Real Estate & REITs
REITWEEK: September 5, 2003

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By Reitnut
September 9, 2003

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September 5, 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. "What, Me Worry?"

Although REIT stocks continue to rock 'n' roll like Jerry Lee Lewis (alas! � I am old enough to remember him), their rally having left us "Breathless," this hasn't been due to any significant new news. Indeed, although investors' love affair with REIT stocks is as ardent as ever, there has been no announcement or "big event" in Reitland to fan the fires. But when you're hot, you're hot; that's all there is to it. Nevertheless, like most anal-ists, I like to look for explanations under every tree � if not goblins under every bed � and will be happy to again regale you with my half-baked theories on the continuing strength in REIT shares shortly (that is, if you remain awake long enough to get to it).

There being few "hot topics" in Reitland to bandy about (assuming anything in our world can be said to be even mildly exciting), let's go and find Reitnut and see if he has anything interesting to say. We'd rather talk with Sammy, of course, but at the moment that fuzzy creature is very engrossed in a new Nylabone so we'll have to settle for the much-less-interesting Reitnut.

Me: Reitnut, let's first talk about the almost embarrassingly strong performance of REIT shares this year. The Morgan Stanley REIT index (RMS) is hitting all-time highs almost every day, and so far this year, according to NAREIT, the average equity REIT has delivered a stunning 23.6% total return, less a bit of giveback today. And yet, while the economic statistics are looking a bit stronger, we still see no signs of job growth, while the consumer confidence indices are looking as tired as a Law & Order re-run. And the "misery index" is, according to perma-bear Jesse Eisinger of the WSJ, at levels consistent with eves of recessions. So, to paraphrase another astute inquirer, "Why is this man smiling?" Are we all a bunch of modern day Alfred E. Newmans?

Reitnut: There is no doubt that the REIT bulls are struggling to find a logical explanation for the continuing strength in REIT shares at current prices, and many analysts have given up trying to help them do so. But that's an old story. REIT equities have been impervious to everything this year, including tech stock bull markets, tax legislation "discrimination," weak real estate fundamentals, a spate of secondary offerings, dividend coverage issues, high valuations (at least relative to historical norms), rising long-term interest rates, queasy bond markets, trash-talking in the popular press (and among some sell-siders), hurricanes and locusts. What we have here is an Immovable Object (historical high REIT stock valuations) vs. an Irresistible Force (strong fund flows pouring into real estate � both private and securitized � which are, for the moment, unrelenting).

Me: But why are funds flowing into real estate assets? The stock market isn't on its deathbed any longer and is providing tough competition for REITs and real estate; indeed, the S&P 500 index is up 16.8% through yesterday, while the NAZ is hotter than an Iraqi summer � scoring a 39.9% return through September 4. Indeed, for the past year, the RMS has been tracking so closely with the S&P that one would think that they were "Twins" � like Danny DeVito and Arnold Schwarzenegger. Check out the following chart:

[Chart omitted but available from YahooFinance]

When do REIT shares begin to non-correlate with other asset classes, as is their wont, and when will investors look for greener pastures outside of Reitville? When will the high valuations cause a meaningful correction in the REIT market?

Reitnut: Well, if we could answer those questions we wouldn't be standing here scratching ourselves, would we? All I can tell you is that there are lots of investors out there who have learned that (a) dividend yields (or recurring distributions from cash flows) do matter, (b) stability and predictability of cash flows is a Good Thing, (c) portfolio diversification is also a Good Thing, and (d) commercial real estate is often a good � and very competitive � investment during periods of slow economic growth and low interest rates. Today's investors are accepting lower prospective returns, but they seem to be happy with that. Who can say they are wrong?

This favorable trend towards increasing allocations to real estate assets, private or securitized, could last for another ten years or another 10 minutes, but my guess is that it has legs. That's not to say, of course, that today's relatively high valuations (vs. historical norms) won't cause periodic sell-offs. They can and will occur. In any event, while I always try to understand the human psyche due to its extreme importance to investors, I lost confidence in my oracular abilities the day I realized that many people really and truly do like Rap "music." Despite the valiant efforts of Freud, Jung and others much smarter than me, the human psyche remains unfathomable, and the only way to avoid being clobbered by its fickleness is to invest with a very long-term time horizon. Personally, I am not selling any REIT shares, and will accept corrections in the REIT market gracefully. God knows, I have a hefty capital gains cushion to work with.

2. Governance: Green Street's Valiant Effort.

Me: Green Street Advisors recently published a report in which they discussed the importance of Corporate Governance for REIT stock valuations. They covered several areas, including conduct and structure of the Board of Directors, the ability to use various devices to prevent a sale of the company (which Green Street cleverly refers to as "Weapons of Mass Entrenchment") and that old bugaboo, conflicts of interest. The firm ranked each of the REITs they follow on several sub-categories within each major topic, based on their experience with each of these REITs and a thorough review of 10-Ks, proxy statements and other disclosure documents. What do you make of their effort? Can we use any of this stuff as a valuation tool for REIT stocks?

