Compensation: It's not just a salary anymore. As the years have rolled by, the ways in which real estate executives are paid have grown more and more complex. Terms like “stock option” and “restricted stock” are as familiar to CEOs as the latest pop-culture catchphrases are to teenagers. And with the prevalence of mergers and acquisitions, real estate executives are also making sure that contracts are in place that assure them of some type of compensation and stability if their company changes ownership hands.
To provide a better understanding of compensation in the 21st century, Chicago-based FPL Associates has compiled the following exploration of trends in base salary, incentives and employment contracts at public real estate companies.
The year 2000 was characterized by stronger investment in real estate than 1999. Indeed, during the fourth quarter, as capital shifted from the riskier technology sector into the more stable real estate sector, real estate stocks rebounded. The SNL Securities equity REIT index was up 25.9%, compared with a decrease of 5.4% in 1999. According to SNL, there were more than $19.1 billion of mergers (including privatizations) announced by public REITs during 2000, compared with $14.4 billion in 1999.
In the first half of 2000, public real estate companies experienced upward pressure on salaries as a result of the tight labor market. FPL saw strong increases in base salaries across the board, especially in certain geographic markets such as San Francisco and New York. However, since the economy has plateaued, upward pressure on salaries has subsided. The average salary increases for 2000 were in the 3% to 5% range, although some companies chose to maintain 1999 salary levels for executive officers. Although it will take some time before this pattern fully emerges in the compensation data, geographic differentials will continue to flatten, and salaries will enjoy only modest increases, FPL believes.
As public real estate companies grew and became more complex, FPL noticed a shift in the characteristics of management teams within these organizations. Management teams at many larger real estate companies are shifting from entrepreneurial founders to more institutional and professionally managed teams. As a result of this shift, certain positions — such as financial, accounting, information technology and legal positions — received larger increases than others. In addition, human resources issues became increasingly complex, and FPL saw the role of the HR department grow in importance with a commensurate increase in compensation.
Base salary represents the smallest proportion of total compensation for senior executives, since total compensation packages are highly weighted toward performance-based incentive compensation. However, base salaries become quite important when they are used as the basis for incentive programs. In many cases, annual incentive award opportunities are expressed as a percentage of the executive's base salary.
The annual incentive opportunity for a CEO may range from 50% to 150% of salary depending on performance. During 2000, annual incentives increased as a result of the improved performance of the real estate industry. Annual incentives are typically paid in cash. Some companies allow the executives to convert the cash bonuses to stock options or restricted stock awards. In addition, many companies allow the senior executives to place all or a portion of the incentives in a deferred compensation account, which can provide income tax benefits.
A growing trend in 2000 was the creation of a specific incentive program for certain company functions, such as development or transactions. In most cases, these programs are for senior and mid-level development professionals. For example, upon the completion of an asset and the stabilization of the cash flow, management will make a determination of the value created above cost and make a payment, usually a cash bonus, to certain members of the development team for producing the asset on time and on budget.
Stock options are the most frequently used long-term incentive vehicle. However, many REITs have shifted from the sole use of stock options to a combination of options and vehicles such as restricted stock. This shift was increasingly evident in 2000.
The most commonly used alternative and complimentary vehicle in 2000 was restricted stock, which provides an incentive for both increasing the share price and maximizing the dividend. One share of restricted stock can deliver the same value as many options. For example, in most REITs in 2000, one share of restricted stock delivered the same present value as 10 options, based on the Black-Scholes option model.
Many companies also continue to provide executives with loans, the proceeds of which are normally used to exercise options, pay taxes on the vesting of restricted stock or purchase company stock. Loan programs are popular because they encourage share ownership among management and prevent executives from selling their shares to pay the exercise price of an option or pay taxes on the vesting of restricted stock. Some companies use loan programs as a compensation vehicle by forgiving the loans, sometimes based upon time, but often based upon performance objectives. The portion of the loan forgiven is considered compensation.
Another growing trend among REITs is the use of super bonus plans. These plans provide compensation, either in cash or in the form of equity such as options or stock, based upon the performance of the company against a market-based or operations-based measure. In most cases, the company must set a challenging performance goal over a multi-year period, which, if achieved, will result in a substantial payment to management. When first announced several years ago, this type of program received lukewarm response from analysts and investors. However, over the past year or so, this type of plan has been used in few cases.
