Tom Crocker faced an interesting dilemma. Two years ago, the chairman and CEO of Crocker Realty Trust, in Boca Raton, Fla., had just created a public company and purchased three major office buildings in the South Florida market. Now he saw the REIT IPO window opening. The question -- to REIT or not to REIT?
"We had to decide at that point whether we were going to continue to grow sort of incrementally, buying three and four and five properties at a time, which would have been a good conservative five-year plan, or should we go out and seek a strategic association with another company or group of individuals that would move us into a greater geographic area faster. We chose the latter."
Crocker is one of the more recent entrants in the real estate investment trust arena, with its July merger with Southeast Realty Trust. The deal puts it among the top office REITs in the south-eastern United States, with a $1.2 billion market capitalization and a portfolio worth an estimated $300 million including 50 office properties in 14 markets in seven states.
Crocker's example is typical of many real estate companies. They need access to capital markets above all, and they need to grow.
"It (forming a REIT) gave us a platform to go out and significantly grow and achieve market dominance, and then also by virtue of that market dominance, bigger market share, better profitability for our shareholders and better service for our tenant clients," says Crocker.
There's no mistaking that REITs are hot, not with a flurry of IPOs as in 1993, but with secondary offerings where REITs are recognizing an opportunity to return to the equity market.
"We're going to have our best year in the industry for raising secondary equity capital," says Mark Decker, executive director of the National Association for Real Estate Investment Trusts (NAREIT), in Washington, D.C. "At the end of July it was in excess of the best year we had ever had which was 1993."
And what a year 1993 was. REITs raised $18.3 billion in total capital, with IPOs accounting for $9.5 billion and secondary offerings totaling some $6.5 billion.
And the taps don't appear to be shutting off anytime soon.
"There is a lot of capital flying to the industry," says Decker. "What we interpret that to mean is that this industry now has a critical mass. Capital is going to continue to flow because of the depth and breadth and quality of the companies in it."
How large will the REIT industry grow to be in the next five years? Many analysts think it will double in size, from its present $45 billion level up to a range of $75 billion to $100 billion.
"That will mean the industry is commanding somewhere north of $150 billion of assets," says Russell Platt, principal with Morgan Stanley Asset Management Inc. in New York. "If you think about the institutional real estate market being $300 billion to $400 billion of total assets, that implies that REITs could control a third or so of the asset base of institutional quality property. That's meaningful. It means that REITs have a very important seat at the table along with traditional institutions like pension funds and others."
Now REITs are availing themselves of the same financial vehicles that other public companies have accessed for years. Decker appropriately calls it the "New World."
"Historically when REITs raised capital it was common stock. It was equity. When that window closed, REITs were not blocked from capital. They're getting secured and unsecured debt, lines of credit, private placements from pension funds and insurance companies. That shows that we are big enough and strong enough today and respected enough and accepted by the financial world, by Wall Street and others," says Decker.
Part and parcel of that growth and acceptance is the potential for major consolidation in the REIT industry, following the recent lead taken by other industries such as banking.
Once the 1993 flurry of IPOs was cooled by dramatic interest rate hikes that pounded the REIT market in 1994, talk in the industry and on the Street turned to the inevitability of fewer, but larger REITs.
"We are participating in an acceleration of consolidation," says Richard Schoninger, managing director and head of the real estate group at Prudential Securities, New York. "We're working on a significant amount of public-to-public mergers among REITs, and public acquisitions of private real estate companies. I think that's a pretty significant trend that will continue. Not all of the deals will happen, but I think there will be a significant amount that do happen as the REITs that have performed well and have good access to capital continue to grow."
And the mergers will make sense. "You won't see mergers where one and one equals two. You have to see mergers where one and one equals three," says Schoninger.
"It's often said that we have too many REITs, but I don't necessarily agree with that," says Platt. "As an investor and a portfolio manager, I relish the opportunity to find specialists in very narrow niches of the market, defined as a product type specialty or by a regional focus. I would hate to see that diversity eliminated through the creation of a smaller number of generalists."
"I think the progress toward consolidation will be very, very slow indeed.," says Platt.
Already, there are clear-cut gargantuans in the individual REIT property sectors, such as Equity Residential Properties (EQR), the $2.2 billion market cap multifamily REIT created by among others Sam Zell in Chicago.
"When we started talking to the investment community about REITs, the biggest complaint was that the REITs were really low-cap stocks and there was little or no liquidity," says Doug Crocker, president and CEO of EQR. "The signal to us was to become very large, become a highly liquid company so that a major institution could trade into and out of our stock without significantly devaluing the price of the stock. In good times that would then open more doors to capital for the company, which has proved to be correct."
