If from time to time you happen to think that real estate investment trusts (REITs) are a short-term phenomenon in commercial real estate, you probably want to rethink that notion.
Recently National Real Estate Investor and Shopping Center World magazines hosted some top REIT executives for breakfast during the recent NAREIT annual conference at the Chicago Hilton & Towers. Their comments, which follow, point to some interesting reasons to consider REITs as long-term market players. The discussion was moderated by NREI publisher Ben Johnson.
NREI: It used to be that you had to get to $1 billion market cap to be considered a player in the REIT arena. Now with the recent Starwood/ITTand all of the flavors of the month, who knows. Why is bigger necessarily better? What is the main driver behind size is everything?
John Bucksbaum: In the shopping center industry, there are a lot of efficiencies that you get from having 100 malls. The people who operate one or five malls today are finding that it's a lot more difficult whether it's marketing programs or just leasing to the national retailers. There are CAM issues. You really can operate a center better. Sam (Zell) talks about the price breaks you get when buying in bulk, and it's true. If you're doing it for the right reasons ... we're doing national marketing programs and sponsorship programs and Steve's (Sterrett) doing the same thing. These were opportunities that were never available to any of us previously. You can offer a company 120 cities across the United States to advertise their product. That's a whole separate business from the shopping center business, but we find a lot of those types of advantages for us.
Steve Sterrett: There are tremendous operating efficiencies, but there are also great capital market benefits to size. Once you get to a certain critical mass that your currency becomes more known and more stable, it becomes more attractive to people as you then seek to grow through acquisitions. You get to a certain size and the rating agencies become comfortable with you, you get to be an investment-grade company, you can tap into the unsecured debt market and I think it perpetuates the ability to then continue your growth because your currency becomes more attractive to a larger group of people.
Bucksbaum: Then those smaller players want to associate with the bigger guy if they're thinking about taking currency for a property because they're looking at who's got the best opportunities going forward and who's going to appreciate it.
David Helfand: It also gets back to why REITs have been so successful and that's liquidity. The size equals liquidity equals value. That's something Sam's (Zell) been preaching for a long time.
Richard Ziman: We're regional, just in Southern California in six counties, and for us, we're almost 10 million sq. ft. and it's big economies of concentration, tremendous economies. We have buildings across the street, down the block, and rather than one or two or three managers, we can have one. We can have roving engineering teams quite honestly, so we cut our costs by a minimum of 15% just by virtue of the concentration and size.
Gary Ralston: I think that size obviously has benefits both from the capital side and operating efficiency. But the real driver should be size as it allows one to better serve their customer. To the extent that happens in REIT-world, it is going to create increasingly distinguishing performance characteristics. Many of the companies that operate in retail and operate nationally with the ability to stand side by side with them and serve them nationally are important, and I think that is going to have a positive impact and eventually become international.
NREI: Isn't there inherent pressure to grow your companies? And is that pressure, be it external or internal, a healthy thing for the industry?
Ziman: As long as it's accretive. We're experiencing tremendous external growth by acquisitions. We started as an IPO in October of last year, at 4 million sq. ft. and now we're 10 million sq. ft. And we're still buying significantly below replacement cost and at cap rates and net operating income that's accretive. Now that's not going to last forever, it just can't.
Bucksbaum: One thing that people don't talk much about - what if for the last four years we had interest rates of 10% for instance, and all of this spread investing and the accretive acquisitions wouldn't be happening nearly at the pace that it is. Then you'd be relying much more on internal growth and I wonder then what question we would be asking, because I don't think REITs would be growing that much, but yet everyone would have gone public, I would think. If all things were equal but interest rates were much higher, what difference would there be today?
Sterrett: Consolidation would still be occurring and occurring rapidly because the weaker operating companies would be cut off from capital. And we all need capital. It's a capital-intensive business. In my mind the whole consolidation thing is very natural. It's a mature industry, there's not a huge amount of new construction in real estate in the United States and it's capital intensive. And capital-intensive, mature industries are going to gravitate toward consolidation. I know it's the theory that Sam espouses again that there are going to be just a few large dominant national players, but you're going to continue to see that happening, to see a lot of public-to-public mergers, acquisitions of private portfolios and the big are going to continue to get bigger because it's a natural evolution, of not just our industry, but of any capital-intensivemature industry.
