For the real estate investment industry, 1999 was somewhat of a continuation of 1998. In the public sector, share prices continued to decline, as REITs lost favor with public investors and more money flowed into high-tech and e-commerce companies. The SNL equity REIT index for 1999 was down 5.4% compared with the 17.3% decrease in 1998. The table on page 60 illustrates the total shareholder return (TSR) in 1999 vs. 1998. The multifamily sector outperformed the other sectors with an overall TSR of 10.1% in 1999, while the hotel industry continued to decline.
Private companies, that don't have to answer to the public markets as much, fared better. In fact, many public real estate investment companies have sought private sources of capital and are beginning to "act" like private companies themselves. A few REITs such as Irvine Apartment Communities and Walden Residential even consummated "going private" transactions. The flow of executives in and out of real estate investment companies mirrored capital flows: Some executives moved from the public sector back to the private sector, while others joined Internet companies, in hopes of becoming overnight billionaires. Why the defection from the public sector? A major reason was the perception that past equity awards - consisting mainly of "underwater" stock options - were worthless or worth significantly less than initially perceived.
Real estate investment companies continue to struggle with structuring competitive and lucrative compensation programs that provide for incentives which align the interests of management, investors and shareholders, while at the same time, attract and retain talented executives. Whereas 1998 was characterized by talk of changing compensation programs, 1999 put words into action. This is especially true in terms of long-term incentive compensation programs as more and more companies shifted from exclusive use of stock options to the use of various "full-value" awards to the executives.
Although many REIT long-term incentive plans are already omnibus plans, which permit the use of various forms of long-term incentives including stock options, restricted stock, and stock purchase loans, many REITs did not use these alternative forms of compensation until 1999. The use of long-term incentive vehicles was the result of the continued decline in REIT stock prices as well as the limited number of shares available for future awards under the existing long-term incentive plan authorization.
Base salaries: 'Cash is king' Because the job market has become so tight and new talent is being hired away from the real estate industry, real estate companies have been forced to pay higher and higher salaries in order to attract fresh talent. Real estate investment companies face competition from several sides, including Wall Street investment banks and the dot.coms. Recent MBA graduates are demanding higher salaries, and if real estate investment companies want to hire an MBA, they'll have to ante-up some cash. In addition, these companies have also been forced to increase base salaries of current incumbents in order to retain them, especially given the fact that prior long-term incentive awards have provided little if any value.
In terms of executive salaries, we have seen most companies assessing their position in the competitive market before determining raises. Firms that realized that their salaries were far below competitive market practices usually established programs to bring salaries up to market over a one- to two-year period. It is possible that a company with a below-market salary structure could provide raises for executives in the 15% to 20% range. Other companies that are at market competitive levels either implemented no salary increases, or they provided small increases tied to an inflationary index such as the Consumer Price Index.
Similar to 1998, certain positions were emphasized more than others in 1999. As acquisition activity slowed in real estate investment companies, more and more focus and energy have been put into managing existing portfolios. For this reason, property management, asset management and portfolio management professionals have become important positions within real estate investment companies, and have therefore seen strong salary increases.
Due to the decrease in acquisition activities, some companies expanded the role of and sometimes even changed the title of their acquisition professionals. Other positions in real estate companies, which have also become more prominent and important in organizations over the past year or so, are Director of New Business Initiatives or Director of Business Development. Individuals who used to be responsible for purchases of real estate assets often fill these positions. These professionals are responsible for incubating ancillary forms of revenue that complement and leverage off of the company's existing real estate portfolio and "captive audiences" of tenants.
Information systems positions continue to be important. This is especially true now that many real estate investment companies have launched e-commerce and other technology initiatives. In order to attract and retain the most talented information systems professionals, real estate investment companies must pay competitive salaries. And the word "competitive" has meant big increases for these positions.
Annual incentives Annual incentives, usually received in the form of year-end cash bonuses, continue to be an important component of total compensation. However, they are especially important this year, given that long-term incentive compensation that has been awarded in the past hasn't turned out to be as valuable as originally intended. Many companies try to compensate for that in the form of larger annual bonuses.