When you put the large and small players in the overall REIT industry in context with the broader U.S. financial markets, its $45 billion market capitalization makes it somewhat of a blip on many investors' radar screens. But the longer the REITs exist, and the more performance statistics that are generated, the more attention they are bound to attract from institutional investors.
"Right now the primary investors are the mutual funds like Fidelity that are set up primarily to invest in REIT stocks," says Mark Brumbaugh, a director with the REIT advisory service of Coopers & Lybrand, L.L.P., Washington, D.C.
"Pension funds have been players in the REIT arena, but probably not as big a player as the REITs would hope. They would like to see them be bigger players," says Brumbaugh.
"The primary problem is that the large pension funds are looking to make major investments to make it worthwhile to do the due diligence on the company. If you're talking about a $200 million REIT, and if they're going to take a $20 million position, that's not a very big position for a CalPERS. They look at it and say, `Is that really worth our time?'
"Right now REITs are not as sexy as they were two years ago, and they have to do a better job to get the attention, and that gets back to why a lot of these companies want to grow bigger. The bigger they get, the more analysts' attention they get, and the more publicity they get," says Brumbaugh.
In the end, institutions will do their homework before investing. "REITs are not going to replace direct investments, but I do think the marketplace is gaining more acceptance of the prospect that there's room for REITs as a vehicle and there's room for direct investments as a vehicle. You will see sophisticated institutions looking at both the public and private markets to see which market at the time gives them the best execution," says Schoninger.
"The public equity market is a market of perception and of future. And it gets emotional, and emotions create different valuations at different times. I think the smart institutions will make that go to their advantage," says Schoninger.
One of the oldest REITs around, New Plan Realty Trust, New York, has steadily ridden over the peaks and valleys of the industry since its IPO in 1972.
Through it all, New Plan's management team has taken a decidedly conservative tack in its day-to-day and year-to-year operations, but its views on the inherent pressures of being under the constant glare of the public spotlight have not changed.
"There should not be in this industry a quarter-to-quarter pressure," says Arnold Laubich, New Plan's president. "This is not a quarter-to-quarter business. Very often we can have a quarterly change in a property, which is merely anticipatory of a major leap forward."
Laubich cites the example of creating a vacancy in a property to attract, ultimately, a larger and more profitable tenant. "So you may sit with an extraordinary vacancy percentage for six months or a year or two years while you do this. In the end it makes the property far better, it produces a far better income stream and makes it more competitive long term and makes the rest of the stores and the space more valuable. But in the short term you show a quarter-to-quarter shortfall in the cashflow on that property, and an increase in the vacancy rate which raises eyebrows," says Laubich.
Ultimately, a REIT investment is an investment in the people who run the show and give each REIT its true value.
"The old adage about real estate is location, location, location. The adage that's applicable to REITs is management, management, management," says Decker. "I would think that's true of all public companies -- you start with the management. Who are they? Do they have a vision? Are they doing the right things? Are they making the right decisions? If you have a good management I think you're 75% there."
And performance counts for a lot. "People should have to prove themselves, so having a track record of performance, not the promise of performance, having two or three years under your belt of producing and delivering what you promised the marketplace is critical," says Decker.
By now, of course, most U.S. real estate companies have recognized the opportunity to access capital that REITs provide and many have taken the plunge. "Many of the best management teams are already public," says Schoninger. "You couldn't say that just a few years ago."
"In the end, just like other businesses which may be less capital intensive, it really comes down to management's performance over a long period of time, not a short one," says Laubich.
And investors look to the total management team, not necessarily only those at the top.
"The No. 1 driving force are the people who run the company and the people who run the assets all the way down to the property manager. You've got to have the best people in the industry to maximize the value of the assets," says EQR's Crock.
An improved outlook best characterizes the nation's office REIT market. After the go-go development in the mid-1980s, the resulting overbuilding and market depression of the late-1980s and early-1990s took their toll on many an office developer and owner.
Thankfully, things are much brighter these days.
"You've got a nice tail wind in two respects," says Morgan Stanley's Platt. "One is that the fundamentals of the business are going to improve over time. You really have very little downside risk at this point. By and large, we've hit bottom across the country, so you've got only one way to go and that's up. Second, you've also got the possibility for acquiring assets still at fairly attractive yields."
That positive outlook in part led to the formation of Crocker Realty Trust (CRT).
Crocker and his partner, Richard Ackerman, have specialized in landlording headquarters buildings for Office Depot, W.R. Grace and Scott Paper.
Through the '80s and early-'90s, Crocker has stuck to its knitting, which fits nicely within the context of a REIT structure.
