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Subject: The Essential REIT: October 17, 2003 Date: 10/19/2003 8:14 PM
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The Essential REIT
(Formerly known as
“REITWEEK”)

October 17, 2003



“There is nothing more frightful than ignorance in action.” --
Johann Wolfgang von Goethe

Avarice, or desire of gain, is a universal passion which operates at all times, in all places, and upon all persons.” – David Hume

“In order to keep a true perspective of one's importance, everyone should have a dog that will worship him and a cat that will ignore him." - Derek Bruce



1. To Dream the Impossible Dream.

A prospective client of ours, a gentleman from Tokyo, recently asked me, “What is a good REIT?” Ah, such a deceptively simple question! It reminds me of the wisdom contained in a subtle koan, or in the very simple but profound verses of the best Haiku. Thus perhaps he could have put his question this way:

Coming to your shores,
I trod the hills of Reitland
Searching for The Good.


It is, of course, a truism that there's no free lunch in the investment world, and it's even difficult to find a freebie iced tea these days. Accordingly, the “highest quality” investment will normally be available only at a steep price relative to its peers. But price and valuation isn't what the Japanese gentleman asked us about. He wanted to know what a “good REIT” is. I will avoid the trap into which a former President fell by refraining from any debate over the meaning of the word “is.” Rather, I will try to answer the question by discussing what a good REIT should be. Thus, like the surfer looking for the perfect wave, I will spend a bit of time searching for the flawless REIT – while knowing, of course, that my chances of finding the Holy Grail would be greater. In other words:

Like Don Quixote,
My Quest is the Perfect REIT;
Come with me, Sancho.


a. The Quintessential Importance of Management. Let's begin our quest with the generals. Although it is certainly true that armies, not generals, win wars, a bad general can destroy not only his troops' morale but perhaps even “lead” his country to ruin. It wasn't until Mr. Lincoln found Mr. Grant that the Union could even think about winning the Civil War. My experience in Reitland has taught me that excellent management, at the top in particular, is crucial in defining a superior REIT. There are lots of ways to evaluate a REIT's management team.

Let's start with something basic: property management. Just as a great football team needs, first, to be able to block and tackle effectively, one mark of a great REIT is excellent property management. This would include, of course, not only effective property maintenance and judicious capital expenditures to keep the properties competitive, but also strong tenant relationships (which can lead to more leases elsewhere in the portfolio) and lessee underwriting skills. We can observe the REIT's effectiveness in this area by several yardsticks, including same property NOI growth over time, tenant turnover (and retention), bad debt expenses, untimely lease terminations, and other similar indicia. And strong operating cost controls are, of course, essential; this can be measured by same-store operating expenses over a reasonable period of time, particularly with respect to the peer group. It will also be vital for the management team to find the right balance between occupancy and rental rates, as Public Storage, among others, will attest.

A related area is corporate overhead (G&A). The ability to control administrative expenses translates into better returns for shareholders and provides assurance that management really cares about its shareholders' capital. This is especially true in difficult environments such as we have today, when some REITs' dividend payout ratios are becoming tighter than Jennifer Lopez' pants. Large G&A expenses, especially in the age of Sarbanes-Oxley, is often a disability of public companies, and overhead costs need to be as low as possible to remain competitive in an environment where everyone wants to buy from Wal-Mart.

The perfect REIT's management team will be flexible and responsive to market conditions. Again, there's a trade-off between playing to one's organizational strengths and following a solid long-term strategy, on the one hand, and changing course to accommodate evolving market conditions, on the other. Prentiss Properties and Carr America are pretty good developers, but they quickly ratcheted down their development pipelines well before it became apparent that leasing new office space would be as difficult as preventing Sammy from barking at the mailman. Another good example might be Chelsea, which has always been a great developer; however, they cut back on development when Factory Stores, Horizon, McArthur Glen and others of their ilk were putting up outlet centers along every watering hole in the California desert, and saved their firepower for a later date when they could get some great locations and with much less competition.