FPL Associates has been instrumental in driving real estate investment companies away from discretionary and subjective bonus programs to more objective programs that are based on pre-specified levels of performance. Two main types of annual incentive programs are in use: One of the most straightforward ways to link pay to performance is through a profit-sharing bonus program. Under such a program, an annual incentive "pool" is established, the size of which is usually based on a percentage of profit the company achieves.
The other type of program more frequently used is a management-by-objectives (MBO) program. Using this method, companies establish pre-defined goals and objectives at the corporate level; at the functional, business unit or regional level; and at the individual level. In a typical MBO program, a range of performance is defined - threshold, target and high performance - which corresponds to certain bonus amounts, usually expressed as a percentage of base salary.
Typically, the performance measures we recommend in these types of plans relate to operational performance and include: growth in funds from operations (FFO), net cash flow and net operating income (NOI). While some companies specify absolute levels of performance, others use growth measures, some of which can be compared to an index or a group of peer companies. In some instances, companies also use market-based measures such as total shareholder return.
Long-term incentives The long-term incentive component of compensation presents the greatest challenge to real estate companies, especially in light of the new e-business economy. Real estate companies are fighting to retain their valuable executives and to attract fresh talent, in part from heavy competition from companies in the Internet and technology sectors. Such companies were able to offer greater upside potential for employees through long-term incentive programs (equity), as evidenced by the overnight billionaires created from the dot.com craze.
Recent corrections in e-business share prices have somewhat alleviated this problem. Executives are facing the reality that the risk-reward trade off holds true: The huge upside potential of e-business companies is accompanied by commensurate risk. However, real estate companies still struggle to design long-term incentive programs that provide competitive value to executives, while at the same time align the interests of shareholders and management. Many REITs also have a limited number of shares remaining for future awards under their current long-term incentive plans. As a result, these REITs are designing plans that conserve the number of shares in the plan while meeting their long-term incentive objectives.
Stock options For public real estate companies, long-term incentive programs were not a problem in 1996 and 1997 when public REITs experienced strong share price appreciation. These companies had just been formed, so they had a sufficient number of available shares in their long-term incentive programs. The long-term incentive vehicle of choice was the stock option. Stock options delivered large amounts of compensation to executives, due to the strong share price appreciation, and were relatively inexpensive from a financial accounting perspective, compared with other vehicles.
Unfortunately, as share prices of public real estate companies began to decline in 1998 and continued to do so in 1999, stock options became far less valuable. In fact, most of the options that were granted in the prior two years are now far "underwater" and have zero value. In addition to the decline in share price, REITs began to use up the majority of the shares that were authorized in their stock incentive plans.
In retrospect, the problem with options shouldn't have come as such a surprise. Because of the distribution requirements placed on REITs, a major part of the value created for shareholders is realized in the form of the annual dividend. With such a large portion of shareholder return paid to investors in the form of dividends, rather than share price appreciation, REIT stocks are more "value" plays rather than "growth" plays. The future share price appreciation of a REIT stock is somewhat diminished, thus limiting the value of an option.
With most outstanding options being underwater and few - if any - shares available in their long-term incentive plans, many public real estate companies have begun to use other long-term incentive vehicles. Whereas 1998 was characterized by talk of new long-term incentive vehicles, 1999 saw prevalent use of them. Such long-term incentive vehicles include: restricted stock, loan programs (with and without forgiveness provisions), dividend equivalent rights, performance shares and units, and other structured participation programs.
Restricted stock Approximately 70% of public real estate companies used restricted stock in 1999, whereas in 1998 this figure was around 30% to 40%. Why the drastic increase? Most companies used restricted stock in 1999 because it delivers immediate value, which doesn't require share price appreciation. Nevertheless, restricted stock still provides an incentive for management to take actions which increase the share price, since any appreciation in share price will increase the value of the restricted stock award to management.