"We're in the business of increasing our profitability by increasing the tenancy, occupancy and rate at which they are occupied office properties. We focus on doing that. You can only really do one thing very well," says Crocker.
Local market knowledge is key to successful office ventures, but there is an apparent lack of geographic diversity in office REITs.
"The existing universe of office REITs is disproportionately weighted toward the Mid-Atlantic and Northeastern portions of the United States," says Platt. "There are very few ways for investors to participate in the office markets in areas like the Midwest, or the Central part of the country, the Southwest and the Rocky Mountains.
That may be changing, as hope springs eternal for more office REITs, particularly those specializing in the suburban markets, says Schoninger. Prudential is working on an IPO for Kilroy Industries of Southern California, which is scheduled for first-quarter 1996 and should be worth "a couple hundred million dollars," says Schoninger. "That market has been very volatile. Values have been reduced significantly and there is evidence that the market is bottoming or will bottom shortly."
One local market that has gotten a lot of national attention is New York, and the storm has been around Rockefeller Center Properties Inc. The REIT's former owner, Japan's Mitsubishi Estate Co., declared bankruptcy in May 1995, after investing $2 billion in the property. In an even more publicized event in September, Mitsubishi walked away from its considerable investment.
At press time, the battle still was raging on for ultimate control of the Center, but a group led by Sam Zell which includes The Disney Co. and General Electric, owner of the NBC television network, a major tenant in the Center, appears to be in the best position to take on the trophy property.
Among the strongest of the REIT performers these days is the retail sector. This growth gibes quite nicely with the growth of factory outlet centers, power centers and malls.
"It's an industry where the investing public has had a chance to invest in the tenants for years and years," says Platt. "Now for the first time investors are able to invest in the landlords of these companies. Essentially all they're doing is buying a different slice of the cashflow of these retail operations. They're buying the rent, whereas before they were buying the operating profit of these retail companies."
Factory outlet centers are among the most active of the REIT stocks, and for good reason.
"The factory outlet business is going to continue with heavy growth over the next three to five years," says Brumbaugh. "I think they are trying to lock up what they consider the key locations. After five years I'm not sure what's going to happen when everybody has covered what they consider the good sites. The growth pattern is fast and strong for a very limited time."
The largest example of this growth is the new $150 million Ontario Mills super regional outlet mall now under construction by The Mills Corp. in Ontario, Calif. When completed next year the 1.7 million sq. ft. mall will be the largest retail development to open in 1996. The Mills Corp. also is developing a megamall in Columbus, Ohio, set to open in 1997.
In another major development, The Mills Corp. and Simon Property Group (SPG) are forming an alliance to develop through joint ventures superregional value-oriented megamalls known as "Mills" projects over the next several years. Target markets include Dallas, Phoenix, Orange County and Valencia, Calif., the New Jersey Meadowlands, Orlando, Las Vegas and Detroit.
"We are delighted to be associated with SPG, the premier retail developer in the world," says Laurence C. Siegel, chairman and CEO of Mills. "SPG's retail and entertainment experience and its financial strength form a perfect match for The Mills Corp. as we continue our leadership role in the value retail shopping center business into the next century."
"The partnership represents an alliance that enables us the opportunity to quickly enter and enjoy a substantial growth in the significant emerging value megamall sector of the shopping center business, with a partner that is the recognized leader in that business," says David Simon, president and CEO of SPG.
Of course, with so much new construction occurring all over the country, talk inevitably turns to the threat of overbuilding.
"Clearly overbuilding is an issue," says Platt. "This is one industry where we've seen continued heavy construction throughout the downturn and the early stages of recovery."
Others aren't so sure there is too much of a good thing.
"I don't sense there's a real fear of overbuilding," says Schoninger. "There's a lot of uncertainty about how and where Americans are going to shop over the next 15 to 20 years."
Actually Schoninger might be considered a contrarian -- he sees hidden value in malls. "The mall sector is significantly undervalued right now. There has been a lot of talk out there about malls becoming dinosaurs, and the stock market has undervalued them and has overreacted like it typically does. I see some of the malls as some of the best opportunities given today's stock prices. As a firm we remain very bullish on factory outlet centers."
Perhaps the least glamorous of the world's property types, the industrial markets are experiencing some of the strongest gains in years.
Why? Primarily because there is never much purely speculative development in the product. Nearly all new construction across the nation is on a build-to-suit basis for major corporate users.
Industrial REITs are active both in development and in acquisition or existing property portfolios.
Security Capital Industrial Trust, the nation's largest industrial REIT, based in Denver, recently acquired an 18-building, 1.4 million sq. ft. portfolio of industrial properties in the Indianapolis market. The portfolio brings Security Capital's total asset value to $1.45 billion.
