"... and the meek shall inherit the earth" -- will probably not be the description of the real estate finn of the year 2000. Paternalism, benevolence and entitlement will have no place in the compensation and human resource strategy that will dominate the marketplace of the next millennium. Product and service differentiation will be utilized to establish competitive advantage. This, however, will only be one side of the success formula. The firms that will dominate their markets will be those that gain and maintain an advantage by maximizing the effectiveness of their human resources. The trend in this direction has begun to manifest itself in the compensation and reward systems being designed in 1995. The dominant themes that have emerged in 1995 include: (1) an expansion of incentives or variable pay in comparison to fixed or salary focused programs and (2) a gradual shift from annually focused reward systems to long-term focused programs.
During 1995, headlines were understandably captured by merger and acquisition activity. A few names below highlight the frenzied activities:
As these firms, and many others like them, grapple with blending two companies into one surviving entity, issues arise relating to the compensation program.
The increase in merger and acquisition activities as well as other key forces such as the stock market, interest rates, tax laws and inflation, will continue to affect executive compensation, particularly the vehicles utilized for long-term compensation delivery, in 1996 and beyond.
FASB's reluctance to change the accounting rules for equity based compensation programs came as a pleasant surprise early this year. This decision, coupled with the year's "bull" market and relatively moderate levels Of inflation, is keeping many executives interested in option and stock awards. A downturn in the market or a significant increase in inflation could shift that interest toward vehicles such as cash awards or performance grants.
Whatever the specific design, programs for 1996 and beyond will be focused but highly flexible. Remuneration that balances the interest of the firm, the executive, the shareholder, and the customer, will dominate. Maximum compensation levels will only be achieved by superior professionals operating within highly successful enterprises.
1996 base salary increases
Within most industries, base salary increases have been minimal for the past several years. Few, if any, industries are offering annual average increases of 5% or more, let alone the double-digit increases that were once commonplace in the '70s and '80s. Historically, stagnant or decreasing annual salary increases may have been a result of poor performance and the cause for great personal concern. Today, base salary increases for 1996 and beyond will continue to remain minimal for more optimistic reasons.
Since the early-1990s, corporate America has recycled its pay philosophy. The excesses of the '80s have been ushered out, and the era of corporate sobriety has taken hold. Firms of the past could afford a certain level of inefficiency in their compensation and still maintain a healthy profit margin. As the real estate market collapsed in the mid- to late-'80s, firms began to realize that to be successful going forward, they had to eliminate their inefficiency. The late-'80s and early-'90s saw the emergence of rightsizing, downsizing, asset redeployment and reengineering. The outcome: fairly few organizations surviving, and only the best performers holding their jobs.
Although the real estate industry is enjoying a much more healthy environment than the early-1990s, base salary increases remain minimal and will continue to be a shrinking part of the total compensation package. In most cases, companies are placing increasing emphasis on paying for performance through annual and longterm incentives. Growth in an individual's economic status is coming primarily through increases in variable pay.
Even companies that can afford above average increases are devising creative ways to funnel a portion of the dollars, that, in the past, would have been utilized for across the board base salary increases, into a "discretionary" bonus pool. This pool is being utilized to reward "star" performers within the organization, thereby aligning pay and performance at every opportunity Table I (above) summarizes the two_year trend for base salary increases.
While increases for most employees have reached a plateau, the amount allocated for "stars" or "high performance" employees has blossomed. The definition for "star" however, is now approaching "walk on water" status. A typical increase allocation matrix is set forth in Table 2 (below right).
As the real estate environment continually changes, certain positions become crucial to the current success of the business. While the typical base salary increases will continue to hover below 5% regardless of industry segment, certain "high demand" positions will receive increases at a rate significantly greater than the industry average. This value surge is undoubtedly driven by the immediacy of the position's impact on financial results, coupled with the relative scarcity of the requisite skills and experience.