Jonathan Weller: There's hardly a strategy that any management or board has adopted that doesn't involve some sort of growth. And it's probably an important function of the fact that we can all grow our portfolios internally, but only to a certain extent, only to the extent that rents might be below market, only to the extent that we can capture operating efficiencies. And virtually every strategy has either some form of growth in terms of assets, in terms of expanding your geography.
Helfand: We've addressed growth from the perspective of the companies and why, but I think the broader picture is that REITs are growing in general because they're a better vehicle to own real estate, and if there's been a sea-change that's going on it's people who are not natural owners, not good owners of real estate, are looking to maximize value by transferring real estate to people who are professionals. And the REIT industry is being driven by well-capitalized, good companies, well run that view their business as a business. They're acquiring assets and they're getting more out of those assets than the people who owned them prior to that.
NREI: Your property niche, for example, is extremely fragmented. Are REITs able to consolidate multiple properties and roll them into a public vehicle to advantage?
Helfand: No doubt. I think in all the businesses, ours isn't so different other than the fragmentation is maybe more severe, but we see a professionalization of the industry. It's driven off Gary's comment that as you try and serve your customer better you need better people on site, you need to deliver better service, you need to be more attentive to their needs. MHC is a better owner we think than others, particularly mom and pops who don't have access to the same type of services, amenities, things like that.
Mike Devlin: What we've seen is the general macro level where you've had the pension funds and institutions that have gone through real estate and have gotten hurt either downsizing or having to pay management fees where they really don't know the business as well as a REIT, as a professional manager. But we've also seen actually on our roadshow the amount of aggressive growth funds, small-cap funds and growth and income funds, and that puts pressure in terms of growth. The story of having a high yield is no longer the case. They really want to understand external growth and the impact of that. But what you have now is not just a real pure REIT buyer, but now you go into a fund complex and you might have four or five different fund managers all representing different spectrums.
NREI: We've mentioned external growth strategies through acquisition, but what are the internal drivers these days if the markets won't be as good as they've been forever?
Ziman: There's a number of things. You can grow by changing property type, additional geographic areas and development, which we've already begun. We'll do in-house all of the smaller development projects. For the larger development projects we're doing joint ventures with local developers. And then there's consolidation among the industry, not just the property type. External growth will continue, I just don't think it's going to continue at the tremendous pace that it has been. We're getting very good same-store growth. Our revenues quarter to quarter, from 2nd quarter to 3rd quarter, we had an 11% increase on same-store growth revenues and a 9% decrease in certain segments of operating expenses, mainly due to size.
NREI: Everyone here has a different niche, from manufactured homes to prisons to freestanding retail to office properties to malls. But the Street has tended to reward companies that focus on a particular niche and don't deviate from it. You can have geographic diversity but really you don't stray from the property type.
Helfand: But there's Crescent and Vornado. In fact, when we took MHC public in 1993, there were a lot of rules. You had to be a local sharpshooter. Everybody's pushing the envelope and that's good for the business, but what was theright thing in the analysts' minds five years ago is very different than what it is today and will be very different. I just want to make a small point but an important one which Dick raised, which is yes, people are focused on growth, but the better investors today are focused on what is same-store growth, who is making it happen on a same-store basis and sort of separating out what the growth component is because if that goes away what you're left with is what is your core business and how can you grow.
Weller: We're a diversified company and have been for 37 years, with our main property types of shopping centers and apartments, and clearly we've had to answer to a lot of people in the industry saying why not spin off one division or another. Our view is that management can build a good team for shopping centers and a good team for apartments and house it within the same company and ration capital based on where the best returns are and also have to be a sharp seller at what point good opportunities arise. So I think the investment community is looking at management teams and saying if they buy into the management team the story is their ability to deliver the results that they've said they can. Then I think you'll find more companies accepted as diversified companies.