As of June 30, Security Capital had industrial property operating or under development in 34 metropolitan areas totaling 54.9 million sq. ft. The also owns about 800 acres of land in 20 cities available for inventory or build-to-suit developments.
"Clearly the high multiples these companies enjoy in general reflects a significant desire and demand for downside protection in their real estate investments," says Platt.
"The industrial cycle, because of the construction time-frame, tends to be shorter and flatter than the office cycle. It's further along in the recovery than is office and, because it's a flatter cycle, you more quickly get to an equilibrium point at which new development can be justified," says Platt.
Another large industrial REIT, CenterPoint Properties, is the largest owner, developer and manager of industrial properties in Metropolitan Chicago, owning about 11 million sq. ft., or about 1% of the market. The company has adopted an aggressive growth strategy, almost doubling in size in the last two years. Its total market cap is now about $370 million.
Industrial has shown the highest total return of any property type in the United States over the last 15 years," says John Gates, president of CenterPoint. "This is particularly true on a risk-adjusted basis. The primary reason for that is that supply and demand don't really get too out of sine because there is virtually no speculative building in the industrial business."
While Security Capital has adopted a highly successful national strategy, CenterPoint has become the dominant player in its local market. In the end, it's different strokes for different folks, and both strategies appear to be working.
By far the largest number of REITs are in the apartment sector. Why?
"With apartments you had a lot of companies in the early-1990s that controlled -- either through direct ownership or through some type of management arrangement -- large pools of projects," says Platt. "So you actually had the raw material in the private market of lots of entities which were available to become new REITs."
Ever the entrepreneur, back in 1990 and 1991, Sam Zell concluded that it would be difficult to build an interest in any one function without major investors. Due to changes in the tax laws and banking industry the REIT structure became the opportune vehicle for Zell.
Equity Residential Properties (EQR) went public in 1993, coming to market with 15,000 units owned plus another 6,000 units it purchased from Starwood, with total market cap of about $850 million and 69 properties.
"We wanted to be the mutual fund of the apartment industry and invest on a national basis so that if there was a problem in any one market it really wouldn't hurt our overall performance," says Crocker.
Growth has been the order of the day. Now EQR has 57,000 units and 193 properties. "We've been a little active," says Crocker. The company manages another 20,000 units nationally, owned by either Zell or the entities controlled by Zell or another director.
EQR also relies on internal growth, estimating 8% to 9% NOI growth over the next two years. External growth is viewed as an additive factor.
Another major apartment REIT, Avalon Properties, focuses only on the Mid-Atlantic and Northeastern states. Avalon has about 11,000 units and a market cap of $800 million.
"It's the large-numbers theory," says Avalon's Michaux. "There are so many people out looking for apartments every day, therefore the demand is much more predictable. Housing is a necessity. Even if a person loses their job, they still have to live somewhere."
Differentiation has become a key ingredient in the strategy of Amli Residential Properties, an apartment REIT based in Chicago. Amli has about 12,600 units across the country and has developed a decidedly retail-oriented slogan, "Operate like a retailer, think like a brand," for all 37 of its properties.
"Before we went public our primary customer was the investor, the capital source. Our fundamental customer today is the resident. We have become a brand-name company," says Greg Mutz, Amli's chairman.
"My feeling is that in 10 years it's going to be a very different world. You will have public recognition of 10 or 15 national companies that will create value in their name," says Mutz.
There may only be six hotel REITs on the public markets right now, but in 1994 this industry sector experienced its highest growth in profits since 1979, and all forecasts show that they will increase again in 1995 and 1996.
As that relates to REITs, "The opportunities for growth seem to be very good," says Brumbaugh of Coopers & Lybrand. "They have made a tremendous number of acquisitions and have doubled, tripled and quadrupled in size since they came out."
Repositioning is becoming a major part of that growth. Recently Starwood Lodging Trust and Starwood Lodging Corp. reached an agreement with Carol Management Corp., the parent of Doral Hotels and Resorts, to recapitalize and reposition the 652-room Doral Inn in New York City.
"When fully renovated and repositioned, our investment will be less than 50% of estimated replacement cost," says Barry Sternlicht, chairman and CEO of the Starwood trust.
Prudential's Schoninger is high on both Hospitality Properties Trust and Starwood. "Starwood is incredibly unique and powerful. Management is very smart and we think it's going to become huge as a real equity play in owning hotels. It's trading in excess of its private market value of assets. FelCor is another good company that has created a nice niche."
Platt of Morgan Stanley likes Host Marriott, Prime Hospitality and Starwood. "We like the full-service sector because it has the best upside and operating leverage."
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