Acquisitions have always been a key to REIT organizations' growth, but the best REITs know that bidding wars and pie-eating contests don't create value. Rather, they look for unusual (often “one-off”) deals that aren't open to competitive bidding, sometimes taking advantage of special relationships. Even better if the property is facing tenant risk, or is in need of major refurbishment, as a superior REIT can often leverage strong market presence and tenant relationships to quickly back-fill the empty space. Location and timing are also vital issues; too many REITs bought too many assets in too many places in the late '90s, then had to “exit tertiary markets” when they learned that return on invested capital is more important to shareholders than gobbling up assets. I won't name names; you know who these guys are, and, like flies in the summertime, there have been too many of them.

Equally as important is knowing when to harvest gains. We can debate until California generates a budget surplus whether today's cap rates are “too high,” but the excellent REIT continually culls its portfolio and use the proceeds not only to repay debt (and/or to buy in stock) but also to find higher-IRR opportunities. It will also understand that “FFO accretion” is important only to the guys not playing with a full deck, and that the REIT should be run for long-term investors who appreciate value-creation, strong IRRs and modest risk.

One of my favorite Clint Eastwood-isms is, “A man's gotta know his limitations.” The same applies to REITs and developments. A development is something about which we should apply the standard warning, “Don't try this at home.” Not many management teams can consistently generate the kinds of risk-adjusted returns that should be demanded by shareholders. Those who can, should – with wisdom and caution; those who cannot, shouldn't even try. Investors would be wise to review major development projects undertaken by their REIT (no pun intended), and make an assessment as to whether shareholder value has been created or destroyed.

Speaking of which – one of the most important, yet difficult, issues that we need to get our arms around is whether the REIT is creating value or destroying it. Before today's Brave New REIT World, REITs have often traded at NAV discounts, perhaps on the conviction that many or most REIT management teams have had a propensity to act like cowboys. There were large “acquisition pipelines,” UIT issuances, forward equity transactions and “FFO accretive” deals. Certainly the ill-fated investments in technology by many REITs a few years ago lent credence to that belief. Today, of course, all is forgiven, and REITs of all sizes, shapes and quality – from Associated Estates to Weingarten Realty – trade at NAV premiums.

However, the flawless REIT justifies a long-term NAV premium for its stock by consistently creating value for shareholders beyond the value implied by its operating assets. Look for well-structured joint ventures that increase revenues and reduce risk and capital requirements (e.g., AMB and Pro Logis), successful ancillary businesses (e.g., Kimco) and highly profitable foreign ventures (e.g., Chelsea). Opportunistic acquisitions and well-executed developments are also obvious examples. The number of ways that a REIT can create significant value for its shareholders is finite, but they do exist; on the other hand, the ability to destroy shareholder value is limited only by the miasmic peregrinations of the feckless mind.

Strategic issues are also vitally important. What is the REIT's portfolio composition? Is it pro-active, buying and selling assets ahead of the crowd (as Archstone-Smith has done)? Is it investing in the types of assets and in markets that are likely to deliver the best results over the next 3-5 years? Is it investing for current yield or for total return? Both can be solid strategies as long as they are executed well and the shareholders understand that there's no free lunch; high yielding real estate will entail more risk and perhaps lower growth prospects, but low cap rate properties will often provide the reverse. I like AMB's hub-market “HTD” strategy; I think its focus will, over time, prove very rewarding. It remains to be seen whether I am right about this on a long-term basis, but AMB's strategy is logical and is being executed well. The perfect REIT will make the right strategic decisions most of the time, and often the best decision is to do nothing.

A related issue: Is the REIT a “local sharpshooter” in its markets, or is it trying to collect assets in every burg of America? Real estate is normally a local matter, and in most sectors the ideal REIT will be one of the most dominant and among the smartest in its market(s). Think of Centerpoint Properties. And, of course, like Alexandria and others, a REIT can be a local sharpshooter in multiple markets. We REIT investors can build our own diversified portfolios; we don't need each REIT to do it for us. I pay $15 for a stock trade; five office REIT stocks, each with a different geographical focus, will cost me only $75 in commissions.

