 billion in assets (today, 7% of ABP's money is invested in real estate, but that will rise to 10% by the year 2000).
Joe Rodriguez, director of REIT management and research for Invesco Realty Advisors, said, "In the final analysis, REITs are real estate over the long term. The industry's going to grow, the question is what's going to happen to managers? There will be closer linkages between the capital markets and those managers. And it will be on a global scale, not just in the United States."
Glenn Mueller, national director of real estate research at Price Waterhouse LLP, agrees, and believes "it's important to understand the fundamentals behind it. Long term that is where the cashflow is going to come."
Ron Lombardo, director of benefit investments for Philip Morris Cos., said his company chose to invest in REITs starting in 1993, because of their lower volatility, stable returns and correlation to the stock market. Now Philip Morris has $42 million invested in REIT stocks. "With the REIT investment, we are looking for more flexibility in our investment core."
Jerry Clark, portfolio manager with the public school employee's retirement system of Pennsylvania, runs a $35 billion fund, which will grow to $49 billion by the year 2000. Right now the fund has invested $110 million in REITs, thanks to a program it began in August 1995. "We wanted to learn the business, so we invested $100 million in REITs," said Clark. The system has 600,000 members in the defined benefit plan, with a real estate investment staff of five people, plus 8 or 9 advisers. The fund also has $500 million invested in the so-called "opportunity funds."
Hi-ho unsecured debt
It's no understatement to say that REITs have been active in the unsecured debt markets. More REITs also have placed an emphasis on obtaining an investment-grade rating from one of the rating agencies.
To date, 38 companies have tapped the unsecured debt capital markets, versus only six in 1993. Also, 56 real estate companies have received credit ratings from Standard & Poor's, Moody's and Fitch (17 are rated BBB, and 23 are rated BBB-). This according to Peter Baccile, vice president and team leader at J.P. Morgan's real estate investment banking group.
"The retail and multifamily REITs have been predominant in unsecured bond issuance," said Baccile. "A majority of that issuance has been in the 5-10 year maturity range, from $75 million to $200 million."
As a firm, J.P. Morgan predicts there will be a $12 billion - $15 billion real estate bond market within the next two years.
Representatives from some of the leading rating agencies provided insight into what they look for when going through the rating process.
"Dividend payout holds most REITs at BBB. That's the primary bogey for the industry," said Lisa Sarajian, director of S&P's real estate finance group. "We're more focused on cashflow than like-corporates, but it's not our job to dictate financial policy to public companies."
So what does S&P look for in a rated company?
1. A balanced capital base
2. Balanced debt
3. Portfolio and strategy, with management team talents wrapped over 1 and 2
"From that balance you get flexibility," said Sarajian.
And there is no magical "black box" full of the same parameters for everyone to use. With more REITs, the entire REIT analysis process is more complicated. "Fifteen years ago we were looking at eight or nine REITs. Over the last six years, there is so much more data that some of our own criteria is shifting accordingly," said Sarajian.
Thierry Perrein, vice president at Moody's, agrees there is no cookie-cutter. "We take each company on its own merits." More specifically, Perrein looks to track record, asset mix and management of the balance sheet going forward.
For John Bonfiglio, senior director in Fitch's structured finance department, "It's a function of how these companies choose to run their businesses. With 50% leverage you're in BBB-land. We level the playing field - a BBB is a BBB is a BBB."
Kevin Riordan, director of commercial mortgage and real estate securities unit, a subgroup of Teachers Insurance and Annuity Association's Mortgage and Real Estate Group, said that for the $4 billion Teachers real estate program, "Ratings are important in buying real estate debt. We start with management."
Kelly Rush, senior administrator of real estate securities at The Principal Financial Group, has asked his staffers to canvass the country to research the quality of and to familiarize themselves with REIT assets. "Ratings are crucial for us, but in the end they don't guide our decisions."
Re-examining malls and factory outlets
U.S. retailing is generally perceived by most observers to be in the doghouse among commercial real estate types these days, be it regional malls, power centers or neighborhood shopping centers. But as with any generalization, there are exceptions to be made. And besides, things may not be as bad as many believe.
Abraham Rosenthal, CEO of Prime Retail, said the factory outlet sector is vibrant and continues to lease up well. As a whole, the company finished 1995 with 4.3 million sq. ft. in its portfolio and is adding another 800,000 sq. ft. in 1996. Its first project was a 100,000 sq. ft. project in 1989 which produced a 13% - 14% yield. Much of Prime's work now centers around "half a dozen Saks deals," meaning the major retailer's new Off-5th factory outlet format.
According to Rosenthal, "The rate of failure in factory outlets is low. If there isn't value, you can't fool all of the people all of the time."
One of the hottest concepts that has gained a lot of attention over the last year is Federal Realty Investment Trust's new Street Retail Inc., a division the REIT founded early last year to redevelop urban shopping environments in select Northeast downtowns. Now plans call for a slow move farther afield. "The opportunity is to create an alternative format, closer to the customer, with higher per-unit sales, with lower operating costs and more profit per square foot," said Ron Kaplan, vice president of capital markets for Federal Realty.
