REITs are looking for new and innovative ways to grow and establish value for investors

By Steve Bergsman

In the halcyon days of yore, or at least as far back as a decade ago, real estate was inefficiently priced as an asset class and yields were high. In those glory days, REITs had good access to capital, which they aggressively used to acquire assets.

Today, the situation is reversed. Real estate is efficiently priced. Capital has become commoditized and privately held companies swing deals quicker. To survive and prosper, REITs have to adjust to a changing world, becoming more than just a publicly traded portfolio of buildings. Now, REITs are looking for more ways to grow and establish value.

“It’s hard to find property that is not completely shopped to all potential buyers,” says Richard Moore, a managing director at RBC Capital Markets. “That’s why REIT management has to bring other skills to the table.”

“REIT management has to find ways to leverage its intellectual capital if they are going to grow assets under management and produce returns for shareholders,” says Scott Crowe, senior vice president, Cohen & Steers.

Managing a core portfolio of U.S. properties is just a small part of the business. Some REITs are vigorously adding development and redevelopment to their operations, others intermediate institutional capital through joint ventures, a few are going global and a handful have proven adept at fund management.
Driving Development

REITs generally have two main avenues of growth: acquisition and development. According to industry analysts, capital is usually cheaper for REITs than for other types of investors because Wall Street gives REITs the opportunity to raise capital.

However, to maintain growth in today’s world of high prices and low cap rates, development opportunities have become more attractive for many companies. For example, AMB Property Corporation (NYSE: AMB) is one of the largest industrial REITs in the world, but until recently it never focused on development.

The company’s previous business model for development was to form a joint venture with local partners that had unique skills for a specific region, whether that area was domestic or international.

In 2002, AMB altered its model, creating an in-house development team for the first time. “We have spent the last few years creating a team in North America as well as in Asia and Europe,” says Hamid Moghadam, AMB’s chairman and CEO. “That has brought our annual development from $100 million, mostly in joint ventures, to $900 million, mostly in-house.”

In addition, AMB also has a dedicated staff looking at redevelopment opportunities within its portfolio, and that would include transforming a purely industrial development into something mixed-use with residential or office, Moghadam says.

“Our business always has been balanced between acquisitions and developments, but at certain points in the cycle one activity gets to be more significant than the other,” Moghadam says. “It is a tougher environment to buy properties today than it was four or five years ago. Therefore, we are doing more development than acquisitions, but we have not abandoned the acquisition business.”

REITs should have a good development strategy, says Sri Nagarajan, a senior analyst with RBC Capital Markets. “It is the only thing that can deliver more than 10 percent returns. However, you need to have some experience to make it work.”

However, Moore says that developments are riskier than acquisitions. “Not everyone can be a good developer. Mistakes can happen that will cause the company some trouble.” Some mishaps include zoning issues, environmental problems, construction workforce concerns and the inability to get equipment and products on time.

Ramping Up Acquisitions

The main advantage of acquisitions for REITs is that the properties coming into the portfolio are well-known commodities with recognizable histories of operating performance.

Comparatively, development is a riskier play. In development, not only can problems occur anywhere along the financing and construction continuum, but there is no sure thing when a new product hits a new market.

Today, individual property acquisitions can be expensive for REITs due to competition from other institutional firms that are financed with lower-cost capital, so one alternative is to purchase large portfolios or operating companies, where the cost can be spread over many individual properties.

However, there are a handful of REITs such as Simon Property Group, Inc. (NYSE: SPG) that can and have purchased other REITs despite the aggressiveness from private equity firms. In February, Simon Property teamed with Farallon Capital Management LLC to acquire The Mills Corporation. Also, SL Green Realty Corporation (NYSE: SLG) acquired Reckson Associates Realty Corporation last year.

Public REITs have operated at more conservative debt levels and they have been reluctant to lever up for acquisitions, which is a wise move. Paul Adornato BMO Capital Markets

In a contentious deal, Ventas (NYSE: VTR) concluded its buyout of Sunrise Senior Living Real Estate Investment Trust. “Ventas wanted to diversify its portfolio and saw a great opportunity in Sunrise,” says Paul Adornato, a senior analyst with BMO Capital Markets.

The REIT was attracted to Sunrise’s pipeline, and the acquisition strengthened the buying company’s ability to grow going forward.

“Public REITs have operated at more conservative debt levels and they have been reluctant to lever up for acquisitions, which is a wise move,” Adornato says.