“Capital allocation” is another way of assessing the excellence of management. This, like “value creation,” is another squishy phrase that encompasses a large number of issues. Think about the REIT's decisions regarding balance sheet expansion (or contraction), its understanding of its costs of capital (and related investment strategy) and its growth via selling equity (or shrinking by buying in stock). Why is equity being raised? Will the return on that equity exceed the REIT's capital costs? Is money being raised to create value or will it merely allow the REIT to puff up in size without adding substance, like one of those weird frogs? The perfect REIT will make the right decisions regarding these issues, and at the right times.

A related issue is how the REIT manages the trade-off between the increased bargaining power – and arguably, cost efficiencies – provided by larger size, and the stagnant growth often delivered by leviathans. The Zellian concept that the larger REITs have greater bargaining clout and the ability to operate more efficiently than their smaller peers is as old as the dawn of the Modern REIT Era, but the reality is like a Scottish Verdict: “Not Proven.” The Cousins Properties and Centerpoints of REIT world continue to maintain that large size can be a handicap, and many would agree. Surely that “killer deal” benefits a large REIT a lot less than a smaller one. Like so much in this world, there's a trade-off, and the perfect REIT is able to successfully balance mass, efficiency and market power.

b. The Beautiful Balance Sheet. Ghouls who love to walk the graveyards of Reitdom seeking to exhume dead REITs for the purpose of ascertaining the cause of death will cheerfully volunteer that a broken balance sheet has often been the culprit. Patriot American is a mere shade of its former self (under the name Wyndham), and La Quinta, nee Meditrust, hasn't paid a dividend almost since the Rams were in Los Angeles. Both these companies imbibed too much debt, most of it short-term in nature. The perfect REIT will have a great looking balance sheet, which affords protection during lousy real estate markets but also provides opportunities to dance on the graves of others less fortunate.

I would suggest that REIT investors look for perfection in several areas. Is the leverage ratio low and comfortable, including preferred stock as debt? How about the fixed charge coverage ratio? Are these in line with historical ratios, or are they weakening? Is the debt maturity schedule stretched out and reasonable, or is a big chunk likely to come due at a time when lenders might wish to extinguish the relationship? Disaster lurks there. How much of the debt is at fixed rates, and how much is variable? Is at least some of the variable rate debt hedged with swaps or caps? The perfect REIT will have fixed interest rates on at least 85-90% of its debt, most of the time.

REITs in sectors that are economically sensitive, e.g., hotels, argue that having lots of variable rate debt can act as a hedge, as interest rates are likely to rise only when the economy does well, which would generate stronger RevPar growth. Well, maybe; ingesting a small bit of arsenic can prevent poisoning, but too much would ruin more than one's whole day. Most REIT investors prefer that a REIT's assets, most of which are held long-term, be matched with long-term, fixed rate liabilities.

While there's room for debate on the subject, and plenty of exceptions to the rule, it is my view that the ideal REIT will keep a large portion of its assets free of encumbrance, and use the corporate debt markets to fund most of its obligations. This provides for more strategic flexibility, allowing for the quick sale of an asset in response to a Mafiosian offer. Exceptions: Development projects will often be financed with property-specific secured debt, and sometimes the mortgage market offers rates so low that no self-respecting REIT executive can refuse.

Finally, the outstanding REIT will devise a dividend policy that enables it to retain substantial earnings during the fat years, providing a cushion when real estate markets weaken. Generally speaking, it's a “good thing” to retain lots of free cash flow; this provides for both dividend safety and the ability to take advantage of great opportunities without having to go cap in hand to the investment bankers. However, there are times when paying out more to shareholders is appropriate, perhaps due to a dearth of investment opportunities. Cousins has taken the unusual – but, in my opinion, wise – course of paying a special dividend with the proceeds from asset sales. Great REITs know not only when to hold 'em and when to fold 'em, but also when to retain and when to distribute.

c. Shareholder-Friendly? I've been investing in REITs since 1975, and have seen the Good, the Bad and the Ugly. There is one common denominator that we see in Ugly REITs: They are not shareholder friendly. On the other hand, the best REITs understand that every public company should be run for the benefit of the shareholders, not the executives or directors. Shareholder friendliness can be measured in many ways, and I will list just a few of them here.