In most cases, dividends are received on restricted stock awards (even when the vesting requirement has not yet been meet).
Because most of the return on a REIT stock is provided in the form of the dividend, restricted stock allows management to share in that return. Furthermore, restricted stock is usually subject to vesting requirements which provide a mechanism by which to retain key talent. Lastly, restricted stock conserves plan shares. Because a grant of one share of restricted stock is more "valuable" than one stock option, fewer shares are needed to deliver the same value to the executive if restricted stock is used.
However, based on current accounting and tax rules, restricted stock awards will result in a financial charge to FFO/earnings and will be treated as ordinary income for executives. Despite the adverse affect on earnings, many REITs do not have an alternative to restricted stock which will meet their desire to provide value to the executives, conserve shares in the long-term incentive plan, and provide a link between pay and performance.
Many companies have provided large grants of restricted stock to serve two purposes: to provide a new long-term incentive award; and to make up for past awards that haven't paid off. These restricted stock awards are either granted annually or once every two to three years. Restricted stock awards that are not granted annually are usually very large awards, which will vest over multiple years and serve as a strong retention tool. There are also tax consequences to the executive as the restricted stock vests and dividend income is received on the shares.
Loan programs When public companies have a very limited number of shares remaining in their long-term plans and the prospect of receiving significant additional authorization from shareholders is dim, companies need to come up with new ways of providing equity-based long-term incentives to the executives. In private companies, employees are often prevented from owning a substantial portion of equity, due to the large amounts of cash that are typically required.
One solution to both of these problems has been for companies to provide loans, the proceeds of which are used to purchase equity in the company. Typically these loans are full recourse, 10-year notes with interest set at the applicable federal rate. For public companies, shares acquired with the loan proceeds are usually purchased on the open market and do not count against the share authorization under a long-term incentive plan. In REITs, the interest is usually offset by the dividend payments received on the purchased shares. For private companies, these programs are a funding mechanism used to provide individuals with the cash necessary to purchase equity in the company.
Loans in themselves are usually not considered "compensation." However, when forgiveness provisions are included, loans are perceived as providing an additional long-term incentive compensation vehicle. Loans are typically forgiven based on continued employment (time) and/or the achievement of specific performance objectives, as well as based on a change of control of the company. As a loan is forgiven on an annual or multi-year basis, the amount forgiven is considered compensation.
In order to result in more favorable accounting treatment, loans containing forgiveness provisions are often structured to provide for forgiveness based on a long period of time (usually 10 years) with accelerated forgiveness based on the achievement of performance goals. When the company forgives all or a portion of the loan, there is a charge to earnings, and the executive recognizes income. When structuring a loan program, it is important for companies to consult their tax counsel to ensure compliance with the Federal Reserve's margin requirements under Regulation U.
Participation programs The programs mentioned are still fundamentally market based. In public REITs, there is the feeling that management has little control over how public markets value their stock. The company's underlying real estate may have strong performance, and yet the share price may not budge. As mentioned, more and more public companies are beginning to "act" like private companies. They are seeking sources of private capital, and they are making decisions without fear of how the market will react.
After all, REITs are no longer the darlings of Wall Street, so what have they got to lose? A few public real estate investment companies are devising compensation programs that provide the executive with a participation in the value created in real estate assets.
This type of program is nothing new to the private companies. In fact, developers frequently use them. These programs are structured so that management will receive a percentage of the annual cash flow and/or value created in a specific real estate asset or in a portfolio of assets.
Management's actions and decisions and the resulting performance of the asset or portfolio of assets are directly linked to management's compensation. Such plans must be carefully structured; usually returns to management would be subordinate to a preferred return on investors' capital. Public sector companies must carefully contemplate the market's reaction and must decide how leading-edge they wish to be before adopting this type of program.
There are infinite variations on these themes which companies can use in designing long-term incentive programs. Depending upon a company's structure and strategy, one approach may be more effective than another.
However, compensation practices are constantly shifting and changing as real estate investment companies grow and mature and as the market impacts the way in which we all do business.