Reitnut: This topic is broad enough to write a book about, but don't ask me to volunteer. However, let me express a few opinions, for what they're worth. Green Street did a very admirable job in looking at all the major issues of Corporate Governance, and assessing how the various REITs stack up within those topics. For example, each REIT was rated on the following: Percentage of truly independent directors (or at least as independent as can reasonably be determined), whether the REIT has a staggered board (which can make takeovers much more difficult), whether the board members have significant investments in the company and whether board compensation is mostly in stock or cash, raw insider stock ownership and the board's past conduct and reputation.

Each REIT was also rated on its use of such "weapons of mass entrenchment" as state-enabled anti-takeover provisions, whether the REIT has taken unjustifiable advantage of the REIT industry's "5 or fewer" rule, whether designated minority shareholders have special voting or veto powers and whether poison pills are in place. Finally, Green Street rates each REIT on the basis of two forms of conflict of interest: the extent of any business relationships between the REIT and its directors and/or executive officers, and whether there is a difference in tax basis between the public shareholders and the directors and management team with respect to the ownership of REIT equity.

The project makes for very interesting reading, and the great majority of REITs was given a "Fail" grade. But before we crawl into a corner and eat worms, Green Street also acknowledged "these grades are probably no worse than what would be found across a wider spectrum of Corporate America." Indeed, I spent 26 years of my life as a corporate lawyer, and can bear witness to the difficulties that even truly independent directors encounter when asked to make tough corporate decisions. Certainly there is room for improvement everywhere on Corporate Governance issues, both within and without the REIT world, and it does appear that most REITs are moving in the right direction. The next proxy season will be interesting.

Me: But, Reitnut, can we use this information to make any money � or avoid losing any?

Reitnut: Well, maybe. First of all, Green Street hasn't yet figured out how to incorporate their governance rankings within their valuation models. But, even when/if they do, this topic is so squishy and unquantifiable that it would be very difficult to figure out whether there has been any correlation between strong corporate governance and good stock performance. My intuition tells me that, all else being equal, investors will pay higher prices for the shares of companies that have (a) strong and independent boards, (b) a willingness to listen to shareholders' views with respect to major potential transactions, including a sale of the company, and (c) an alignment of interest between management, board members and outside shareholders. However, it is very difficult to quantify some of these issues.

Look, corporations are not democracies where all major issues are submitted to the "voters." Boards pretty much do as they please; with a few exceptions, shareholders generally have to accept board decisions or "vote with their feet" by selling their shares. Perhaps we can compare corporations to petty (or large) tyrannies, which govern their constituents as they, in their infinite wisdom, think best; we constituents are free to leave and go dwell in another country (and can become residents in many countries), but we won't be able to recall our "governor," as the proud (and oft-silly) residents of California are about to do.

I think, too, that the importance of governance issues varies with the REIT management's ability to create (or tendency to destroy) value for the shareholders, as well as the price at which the stock is trading relative to underlying asset value. I doubt that anyone will be making a hostile offer for Boston Properties or Chelsea, so perhaps those companies' lack of a staggered board shouldn't be as important as it might be for a Chateau or a Crescent.

The bottom line, of course, is that we want to invest in REITs that have truly independent boards which have the best interests of all the shareholders in mind at all times (even though they won't ask our opinion on whether or not to boost the dividend, leverage the balance sheet, buy or sell assets or develop new properties). We want these independent boards to allow us shareholders to vote upon any rational proposal to buy the company even if the offer is less-than-Mafiosan, e.g., Hometown America's recent bid for Chateau or Rodamco's proposal to Urban about three years ago, and to place in proper perspective the personal desires of the management team. We shareholders can be trusted to factor in the long-term total return potential of the REIT's shares and, in many cases, may not want to accept a buyout offer even at a premiums price. But that should be our choice. And we want to own companies where the conflicts of interest are few or, even better, non-existent.

But will we own a REIT in which most of the board is composed of golfing buddies? Or where the CEO and CFO hold OP units with a much lower cost basis than that of the shareholders? Or a REIT that has staggered terms for its directors? Of course we will. But all else equal (which it never is), I would rather own shares in AMB or EOP than in RA or TCO, and I would be willing to pay a somewhat higher valuation for the former. In the final analysis, however, there is no substitute for knowing � and having confidence in � the management team (and the Board) of the REITs in which we invest. After all, we REIT investors are not buying individual properties; we are buying active real estate businesses that finance their projects with public money. There's a big difference.