Ralston: The scrutiny today has shifted from examining particular property perspectives to more of how the business is run. It should be expected as part of maturity. A lot of the companies have now been publicly operating in their present mode for five years or more. So there is a different analytical focus. It's easier to get your arms around the operating track record of the company and their execution and not be as focused on going and looking at properties on a property tour. Not to say that the assets aren't of paramount significance, but how those assets are run and managed becomes more expressed via the management team and the company business. I think you're going to see increased flexibility. There is obviously a lot of talk about the Crescent/Vornado being opportunity funds. They've taken a different approach to the business, but by the same token, look at the multiples that they're being rewarded with. So obviously they're providing particularly their investors what they're looking for. It may not work for everybody, but it works for them.
Bucksbaum: To get back to your 'flavor of the month,' Basic fundamentals will always win out in the long run. You'll always be rewarded, while it may not seem like it at the time and you don't have a 20 multiple or an 18 multiple today because you're boring and you're operating manufactured homes or malls or whatever it might be. But if you do a good job of operating those properties the market will always recognize that in the long run.
NREI: Will it ever recognize REITs as being above BBB-rating status?
Mark Whiting: I think that's been a differentiating factor for us in terms of being able to do things that perhaps we wouldn't have been able to do on the investment front. Certainly I think the ratings matter less. If you look at the average REIT today, the capital structure is 50% to 100% equity, so if that's a substantial piece of your capital structure and you're not retaining the majority of your earnings, there is such pressure to grow from these companies to sustain a cost of equity that allows you to be competitive. As you said John, all of the stars are in alignment in these companies, the cyclicality of the industry is in a good place. The underlying assets are generally performing well. But there's pressure on every one of the guys running these companies today to sustain growth. The first thing you get asked when you walk into a room of analysts or investors is, 'What's your rate of growth in the next couple of years and how sustainable is that?' It's amazing. If you look at the average growth rates of the top quartile performers, the growth rates have really accelerated over the last four years. There are a couple who have figured out ways to grow by getting a lower cost of equity whichbegets more growth.
Sterrett: Don't forget, too, pick your number but it's 5% or 7% of the commercial real estate in the country is owned by REITs so we're in a massive growth phase as real estate fundamentally in this country goes from privately held to held as a securitized basis as these REITs accumulate property. So BBB is a very sweet spot on the rating curve right now. You can borrow money relatively inexpensively. You have access to the unsecured market, but yet you're still leveraged enough to really benefit from the growth that's occurring and really have access to capital to take advantage of those opportunities. That won't always be the case. We'll get to a level where the growth will start to plateau as a larger percentage of the real estate is in the REIT hands, but we're nowhere close to that point yet. We're in a cycle where if it's three years, five years, 10 years, you're going to continue to see growth by the aggressive REITs because the opportunity is there.
NREI: And the money's out there. We're watching all of the announcements of unsecured lines of credit. These days they are incredible numbers. And REITs have very little leverage overall, so is there still a lot of room to borrow?
Whiting: The banks are getting increasingly aggressive. That's a plus for the big players. Certainly if you've chosen to go the unsecured rating route you have to operate within a paradigm which probably limits your flexibility more than if you choose not to be that. Certainly most of us are borrowing on revolvers today at 100 over or less. And most of us are putting competitive-bid features in our revolvers which allow us to borrow at something closer to 50 over, and certainly a secured borrower can't compete with that today.
Ralston: The credit facility really provides an opportunity to compensate for market timing, to address the availability of assets by having immediate funding and liquidity if you will, and then being selective as to when to convert that to a longer term capital. And that's a demonstration of an increased level of sophistication in running your balance sheet which is now becoming standard operating fare within the major REITs. The spread issue that Mark mentioned is interesting. When you think about it, we still are paying spreads in excess of industrials and yet our earnings engine is in many respects a more solid, predictable performer than an industrial business. There's less volatility, less leverage in many cases, and one certainly could make a case that over time we'll have an opportunity for a REIT to access capital at spreads that may be below most industrials. So there's probably additional compression opportunity.
