Real Estate Inv. Trusts: REITs
Bluest of the Blue Chips

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By Reitnut
February 11, 2010

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Commercial real estate is cyclical - with respect to both space markets and pricing. However, this asset class has always offered solid, conservative, income-based returns, if bought and held with no (or only modest amounts of) debt leverage. Investors have historically been able to get average annual total returns of approximately 9% (or real returns of approximately 6%), with only modest risk, over an entire real estate cycle.

REITs are securitized commercial real estate, "plus." The "plus" consists of a management team that, over time, is able to create an incremental amount of added value for shareholders via acquisitions, developments and even joint ventures that generate fee income. Conservative REIT investors do not view REITs as growth companies; they expect moderate risk-adjusted returns that consist, largely, of a stable and slowly-growing dividend, plus a modest component of capital appreciation via value creation, increasing real estate values, and intelligent deployment of modest retained earnings.

What, specifically, do conservative investors look for? I don't know, but I can guess: Good management teams that know how to allocate precious capital wisely and conservatively, and how the restrictions of the REIT format limit external growth. Stable dividends, increasing at least in line with inflation. The REIT's properties should be in good long-term locations, well-managed and kept in good shape. They may be looking for some value-add, via the methods briefly summarized above, but they don't want the management to take on undue risk.

They also should want a conservative balance sheet, with debt in modest amounts, well covered by free cash flow, and with carefully laddered maturities. Similarly, they should want their REITs to manage the balance sheet so that it always - or almost always - has access to debt and equity capital when advantageous, at reasonable cost. And, of course, good governance, with management having lots of "skin in the game."

In short, conservative REIT investors should be looking for safe dividend yields, plus 3-4% average annual cash flow growth from rising NOI, value creation, and reinvestment of retained earnings. They would normally want to recommend the same REIT stocks they own to their moms and their grandmothers.

What should they NOT look for? They shouldn't expect to shoot the lights out; there are plenty of other investments that offer double-digit return prospects. They don't want the management teams to take the risks inherent in business strategies that "promise" to generate 8-10% growth rates. And they don't want to run the risk of a company failure via a risky balance sheet, e.g., General Growth.

I therefore, personally, define a "Blue Chip REIT" as having five of the following six attributes (not in any particular order):

1. Strong management team that routinely creates a modest amount of value via the exercise of its own particular expertise, without taking excessive risk.

2. Sound balance sheet, strong capital allocation skills, and access to capital

3. Conservative dividend policy, sustainable except in the event of a 100-year flood

4. Owning good properties in stable markets, and well-leased

5. Business strategy consistent with the ability to deliver 7-8% total returns with modest risk

6. Good governance, good disclosure, and concern for the shareholders

I have not included a 5- or 10-year stock performance track record in this criteria. I understand that others will want to do so; however, it seems to me that there are so many variables that will impact such performance that its value for determining a "blue chip" REIT is marginal. Nonetheless, I think it's justifiable to add this to the mix. I question only its weighting.

Unfortunately, many (perhaps even most) of these criteria are at least somewhat subjective, and one man's Blue Chip will be another's sleepy dullard. There is no Pope or Grand Poobah who, in his or her infinite wisdom, can legitimately confer Bluechiphood on a REIT - so the anointment process is very messy. Furthermore, sometimes a REIT will lose its way, while another will ascend to higher levels of respect. The process continually changes and evolves.

As for the "Bluest of the Blue," I am not sure how this designation came into being. But so be it. I will assume, for purposes of this post, that "Bluest of the Blue" means, simply, a Blue Chip REIT exalted to a higher level.

Before I begin to judge this beauty contest, I will note that many erstwhile Blue Chip REITs have been caught swimming naked during the Great Economic Tsunami, and I believe that naked ladies, whatever the interest in their attributes, normally don't win beauty contests. Thus I believe our list of Blue Chips (and Bluest of the Blue) should be whittled down in quantity this year.

OK, here are my REIT-specific thoughts. Caveat: Reasonable minds will surely differ. And, I am making the assumption that stock pricing is NOT one of the criteria.

AVB: Still a B of B. Strong balance sheet helped it to avoid selling stock near the March lows. Still the best balance sheet in the sector. Same strong management team, with the best development skills. No major errors during the Tsunami.
EQR: A blue chip, but why a B of B rating? Is this REIT that good? I am willing to be convinced.
HME & UDR: Why are they blue chips? What have they done to deserve it? I am willing to listen to a good argument.

ELS: No suggested changes. Low leverage has helped. Tortoises often win races.