3. Acqua Alta.

Me: Although we just scratched the surface of that topic, let's move on. The accepted wisdom among real estate professionals, as well as REIT investors, is that rising interest rates will bring, in their wake, higher cap rates and lower prices for real estate, and the rising cap rate tide can be stanched no more effectively than Venice's Acqua Alta. The negative effects of this happenstance will overwhelm improving real estate net operating income and thus lead to declining NAVs � as well as, perhaps, weaker REIT stock prices. We know that interest rates are a key determinant of cap rates, and that cap rates have been driven down to extremely low levels by Mr. Greenspan's fear of deflation and an economy that's been as sick as a freshman after his first Toga party. So why are the public markets ignoring a prospective increase in cap rates and inevitable decline in real estate values? Is A.E. Newman making another public appearance?

Reitnut: Let's think about this for a few minutes before we blindly accept "conventional wisdom." When we study non-REIT stocks, we observe that the shares of the same company can trade at very different P/E multiples over time, and that different companies within the same industry will also trade at different multiples of net income. What causes a stock to trade at a high (or low) multiple, relative to its historical range, or in relationship to its peers?

The answer, I think, is a combination of things, the most important of which are prevailing interest rate levels (the lower they are, the higher the multiple), growth prospects (a higher multiple is awarded for better prospects) and perceived risk (all else being equal, we're not prepared to pay a high multiple for a riskier stock � no matter how we define "risk"). These principles also might apply in the private real estate markets, as well as in Reitland.

We should be willing to pay a higher multiple of AFFO when interest rates are low, when the perceived growth rate is relatively good and when risk is modest. Today's average REIT industry P/AFFO ratio is higher than normal, as interest rates are low. But, in addition, Chelsea may trade at a higher multiple than Tanger due to the former's perceived higher growth rate (as well as the lower cap rates applicable to its assets). And maybe Aimco trades at a lower multiple than Gables because of differing perceived risk levels, including more balance sheet leverage and less stable income streams at the former. Certainly most of us understand that a REIT with lower debt leverage justifies a higher trading multiple, all else being equal.

So let's take this a step further. What will happen to private market cap rates as interest rates move higher? Will they rise, as most of us expect? But wait. If rising interest rates are accompanied by a stronger economy, better job growth and more demand for space, wouldn't this bolster the prospects for a property's NOI growth? Perhaps even more important, wouldn't this impact buyers' perceived risk levels by reducing the likelihood of increasing vacancy rates, persistent concessions, obscene tenant improvement allowances and sliding market rents? And won't these improved long-term growth prospects and reduced risk levels put upward pressure on cash flow multiples (or downward pressure on real estate cap rates), overpowering the upward cap rate thrust caused by higher interest rates?

We might recall that San Francisco Bay area office buildings traded at very high cap rates (low multiples of current cash flow) at the peak of the market in 2000. According to a Green Street report dated August 18, 2000, "Private market buyers of recently leased buildings in the Bay Area are getting double-digit initial yields on their investments, indicating that expectations for future rent growth and appreciation are quite low." I needn't remind anyone that mid-2000 marked the peak of the late real estate cycle. Isn't it therefore possible that, just as buyers demanded very high cap rates on commercial real estate purchases at the top of the cycle, they might be willing to settle for even lower cap rates tomorrow than they are today, assuming a bottoming in the current real estate cycle? Investors will be facing fewer risks and enjoying better growth prospects, while interest rates � though rising � are still relatively low.

Today's low spreads on REIT debt support the lower cap rate argument, i.e., "Look, Ma, low risk!" Finally, cap rates haven't come down as much as interest rates during the past couple of years, so the effects of rising interest rates on real estate prices may be offset � or more than offset � by the positive impact provided by recovering real estate markets.

Me: You are insane, Reitnut. You are suggesting that cap rates could decline even further! Should that happen, properties would be priced well above replacement cost and bring about a new wave of development � which, in turn, would reverse the property appreciation spiral.

Reitnut: Sure, that could happen. However, rising interest rates will make new construction more expensive, and substantial pre-leasing would still be required for most property types. And pre-leasing may be very hard to attain, even assuming a modest economic recovery; tenants are still Scrooges when it comes to signing up for more space. If the profit margins on developments narrow � which could happen despite falling cap rates � we may not see lots of new developments, given what will remain a higher than normal level of tenant and interest rate risk for developers.

Me: You're missing another important point, Reitnut. We know that a substantial reason for today's low cap rates is the existence of levered buyers, who are willing to finance 75% or more of their real estate acquisitions at sub-6% interest rates. When short-term rates move back up, so will cap rates.

Reitnut: This is certainly possible � or probable. I am placing no bets on firm (or lower) cap rates. However, we should allow for the possibility that the securitized real estate markets, by pricing REIT shares at today's levels, may be discounting even lower cap rates in the private markets, resulting from higher growth prospects and reduced risk in our nation's real estate markets. If so, the cap rates being used today by analysts in estimating NAVs are too high. Even a 50-75 basis point reduction in cap rates across the board could eliminate most of today's 12-15% average NAV premium. I'm not betting that will happen...but we should all be very humble when attempting to forecast interest rates, GDP growth rates, dollar exchange rates � and real estate cap rates.

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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