Sterrett: Clearly the gap has been narrowing a lot over the last three years and I think that's one of the reasons that you see people redoing their lines and repricing their lines. We are becoming more and more like the rest of Corporate America.
Devlin: I also think that on a macro level we're finding that commercial banks feel they can come in and offer debt, they offer you a line of credit, they want to have your equity participation, and the REIT is a perfect vehicle for them to showcase what are the synergies in buying up the equity distribution that they're doing now.
Sterrett: The banks are paying so much attention to REITs because of all the activity in the IPO and secondary market. We're a huge percentage of their banking fees now. I heard a story about one bank where real estate was over 50% of their investment banking fees for the last year.
Devlin: We're also seeing on the calls and when they come to see us, you've got the commercial banker with their new partner, the investment bank they just bought.
Ralston: Following up on Steve's comment, the activity level within REITs means that our management teams for the most part have become better at addressing the capital markets like some of the major industrial companies because we're practicing it more often. That, I believe, will add to increased capital efficiency and help to drive down the cost of capital.
NREI: Something strikes me about what Mr. Devlin said, that the money is often coming to see you. How many bankers are knocking on your door?
Devlin: Although in a strong market there is a lot more competition, when the market turns down, we'll see what happens.
NREI: Is the money coming after everybody here?
Ziman: It's everywhere, every sector, whether it's investment banks or insurance companies. There's just a lot of money in the system trying to find a home.
Ralston: There is a lot of money available for other business. Look at the availability of technology stocks and technology companies to access via issuance of stock capital at multiples that are astronomical compared to REITs. So there's just an increased capital efficiency in this country and we are benefiting from it. But I don't think it's the result of too much capital chasing real estate per se. It is more readily accessible perhaps.
Helfand: There's a lot of liquidity in the system, no question about it. There's also a lot of supply of real estate and these guys can comment on their property sector, but we haven't seen compression in cap rates. We haven't seen people paying wild prices by and large. And that's because while there's a torrent on the supply side there's a torrent on the demand side.
NREI: You all have a currency which is your stock. How closely and often do you watch your share price? Every day in the paper?
Weller: I can't imagine that anybody has to wait that long. (laughter)
NREI: Do you all have Blumbergs on your desks? Has it gotten to that point?
Ralston: Everybody in our company has PointCast now loaded and what to me is impressive is not just that I know or our CFO knows, but that the administrative assistants in the company are cognizant of how the stock is performing. That's going to have an interesting impact on overall performance.
Helfand: It's amazing how when you grant options how focused people become.
Bucksbaum: That's the exciting part though, when you see the sort of rank and file if you will who takes that same interest, really watching the performance and recognizing that they can affect it, that they really play a part in it.
NREI: Do they also recognize innovation? Every one of you has some interesting twist or turn to what you do as an operating business that makes you different. How much are you rewarded for innovation?
Weller: We're all challenged every day to say what makes us different, what makes us better. When you don't have a good answer to that question is when you have a real problem.
Sterrett: You mentioned something earlier Ben about valuation. If you look at this on a net asset value basis, most real estate companies are now trading at 20% to 25% above true NAV. That's the premium that's attached to good managements who are out there being innovative and trying to create new revenue streams and be aggressive and consolidate and all of that. And that's perfectly logical, but I think that's a function of the markets having to recognize that REITs are more than just collections of assets. They're real live operating businesses with managements who are out there thinking about ways to make money every day.
Bucksbaum: But don't you think Steve that some of that though is the bull market? Almost all companies are trading at premiums to NAV today, and again, the interesting thing will be when there's a downturn, who stays up and who goes down.
Sterrett: There's not been a great differentiation today because of the market. Remember too, that one of the great characteristics of REITs and real estate is they are defensive in nature, so in a downturn ... our single-largest shareholder right now is a growth fund. Partly they like the characteristics of the industry, but partly I think they were a little skittish about the market and turned to us as a little bit of a hedge. A lot of real estate stocks have Betas of .4 and .5, and as people get nervous about the market, a real estate company stock is a great haven to weather out a rough ride.