As dollars return to the market, investors look for assurances that the leadership of the firms in which they are investing is strong. Therefore, the role of chief executive officer is crucial during this time of industry change. Chief executive officers with strong strategic planning skills are fundamental for securing the firm's continued success. Chief executive officers with a proven turnaround history as well as capital markets experience are demanding extremely high premiums.
With competition for dollars on the rise, the ability to attract and retain clients while remaining focused on their ever-changing needs is essential. An added value is being placed on those client relationship specialists who can understand their clients' needs and develop strong relationships with them.
Although dollars are flowing into the industry more easily than they have in years past, many believe it is much more difficult to find investment grade properties today. As a result of decreased capital availability, it is more difficult to buy at attractive prices. For the time being, acquisitions professionals who can identify investment grade properties and successfully complete transactions are in great demand and are receiving larger short-term incentives.
Bonuses align pay and performance
As mentioned previously, the 1990s are turning out to be the decade of incentive or variable pay adoption, expansion and enhancement. By now, most companies have introduced some sort of variable pay into their current compensation program. During 1996, we will see a continuation of this trend at a much stronger pace.
As organizations become more comfortable with this type of compensation structure, they are quickly recognizing the necessity of clearly defining and communicating their goals and strategies. Top management realizes that if they are going to pay for performance, not only do they need to carefully outline their performance expectations, but they also need to ensure that these goals/expectations are understandable, attainable, and that their achievement will place the firm at a competitive advantage. A well designed incentive program will be self-funding if the rewards are identified as a portion of the enhanced economic results.
An effective pay for performance plan is an integral part of an organization's culture and management style. It should clarify the role of each individual contributor in the success of the organization as well as identify the performance requirements that are expected. Many times, however, roles and expectations are difficult to define or change rapidly in response to changes in the competitive environment.
Companies today are challenged to constantly evaluate their strategic goals and objectives; it is essential to do so if they are going to continue to align pay and performance, thereby trading fixed for variable costs. This is no easy task. It forces decision makers to continue asking themselves if 7% growth in operating income is an appropriate target measure or if 8% - 9% would be more appropriate. Competitive advantage cannot be established merely by achieving company identified goals and strategies; more importantly, it is attained by outperforming the competition on these critical measures. True advantage is gained when FFO growth, acquisition return and stock price appreciation is better than that of the competition. Relative industry performance is critical if high levels of total compensation will be economically justified.
Today, one of the main concerns companies are experiencing, as they increasingly shift their pay strategy to include more variable pay, involves the risk associated with this type of program. Incentive pay is often referred to as pay "at risk". This means quite simply that a portion of the compensation package has been placed at risk and may not actually be paid out. In order for a company to utilize a pay for performance strategy properly, executives must be willing to pay out in good years, and must accept that they should not receive a payout from not-so-good years.
While "pay at risk" has been present for senior and top management for some time, the introduction of this concept throughout an organization may ultimately be very threatening. When adopted as a "culture change," the implementation of these programs needs to progress in a highly sensitive manner. Good employees should be excited by the compensation program, not scared into a defensive flight response.
The table below summarizes the average awards to be paid for 1995 performance along with our forecast for 1996.
1995 compensation forecast
The following briefly outlines four specific industry segments in terms of market competitive base salary compensation and annual incentive opportunity. It is important to note that choosing the appropriate peer group of organizations is essential when comparing compensation levels. The following data provides a helpful overview of the industry sub-groups and illustrates the internal equity differences between positions. Smaller organizations, turnaround companies, and recently merged organizations would need to establish a more appropriate peer group than the one presented here.
REITs
The REITs that are surviving and flourishing will tell you, "Bigger is better." The median market capitalization of the top 25 REITs at the start of 1994 was approximately $500 million. That number today stands close to $1 billion! It is easy to see why acquisitions professionals are currently being paid at a premium within this industry segment. The acquisition activity will continue for some time, but ultimately, REITs will shift their focus from acquisitions to property management. Increasing emphasis will be placed on the property management professional's ability to help increase FFO and ultimately total shareholder return through the skillful management of the acquired properties. As this occurs, compensation for this functional area will steadily increase.