Last year Street Retail centers did sales of $264.26 per sq. ft., and occupancy costs averaged only $13.61 a foot, said Kaplan.
"Our emphasis is on prime locations in key markets, regardless of the retail format, but particularly in major metro markets, in infill locations, where there are solid demographics and there is strong retail demand. The consumer has gotten tired of the sameness of regional malls. We provide a synergistic sense of place, and our strategic Main Street markets are attracting high-quality, national retailers," said Kaplan.
Stephen Sterrett, vice president and treasurer for Simon Property Group, tackled the issue of malls and how they are positioned in today's retailing environment.
"We try to make that mall unique in the marketplace, because we compete with all other forms of retail," said Sterrett. "We're on the verge of a renaissance of the retail/entertainment market. The lines between the two get blurrier every day, but we have been able to re-energize the malls with our services."
Simon has successfully partnered with the Mills Corp., a major developer of outlet-malls. And ground was just broken on the joint venture's latest property, Grapevine Mills, in the Dallas/Fort Worth Metroplex.
"It's a segment of the business that intrigues us because clearly the consumer is looking for value," said Sterrett.
As far as a retail turnaround, Sterrett is adamant. "If we're not there we're a helluva lot closer than we were a year ago."
David Cohen, a principal with The Yarmouth Group, said that in the recent past "a lot of the retailers haven't been innovative, but the specialty retailers will create new concepts in the next three years."
Office/industrial scores big
Though there are only 14 office/industrial REITs today, this sector is one of the most active, and holds some of the greatest growth potential, of them all.
Why? Despite the much-heralded cutbacks in Corporate America, smaller growth firms are experiencing significant growth, and they have driven much fo the new office development into the suburban markets. Also, as manufacturers continue to consolidate and modernize their distribution centers, the industrial REITs have picked up volume.
"The office sector has grown much faster than the retail and multifamily sectors," said Richard Schoninger, managing director and head of the real estate investment banking group at Prudential Securities, New York. "By the end of the decade, there might be 3-5 office REITs with $5 billion in assets. There aren't 35 companies in this sector chasing capital. Each has created its turf."
On the industrial side: "Manufacturers are working with fewer real estate companies, developing pure relationships. That's going to increase to the benefit of the REITs."
In terms of access to capital, "I don't see the private companies competing with the public companies for capital. The better companies can raise $300 million to $400 million in 10 days if they want to. Any of the stronger companies have effective shelf registrations. Private companies can't do that," said Schoninger.
Schoninger, who has handled many of the Street's most recent REIT IPOs and secondary offerings, firmly believes in the concept of brand strength and name identification.
"These REIT shares are underpriced. The multiples do not reflect the true value of the companies. There is enough predictability that multiples should reflect the franchise value of the company in the marketplace." Schoninger said that regional franchises are priceless, and are comparable to the impact made by yesterday's regional utility companies.
John Gates with Centerpoint Properties described how the industrial market in Chicago has changed and provided insight into some of the present-day dynamics.
"We've reached the point where we're developing on the build-to-suit side in the Chicago market right now. Half of what we do this year will be build-to-suit development," said Gates. What that says is that new companies are moving in and existing companies are expanding in the country's largest industrial market of Chicagoland.
Gates said he still sees manufacturers which are consolidating their distribution systems into four to five national distribution centers. This presents the need for new, modernized and much larger physical buildings equipped with the latest in delivery technology.
Centerpoint has successfully cushioned the cyclical peaks and valleys of its business by buying distressed properties at their lowest price, then adding value and repositioning them as the market begins to rebound. And since industrial cycles are much shorter (less build-out time), the buy low/sell high strategy seems to work.
Though the industrial sector has more insulation than other product types, there are pitfalls. "The hardest part of our business is waiting for the good deals. It's easy to become a deal junkie in our business, but we don't want to grow for growth's sake," said Darell Zink, executive vice president and chief financial officer of Duke Realty Investments.
"While I've been in the business, there's never been doubledigit vacancy in industrial. The risk is that there's so much capital chasing industrial development on the office side it's just the opposite."
On the office side Zink sees appreciable demand if positioned correctly. "The pop is in the office (sector). There is a tremendous amount of demand potential. If you own trophy properties downtown, you'll do well, but if you own B or C properties, you're going to die," said Zink.
In another area of the country, the Southwest, many are waiting for the time to be right. "We're still short of equilibrium in our markets of Dallas, Denver, Phoenix and Austin," said Dallas Lucas, senior vice president and chief financial officer at Crescent Real Estate Equities Ltd.
Lucas said there is virtually no construction in Dallas right now. "We're 18-24 months away from a new construction cycle in Dallas," but Denver is experiencing some significant suburban construction.