FRT & SKT: The past year has shown why they deserve their B of B ratings. Sure, there cash flow growth has ceased, but they are in great shape. Splendid balance sheets, and able to acquire if opportunities arise.
KIM & REG: Should they be demoted just one notch, or kicked out of the Blue Chip family? I could go either way. Both used aggressive business strategies that bit us all in the butts - hard. But the management teams remain solid, and both have de-levered quickly. Both own quality assets in good locations, and have dropped their dividends to sustainable levels. They are both pursuing more conservative business strategies going forward. I still own ‘em both, but more of their pfds than their commons.
AKR: Blue chip. OK. But I don't follow this company.
WRI: Blue chip? Why? Management is very experienced and capable, but they were late to the development game and had balance sheet issues. A reasonably good company, but not sure Blue Chip. I would love to be convinced.

SPG: They cut the dividend out of an abundance of precaution, and de-levered hard and quickly. The dominant US mall owner. The management team is top-notch. They are loaded for bear. If they buy GGP, they will do it on attractive terms. Still a B of B, in my opinion.
TCO: Still a blue chip. No reason to change its ranking.
MAC: I have always liked this local So. California mall REIT. But they found themselves with too much debt leverage, and some uncomfortable near-term debt maturities. I never doubted their survival but, because others did, a dire future could have become a self-fulfilling prophecy. But they are a survivor, thanks in part to the reputation they have developed with private institutional investors who bought some of their assets to help them to de-lever. MAC meets 5 of my 6 criteria, and I would vote to keep them as a blue chip. I realize, however, that this judgment may be controversial.

BXP: Like Simon, they cut the dividend. But in all other respects they are as fine a REIT organization as exists anywhere. Great properties, great management team, excellent balance sheet, capable of creating value without taking on undue risk. I continue to regard them as B of B.
OFC: I don't follow this company closely enough to add anything to the discussion.
SLG: Too aggressive a balance sheet, too aggressive a business strategy. They sold stock late, and haven't delevered enough. Dividend was slashed very hard. Good properties and a smart management team don't offset these negatives. I'd have to vote to drop SLG from the Blue Chip list. If this happens, I am confident that, like the Terminator, it will return.

AMB: Still a Blue Chip despite a large dividend cut. They had an aggressive business strategy, but it was working well until the Tsunami. They were one of the first to raise equity, an industry leader. They still have great relationships with JV partners, and a fine management team. They still know how to create value.

DLR: The company is doing well, their stock performance has been excellent, and they've been raising the dividend. This is a niche company, going where no office REIT has gone before. I do hope that their product doesn't become obsolete. They've managed the balance sheet well. Certainly it's a Blue Chip, but I believe their aggressive business strategy disqualifies it for B of B.
DRE: Can someone remind me of why this company is a Blue Chip, let alone a B of B?
PSB: Blue chip. OK, no issues with that, but I don't follow the company.

PSA: B of B, no need for any discussion. They have reminded us why debt leverage can be a dangerous toy to play with. Ron Havener is one of the most under-rated CEOs in the business. I just wish they'd be a bit more liberal with the dividend.

HC & NL:
It is odd that we have 5 B of Bs in this space, which doesn't make much sense to me. OK, these companies have held up well, but they should, given their sector. Many of you will disagree, but I propose that we keep all five as Blue Chips, but confer B of B-hood on only two of them:
NHP & VTR: Both have very strong balance sheets, and have allocated capital conservatively and wisely. OK, VTR screwed up (short-term, anyway) by buying the Sunrise assets and choosing to manage them, but other than that their capital allocation skills have been awesome. NHP's management is conservative and smart; they handled the problems with Hearthstone and PMI very well. They underpromise and outperform. They are a leader in disclosure in this sector. As for VTR, well, leadership doesn't get any better than Debbie Cafaro. Both of these should be B of Bs.
HCP & HCN: A cut below the above two. HCN's balance sheet is excellent, and HCP has very good tenants and is well-diversified. But why did it interfere in VTR's acquisition of Sunrise? HCP's business strategy is just a tad too aggressive for election as a B of B, IMO. HCN has a huge development pipeline that may not deliver adequate returns, and its MOB portfolio is not performing well. Blue Chip? Yes. B of B? No.

O: OK, some investors love the Big O. I have lots of respect for management, but can someone remind me of why it's a blue chip besides its steady dividend? Is it creating value for shareholders? I am agnostic on this one, but would love to be convinced.

Last year CUZ, VNO and WRE were all anointed not only as Blue Chips, but also as B of Bs! Say what? I wouldn't give B of B-hood to any of them. VNO and WRE should be cut to merely Blue Chips, as I don't know what they are doing to merit a higher rating than that. As for CUZ, well, suffice it to say that their business strategy has always been very aggressive, and they didn't know when to rein it in. They have been overpaying the dividend for years, before slashing it, and they've been playing Musical Chairs with respect to the management team. Heck, I'm even afraid to own their pfds.

Sorry this post has been so long. Hope I haven't bored you to death. All the foregoing, of course, is just one guy's opinion. I have been wrong many times, and surely will be wrong again.