Perhaps most important, there will be an “alignment of interests” between the executives/directors and the public shareholders. That term, while worked so hard it's about to collapse, is nonetheless crucial to the long-term well being of shareholders. This alignment is most easily seen in share ownership. How many shares, and what percentage of the company, do the insiders own? Are they real shares, or OP units with a different cost basis? Are there other conflicts of interest? The best REITs won't have worthless brothers-in-law on the payroll, or buy supplies from the company owned by the CEO's wife.

What about compensation? The ideal REIT will structure compensation plans, for both executives and directors, which put them in the same boat as the shareholders. Together, they will either sail away to the lush Spice Islands or sink into Davey Jones' locker. And such a REIT will, like AMB Properties has done, formulate rules requiring that the independent directors have some significant “skin in the game,” i.e., $100K in stock per independent director. There is nothing like having a significant portion of one's net worth in a single company to focus attention on creating long-term value.

Another area of great interest these days is shareholder communications. Again, this is a nice-sounding phrase, but can be more complex than the rules of cricket. Does your REIT provide detailed press releases, including expected returns on asset acquisitions, and discussion/analysis of quarterly earnings and other material information? Although the “supplemental package” need not include so much detail that every REIT wonk with nothing better to do can ferret out the janitorial costs for every single property, it does need to provide investors with certain property and other information not obvious from the financials, as well as substantiating guidance assumptions. The ideal REIT will make quarterly conference calls available to all shareholders, tell it like it is in Cosellian fashion and take the time to make a thoughtful and detailed presentation, with both details and “macro” discussions. It will also provide the assumptions behind future earnings guidance. Prentiss Properties is a good model here. It will “underpromise and overperform.” Does your REIT webcast investor conferences? Does it return phone calls, even from the fellow with 200 shares? Is it willing to listen to suggestions from both the little guy (regardless of his height) as well as the large institutional players? The perfect REIT will do all these things.

d. Board of Directors Issues. The Era of Enron has unleashed a new wave of thinking about corporate “democracy” and what we shareholders should expect of our boards of directors. The topic could fill a book, and the professorial types are much more qualified than I to write one. However, I will offer just a bit of what I think is common sense when thinking about boards, and how the flawless REIT should structure them.

An obvious issue, but one that's not discussed very often due to uncomfortable (and perhaps even ghoulish) implications, is succession at the very top. The ideal REIT will prepare for the eventual retirement (or even untimely demise) of the top guys, and its board of directors will be thinking about these issues and developing contingency plans. A corollary to this is organizational depth. It's particularly important for mid-size and larger REITs to have outstanding executive talent deep enough to compete effectively with smaller and often more nimble private real estate owners and developers.

Compensation is another topic that's been ignored until recently. While shareholders don't seem to focus on executive pay packages during bull markets (“jus' win, baby!”), we have to assume that sharp claws inevitably follow long horns and that shareholders will again watch compensation levels closely. The best REITs will, of course, figure out a way to meld operating results and stock price performance with pay levels and incentives, for both officers and directors.

The nature and competence of the “independent” directors is another fuzzy issue. The word “independent” means different things to different people, and regulators hesitate to prescribe exactly what facts make a man or woman independent – and rightly so; here there be dragons. But this makes things difficult for shareholders. However, the perfect REIT will require that its outside directors be truly independent from the company, both economically and perhaps even socially.

This doesn't mean, of course, that such a REIT will need to appoint a bunch of yapping Ralph Naders. Rather, it means that each outside director should be financially independent of the company and not reliant upon any company relationships, and be mentally tough enough to vote to override or reject any ill-conceived proposal, plan or strategy suggested by the CEO. And he or she, as noted above, should have a meaningful stake in the company in relationship to his/her net worth; guys who accept directorships for freebie lunches and golf games, or to add luster to their resume, are as worthless as snowmobiles in Phoenix. Of course, it ain't easy to determine the motivations or feistiness of the independent directors. But it's a topic that won't go away, and the ideal REIT should be able to provide, when asked, some satisfaction to us shareholders on this issue.

Finally, there's the problem of corporate control, and who makes those decisions. Too many REITs won't allow major issues, including a sale of the company, to be determined by their shareholders, and reserve that right to the executives, directors and principal shareholders – whose motives may be very different from the public shareholders. Can you say, “Taubman Centers?” These self-entrenchment devices (or, as Green Street would say, “weapons of mass entrenchment,” come in all flavors, sizes and colors. They include limits on shares that can be acquired by any one person or organization, the ability of the board or management to exercise veto power over major corporate decisions, staggered boards terms, poison pills and other nefarious creations devised by evil minds at large law firms. The perfect REIT will “just say no” to such nonsense.