During 1995, the REITs progressed more confidently down the path of disclosure. Although it is still relatively new to them, and some degree of discomfort is still noticeable, the REITs are learning the benefits of disclosing, or, in some cases, the loopholes around it. Going forward, REITs that have made large stock option grants to their executives will be waiting to see if stock prices will respond to changes in FFO. If not, REITs may need to look toward alternative vehicles to compensate their executives.
Many REITs have issued founder's stock or have awarded stock grants to their executive managers in amounts that provide significant dividend payments to the holders. This compensation is above and beyond the total compensation amounts shown in Table 4. Some of the smaller REITs have also wrestled with the development of golden parachute arrangements for key executive staff in anticipation of the rough waters which still lie ahead. Arrangements such as these should be developed in accordance with IRS-sanctioned guidelines.
Pension fund advisers
More so than any of the other three industry segments presented, increases in compensation for large-sized pension fund advisory firms will take the form of incentive dollars. The average bonus award as a percent of salary for the executive level positions of a pension fund adviser has already increased from 50% to 55% from 1994 to 1995.
The restructuring of the advisory industry has led to increased emphasis on long-term incentive arrangements. Management succession, coupled with the necessary bonding of a merged management team, makes long-term compensation critical for sustaining a firm's competitive advantage. Sharing in the value creation process will be the key aspect of future compensation arrangements.
Changes in this industry niche will continue in the form of consolidation of finns and new product development. Yet as long as interest rates remain stable, the pension fund advisory firms will continue to flourish, and their compensation will reflect this for years to come.
Insurance companies
The downsizing that occurred within the insurance sector of real estate in the early-1990s continues to affect compensation as roles and responsibilities are still being fine-tuned, or, in some cases, redefined.
Decisions rendered regarding the riskbased capital rules which require insurers to maintain minimum levels of reserves on specific investments will affect whether insurance companies will choose to invest in REIT stock or alternative securities going forward.
Surprisingly, an increasing portion of insurers' investments this year were industrial based. This may be a result of the fact that, in many cases, the pension funds were so comfortable with these types of investments that they purchased them before completion. In general, insurers today are enthusiastic about the possibility of a reduction in the capital gains tax which would spark even greater investment activity.
Asset/portfolio management professionals who ensure that the portfolio is being properly managed, as well as transactions professionals who can effectively manage the influx of dollars and successfully complete transactions, are compensated at a premium within this industry segment.
Homebuilders
Increased competition has impacted the profitability of most homebuilders during 1995. Consolidation within the industry has resulted from increased pressure on profits. As the homebuilding industry evolves, builders will become larger and will diversify as a way of softening the cyclical nature of their primary business.
Successful chief executive officers who can delicately balance consumer orientation and the financial skills to effectively manage the business are compensated at a premium. The focus of leaders within this industry segment needs to remain on long-term issues rather than the short-term cyclical demands of the business.
The availability of qualified labor has also become a major issue for homebuilders today. Locating skilled labor has become increasingly difficult, primarily due to the fact that third generation family members are choosing not to enter the business. This shortage will effect compensation of key positions, subsequently driving up labor costs.
Conclusion
During 1996, both internal and external market forces will continue to influence compensation. For example, a change in the political climate very likely will affect the tax implications associated with executive compensation. A decrease in the capital gains tax would widen the gap between the ordinary income tax for highly paid executives to almost 20%. This would greatly influence executives to examine ways in which to receive income as a long-term capital gain instead of ordinary income.
Establishing a compensation program that is ap-propriate and that works is no easy task. Occasionally even the best of programs should be challenged to see where improvement can be made. Those involved in assisting management in strategizing for 1996 and beyond must have extensive industry knowledge, the experience necessary to understand the functions of each job, the unique value and worth associated with those skills, and the appropriate mix between pay and performance that will attract, retain, and motivate employees through the end of the century.