Interim debt financing is still cheap. Presumably, a private equity firm can get good fixed-rate debt in the 5.5 percent to 6 percent range, which they can “lever up” 70 to 80 percent. “REITs traditionally have been at 50 percent leverage,” says Nagarajan. “That’s key. Investors are not accepting more than 50 percent to 60 percent leverage in REITs and they often have to issue debt or equity to finance deals. ”

According to several industry analysts, a well thought-out merger can boost the prospects for revenue growth in a number of different ways including diversification, bolstering a portfolio while eliminating a layer of management and adding experienced personnel. Additionally, if properties in the portfolio don’t fit the strategic plan, they can be divested thus helping to reduce the deal’s debt load.

Prospering Fund Management

Some REITs run a varied revenue-generating program, and there is one investment vehicle that is gaining popularity: fund creation and management.

The development of REIT joint ventures with financial institutions, and subsequently with investment funds, were designed primarily for REITs to have access to capital in order to make immediate decisions in regard to acquisition or development. For example, a portfolio of properties comes to market, and instead of searching for ways to finance a deal, capital has already been raised and immediately can be committed to the purchase.

By joining with other financial sources, REITs are able to share risk with other investors. Additionally, especially in regard to the creation of independent funds, REITs that manage funds create another source of income.

Right now, it looks like industrial and retail have been the most aggressive in going global, because they are following their customers. Louis Taylor Deutsche Banc

One of the newest participants in fund management is Regency Centers Corporation (NYSE: REG), which closed the first phase of Regency Partners LP, an open-end, infinite-life fund in January. The fund is expected to have a total capitalization of $1.2 billion when fully invested with approximately 60 percent leverage.

“The creation of the fund is an extension of a joint venture,” says Lisa Palmer, Regency’s senior vice president of capital markets. “However, there are several investors instead of just one.”

Fund management is not something every REIT can do. The market takes its time before conceding continuity of value in fund management income streams. Additionally, institutional capital is interested in better quality real estate so it strongly scrutinizes REIT skill sets. “The ability to build a fund management business is key because it is a different business than just managing real estate,” Crowe says.

Regency did its first joint venture back in 1999 with the Oregon’s Public Employees Retirement System (Oregon PERS) and has since done others with Macquarie CountryWide Trust and the California State Teachers Retirement System (CalSTRS). The efficacy of joint ventures can best be illustrated by the 2005 Regency and Macquarie CountryWide purchase of the CalPERS/First Washington portfolio, which consisted of 100 retail centers that had more than 12.8 million square feet.

Palmer says joint ventures and fund management work for Regency because of the extensive fees involved through property management, asset management and leasing commissions. “If you looked at our income statement for 2006, consolidated net operating income was $302 million, with NOI from joint ventures totaling $77 million.”

“Pension fund and other institutional investors will pay REITs a fee for acquiring, managing and developing real estate for them,” Crowe says. “That allows REITs to buy an asset on a 6 percent yield and through fees turn that into a 15 percent return on equity. It’s an attractive business model in this environment.”

International Affairs

However, what really separates some REITs from the rest of the pack is international exposure. Some REITs have gone overseas to follow their clientele as they expanded globally. For others, it was to find markets that were not fully valued. REITs that are active outside the United States are finding opportunities for investment, profitability and growth that are far greater than anything within the United States.

This has led to massive capital movements. For example, approximately 55 percent of AMB’s capital deployment sits outside the United States and much of that is through investment funds. “We have funds all over the globe except in Europe, but we are in the process of marketing a fund there,” Moghadam says. “We have one active vehicle in any region of the world at any given time.”

Simon Property has also become very active overseas and currently about 5 percent of its revenue and 5 percent of earnings before interest, taxes, depreciation and amortization (EBITDA) comes from operations in Asia and Europe. Those global projects are essentially joint ventures. For example, Simon property has teamed up with the Japanese company Mitsubishi Estate Co. Ltd., one of the largest real estate companies in the world.

“Right now, it looks like industrial and retail have been the most aggressive in going global, because they are following their customers,” says Louis Taylor, a senior real estate analyst for Deutsche Banc.

He says that some self-storage and apartment REITs have ventured overseas as well. “However, the pricing for multifamily units abroad doesn’t seem as attractive as developing in the United States.”

A Variegated Model

Companies like SL Green, Simon Property and AMB Property can be considered prototypes of the new era of REITs because they have employed and embellished the model of multifaceted revenue-generating streams, sponsoring and managing investment funds, operating internationally, working joint ventures, redeveloping existing properties or creating a new development scheme.

However, Adornato warns this model doesn’t work for everyone. “In some cases, REITs have gotten into trouble over the years as they have tried to expand their capabilities beyond their expertise. It depends on the skill set of management. This really has to be evaluated on a case-by-case basis.”

“The real estate company of the future is not just going to be a company that owns several properties,” Moore says. “That’s the real estate company of the past: collect assets and admire them. The company of the future is going to contain a strong management team that can take core competencies and extend them by going international, doing joint ventures and generating income fees.”