Eight REIT executives discuss the reality of available capital and the possibility of a downturn, among other topics.
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 in. Their comments, which follow, point to some interesting reasons to consider REITs as long-term market players. The discussion was moderated by National Real Estate Investor publisher Ben Johnson.
Q: 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/ITT, 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.
You really can operate a center better. Sam (Zell) talks about the price breaks you get when buying in bulk, and it's true.
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.
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.
Q: Everyone here has a different niche, from manufactured homes to prisons to freestanding retail to office properties to malls. But Wall 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.
Everybody's pushing the envelope, and that's good for the business. But what was the right thing in the analysts' minds five years ago is very different than what it is today and will be very different [in the future].
Jonathan 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.
Our view is that management can build a good team for shopping centers and a good team for apartments. [Management can] house them within the same company, ration capital based on where the best returns are, and be a sharp seller when 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.
Gary Ralston: Today, the scrutiny has shifted from examining particular property perspectives to how the business is run. It should be expected as part of maturity.
Bucksbaum: 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. If you do a good job of operating those properties, the market will always recognize that in the long run.
Q: Will the market ever recognize REITs as being above BBB-rating status?
Mark Whiting: 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 which begets more growth.
Sterrett: Don't forget, too, only 5 percent or 7 percent of the commercial real estate in the country is owned by REITs. 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.
Q: 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 that 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 that 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.
Michael 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. The REIT is a perfect vehicle for them to showcase 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 percent 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.
Q: Is the money coming after everybody here?
Richard 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.
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.
Q: 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 percent to 25 percent 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 is the bull market? Almost all companies are trading at premiums to NAV today. 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.
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.
Q: John, you've mentioned that a downturn will come. When?
Bucksbaum: At the investment banking dinner that I was at last night, the head of their national research group, a well-respected guy, said he is bullish on 1998 and bullish on 1999 and they don't really want to go out further, but he's talking 10 percent to 12 percent returns for the overall market. They don't expect the pace to continue as it has for the last few years.
Weller: 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.
Bucksbaum: One forewarning. What you really want to look out for is an overheated economy. The danger is that it could accelerate too much.
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.
John Bucksbaum, Vice President - General Growth Properties; Michael Devlin, Vice President - CCA Prison Realty Trust; David Helfand, President & CEO - Manufactured Home Communities; Gary Ralston, President - Commercial Net Lease Realty Inc.; Stephen Sterrett, COO - Simon DeBartolo Group; Jonathan Weller, President & COO - Pennsylvania Real Estate Investment Trust; Mark Whiting, President & CEO - TriNet Corporate Realty Trust; Richard Ziman, Chairman & CEO - Arden Realty Inc.