To end this exceedingly long discussion, let's just note that the shares of “perfect” REITs will be more highly valued by rational investors (if any there be these days), perhaps in the form of a lower required rate of investment return (i.e., a cheaper cost of capital), a higher NAV premium (if anyone cares about NAVs any more), and perhaps a higher trading multiple. How much more value should be assigned to such REITs is, of course, up to the individual investor, his/her total return goals and risk tolerance levels. Some prefer low-risk investments, while others like swinging for the fences. So what kind of premium we should pay for high quality in a REIT is, like politics and religion, a matter of personal choice (and perhaps even determined by one's inherited genes).

2. Chips Off the Ol' Block.

This issue of REITWEEK is already disgustingly long, so I will end it with a few stray thoughts. First of all, I have learned that Joseph Pagliari, Kevin Scherer and Richard Monopoli have written an article, which is being published in the Journal of Portfolio Management (“J of PM”), that addresses the issue of whether the performance of REIT shares correlates with the performance of privately-held commercial real estate when adjusted for certain gremlins that makes the comparisons difficult.

The authors have been kind enough to let me read the article, which might soon become available for viewing on the J of PM website. This could be a very important piece of work, perhaps comparable to the Ibbotson studies. I believe the article is very persuasive, and I will devote the next issue of REITWEEK to it (and its possible ramifications). It's probably smart to assume that the article's conclusion – that “public and private market vehicles ought to be viewed somewhat interchangeably” – won't revolutionize the market for REIT stocks; however, it presents some very interesting issues for investors.

Second point: October 2004 REIT stock prices are, in my opinion, a bit over-heated. Readers of these pages in prior issues know how much I have been wrestling with the REIT valuation conundrum; I never want to say that “this time it's different,” but I also don't want to drive forward by looking through the rear-view mirror. However, while there are certainly good reasons for REIT shares to be valued higher today than in prior years, on the basis of both NAVs and AFFOs, an immense inflow of capital has been driving REIT share prices up, and that capital doesn't seem to be much more discriminating than a 15-year old punk rock groupie.

2004 is shaping up as the year in which even the slimiest of REIT organizations have not only found demand for their shares (perhaps in the form of Alfred E. Neumanesque buyers), but have also been able to raise lots of fresh equity capital with which to pursue God-knows-what. Students of history know that these kinds of non-discriminating markets tend to have unhappy endings. Thus, while REIT investors should focus on long-term returns, cash flows and dividend growth, and ignore current market fads and even, to some extent, current stock prices, I think now is a particularly good time to take stock of our REIT allocations – and re-balance where necessary. In two weeks or two months from now we could be mighty glad we did.

Part of my concern has to do with today's “investor,” who's mantra seems to be, “We don't need no valuations.” Indeed, the markets today seem to be as momentum-driven as they were a few years ago when the inmates ran the asylum. REIT stocks are trading with little regard for NAV estimates, non-REIT stocks bounce around like errant gymnasts and the techs trade on the basis of 2006 earnings forecasts. On Tuesday large-caps First Data, State Street, EMC Corp, Scripps, Moody's and Interpublic each rose or fell 5% or more, in each case for little fundamental reason. On the same day, Red Hat (remember that one?) spiked 20.3% in response to an upgrade from McDonald Investments. As noted by Ed Yardini, “In America one of the most painful emotions is the feeling that your neighbor is getting rich and you're not.”

Best,
Ralph (Block)

Disclosure: I and/or the firm(s) to which I provide services may from time to time have long or short positions in some or all of the stocks (if any) mentioned above. Further, this “newsletter” is not intended as a recommendation for the purchase or sale of any particular security and is not intended to be investment advice – or any other advice for that matter. The statements made in this newsletter are my own personal opinions, and do not represent the views of any other person, real or fictitious, or even the views of Sammy, my Golden Retriever. © 2003 Ralph L. Block


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