Ralston: When you look at the net asset value of REITs, however, many people forget to take into account the value of the management operation. And it's becoming easy to do that by comparing some of these real estate operating companies, thecompanies. If you take their multiples and match that to the EBITDA of the operating side of the business it shrinks some of the difference between net asset value and the market capitalization of the company.
NREI: Mike, your company has explored one of the more innovative market niches to come along in a while, the prison and jail business. You gained a lot of attention with your IPO earlier this year. What has the increased attention to new and innovative niches meant to you?
Devlin: In general terms, I don't know where we are in the cycle, but looking at operating companies and looking at the real estate on the books, CCA Management Company had all of this real estate as part of their core strategy for owning prisons and jails as well as managing it to control their destiny. But Wall Street didn't value that at all. That real estate was sitting on their books as a drag. As prisons and jails get larger in size, and the amount of capital that is outlayed is getting larger and larger, it became actually an overhang on CCA's stock. Taking that off, I think what you see is that it was a good idea, and I think in general, you're going to see a lot more of that going on.
Helfand: You're already seeing it. Just down the street from where we sit today is Sara Lee's headquarters. And Sara Lee just came out recently and said they don't need to own the plant to produce the business they're in. That's a mass restructuring of their business to focus on what they do and eventually that real estate will wind up in the hands of someone who will optimize its value. There are great stories about Reckson and other opportunistic real estate companies that have taken properties that the old owner thought was essentially a white elephant and created value out of nothing.
Sterrett: Don't lose sight of the fact that the reason 20% of the regional malls or 10% of the apartments in the U.S. are owned in public hands is that the public companies are the best real estate operators. I think all you're seeing now is that same philosophy applied to different segments, whether it's prisons or whether it's golf courses or any of the other segments. Ultimately people who are focused on operating the real estate in scale day in and day out are going to be the most efficient operators.
Whiting: It goes beyond that. It goes to public company capital efficiencies. The premise for our company is to get the real estate off the balance sheet. That's something that's been a growth business for us dramatically and continues to be so. We structure a purchase lease or do a build-to-suit with one of our public company tenants and generally their stock goes up. They're rewarded for getting the real estate into more efficient hands.
Ralston: The opportunity to outsource real estate for Corporate America on a principal basis has got to be double just taking the investor-owned property, which has been the focus heretofore of the REITs.
NREI: John, you've mentioned that a downturn will come. When?
Bucksbaum: At the investment banking dinner that I attended last night, the head of their national research group, a well-respected guy, said he is bullish on '98 and bullish on '99 and they don't really want to go out further, but he's talking 10% to 12% returns for the overall market. They don't expect the pace to continue as it has for the last few years. Then they took a survey of investment options and the overwhelming majority of the people in the room voted for U.S. stocks. There were a few for the Asian markets. So they're just saying that every indicator is right and they see no reason that this economy shouldn't continue the way it has been.
Weller: If you took that survey a year ago, you'd get exactly the same answer but just ratcheted back because the economy was in reasonably good shape. I recall at a conference involving CEOs of REITs earlier this year somebodytaking a survey and the question might have been if we have a recession when is it going to come? None of us is being paid for our ability to predict the economy or the direction of interest rates necessarily, but I think we all feel relatively optimistic about the economy and the real estate fundamentals in our particular areas of expertise. So you foresee a downturn, but those of us who have the color hair that I have have been through at least two cycles and probably more. We know we're in a cyclical business and something is going to happen.
Ziman: Regionally, in Southern California, we were the last to go into the recession and the last to come out. But if you look at our economy today, it is so segmented but with such strong segments in almost every aspect of Southern California, everything is expanding, everything is growing. I go beyond two years. I'm three and four years out where I see for our region tremendous strength.
Ralston: If in fact we are the best operators of real estate and we own just a fraction of the real estate in this country, why is it we assume that a downturn is going to have such bad connotations for us? I think a downturn could be very good for REITs because we are efficient operators, the companies are more conservatively financed than the private side, and there will be a lot of opportunity to acquire assets at less than replacement cost in distressed situations. We will all get to play Sam Zell for a while.