When the more traditional vehicles are unavailable to a company, a “synthetic” long-term incentive vehicle may be crafted. The synthetic vehicle is a good alternative for a company that has limited shares available under existing long-term incentive plans. The benefit of a synthetic vehicle, which can mirror an option, share or “super” cash payment, is that it can be based on multiple performance measures and can be tied to diverse collateral, such as corporate enterprise value and FFO growth.
The decline of REIT share prices during 1999 was viewed as an opportunity for an increase in mergers, acquisitions and privatizations. With more than $19.1 billion of mergers (including privatizations) announced by public REITs during 2000, and many pending mergers for 2001, many companies examined the terms of existing employment contracts. How much compensation should an executive receive if he is terminated without cause following the completion of a transaction of this nature? How do companies retain key executives to assist in the completion of the transaction? Employment contracts play a significant role in addressing these issues.
Even within the real estate industry, employment agreements vary widely in practice, differing in scope, complexity and value. Some companies may not use contracts at all for levels below the most senior executives; rather, they may adopt broad-based severance policies that will cover certain circumstances of termination. Other companies may issue a one-page contract detailing severance arrangements in a change-of-control circumstance for positions below the CEO level.
A change of control marks a special time of uncertainty and instability at a company. By protecting the interests of both the company and the executive through a change of control, a company can ensure a more equitable and stable transition. On the one hand, shareholders hope that management will pursue all merger and acquisition possibilities to maximize shareholder value. On the other hand, management needs to know that they will be fairly compensated if they proceed with a transaction that might result in the termination of their own employment.
Most employment or severance contracts provide for a severance payment to an executive only if the company undergoes a change of control and the executive's employment is terminated without cause within a certain time period following the change of control. The time period may be anywhere from six months to three years, with a CEO having a window at the high end of this range. These are called “double-trigger” agreements.
The severance payment for a CEO who is terminated without cause following a change of control may be as much as three times the sum of the executive's salary and annual bonus. In several cases, an actual monetary figure is stipulated in lieu of the multiple. The “window period” in which an executive must be terminated in order to qualify for this severance ranges quite broadly from 30 days to 3 years.
In addition, the vesting of any stock options, restricted stock grants or forgivable loans is usually accelerated following a change of control, and all health benefits generally continue for the duration of the contract or some agreed period of time. Some agreements will limit the length of time to exercise options following a change of control to a period as short as 30 days.
In some cases, both the severance payments and the benefits are reduced by the amount gained in the executive's subsequent employment. Therefore the company limits its obligations, but at the same time provides the executive with guaranteed compensation for the next two or three years, or until his next employment, whichever comes first.
In the case of a modified double-trigger agreement, the executive can voluntarily terminate his employment during the window period in order to qualify for a severance payment. In some provisions, this requires a reason such as a change in responsibility, a change in compensation, a relocation, etc.
In single-trigger severance arrangements, which are rare, executives are entitled to a severance payment as sort of a bonus even if the employment is not terminated. Accelerated vesting of outstanding stock options, forgivable loans and restricted stock grants is also common in this situation.
Because of the generous nature of the change of control provisions, payments received may be subject to Internal Revenue Code Sections 280G and 4999, which specify a special excise tax on payments considered to be golden parachute payments. In general, a payment is considered a golden parachute payment to the extent that it exceeds three times the individual's average annualized gross income (base amount) for the previous three years. If the payment falls within these rules, the company loses its deduction for the amount of the severance payment above one times the base amount, and the executive is subject to an additional excise tax of 20% on the severance payment above one times the base amount.
Compensation practices in the real estate industry are constantly changing in response to industry dynamics as well as competition from other industries to attract and retain key executives. With the rebound of REIT share prices in 2000 and the strong growth in FFO/share for the first quarter of 2001, one should anticipate further flux and innovation in compensation practices within the real estate industry.
Cimi B. Silverberg, CPA, and Linda R. Samson, CPA, are directors of executive compensation for Chicago-based FPL Associates.