FOCUS ON REITS

WHAT IS A REIT?

REITs first came into existence in 1960 when President Eisenhower signed the real estate investment trust tax provisions into law. REITs were created to provide investors with the opportunity to participate in the benefits of ownership of larger-scale commercial real estate that were otherwise only available to those with significant resources. In essence a REIT serves like a mutual fund for real estate. As most REITs are public companies traded on a major stock exchange they provide their investors with liquidity and a steady stream of pass-through rental income. A REIT’s defining feature is that it must pay out 95% or more of its taxable income each year to its shareholders, which income is not taxable to the REIT, only to the shareholders.

REIT INDUSTRY OVERVIEW

Of the more than 250 REITs in existence fully 45% are retail oriented, with 60% of the retail REITs having a strip center asset base, one-third focused on regional malls, and only about 7% covering outlet centers. The remaining categories of REITs (in descending order of prominence) include residential (34%), healthcare (12%), office/industrial (10%), self storage (6%), triple net lease (4%) and hotels (2%). About 25% of the current number of REITs were created in 1993, 1994 and 1995.

RECENT HISTORY (1993-1995)

REITs are generally acknowledged to have gone through several historical cycles that largely mirror the real estate cycles in the last twenty years. The recession that hit real estate in the late 1980s contributed to the resurgence of the REIT market in 1993 and 1994. 1993 was a banner year witnessing 31 public offerings and over $7 billion in capital raised. The rise to prominence of REITs in 1993 is attributed to the combination of declining market values over the three to four preceding years, as a result of the disappearance of capital for real estate and the national recession, and declining costs of capital from lower interest rates that led to the highest acquisition investment spreads (300 to 500 basis points above the cost of capital) ever seen in many segments of real estate. Combined with the near elimination of new development in retail real estate in the early 1990s produced a boom market in REIT stock prices when REIT yields were offering a 250 to 300 basis point premium over one-year treasury yields.

1994 started out to easily outdistance 1993, but the fourth quarter saw the withdrawal of about one-half of the REIT public offering filings and the year ended with 36 new public REITs, with slightly in excess of $6 billion raised. Of the 1994 offerings fully a quarter, or nine, were retail REITs, and they raised slightly in excess of $2 billion, or about one-third of the total REIT financing for the year.

The largest retail REIT offering in 1994 was by the DeBartolo Realty Corp. which raised $560 million. The proceeds were used in the same fashion as most other retail REITs, to pay down mortgage debt, allow for expansion or renovation programs, commence new developments and add key personnel.

WHAT CAUSED THE RECENT SLOW-DOWN?

1995 has largely been acknowledged as the year that the REIT boom “hit the wall.” Higher interest rates normally are the enemy of REIT share prices, as historically, REIT shares have acted more as bond equivalents, falling in value as rates went up. And interest rates did start to go up after bottoming in late 1993 and early 1994. The Federal Reserve began driving up rates to slow down the economic recovery. The increases in interest rates in 1994 gradually eliminated the difference between REIT dividend yields and the return on “risk-free” investments, such as treasury bonds. The effect has been what has seemed to be an “overnight” end to the REIT phenomenon of the previous 24 months. Although the Fed has recently begun to slowly reduce rates again to attempt to implement an economic “soft landing” REITs seem to have lost their luster and Wall Street seems to have moved on to other “hot” issues. The movement of capital out of the REIT market has accelerated a drop in recent IPO share prices. Selling pressure has been aggravated by the public mutual funds that focus on REITs, which became “net sellers” in late 1994, liquidating their holdings and moving to heavier cash positions at that time.

WILL REITS RECOVER?

REITs presently own only about 1% of domestic income producing real estate, which is an extremely small portion in comparison to ownership by comparable entities overseas. For example, in European and Asian industrialized countries public real estate companies own between 5% and 30% of income producing properties. It seems very likely that when a more favorable interest rate environment returns that the securitization of real estate will continue. In the 1990’s real estate investors are looking for greater liquidity than is offered by traditional real estate investment vehicles. Real estate owners who can provide liquidity to investors through their REITs should continue to enjoy access to capital that other real estate owners do not. Most REIT industry followers believe that the REIT market will triple in total market capitalization (to over $150 billion) by the year 2000, with more retail REITs to be added to the current group.

Q. We are a closely held shopping center investment company that just merged with a similarly situated company in Arizona. Together the new entity owns 20 neighborhood and community centers with a market valuation of around $300 million and about 3 million square feet of gross leaseable space. Our net operating income is around $15 million. The portfolio is approximately 50% leveraged. Are we a good candidate for a REIT?

A. Yes. There are a number of factors that Wall Street underwriters will consider in determining whether a shopping center portfolio will be an attractive candidate for a REIT offering.

* Minimum Asset Base. Generally, to be considered a company must have a minimum asset base of $100 million. Once a REIT has assets of $100 million certain economies of scale are available. The REIT should be of sufficient size so that its overhead is no more than about five to ten percent of its total assets.

* Leverage. Debt before the offering is commenced should be at or above $100 million as well. In the REIT context substantial leverage before the offering is acceptable, because the offering will infuse new equity capital into the company to “deleverage” the portfolio and pay down debt. The goal after the offering is to accomplish as nearly as possible a debt free balance sheet.

* Long Term Ownership. The REIT’s inventory should be made up of shopping centers that have been owned by the company for a substantial period of time, at least several years. Although a portion of a REIT portfolio can consist of newly acquired properties this segment should be no more than about 20 percent of the overall asset base. And investment bankers will generally discourage the allocation of more than 10 percent of a proposed REIT offering to be used for new acquisitions.

* Good Track Record. The proposed REIT sponsor should have considerable experience with the property type to be included in the REIT. Perhaps the most frequently asked question is whether the sponor has a niche in which his company out performs others? The underwriters will want to know whether the sponsor is the dominant owner is the marketplace in question.

* Specific Portfolio Focus. The portfolio should have a specific geographic and property type of focus. Because of a need for strong management a diversified geographic base and mix of properties is not considered desireable. Thus while a REIT that concentrates in Southern California community and power centers will be well received one that has properties on both coasts that consists of regional malls, outlet centers and strip and community centers may appear less desireable.

* Net Operating Income/Cash Flow. Since REIT stocks generally trade as a multiple of their dividends the properties owned by the REIT must have a strong net operating income that will sustain the anticipated dividend payments. In new REIT offerings, the expectations are for a 7.5% to 9% current return, plus an opportunity for five percent growth through capital gains. The return required varies with property type. Regional mall REITs are considered to represent a lower risk than strip centers and therefore command a lower yield or dividend. Typical recent yields for regional mall REITs were in the 7-8 percent range while strip center REITs were yielding 9-12 percent.

* Conflicts of Interest. The REIT must become the focal point of management’s activities after the offering. Critical to the REIT’s perception as a going concern is the length of tenure of management with the company. Underwriters may insist on at least three to five year employment contracts for the key principals. Additionally, the principals should own between five and 25 percent of the REIT’s stock. The sponsor’s interests and the REIT’s interests should be identical. Outside activities should be minimized.

* Willingness of Management to Endure Public Scrutiny. Of all the factors necessary for a REIT to go public this is perhaps the most intangible, but one that is absolutely essential. Management must be prepared to act as a public company and work with the Securities and Exchange Commission and the periodic reporting requirements of the 1934 Securities Exchange Act and the additional reporting requirements of either the New York or American Stock Exchanges or the NASDAQ.

David M. Griffith is a real estate and business attorney with offices in Long Beach. He serves as legal counsel to California Centers Magazine. For more information please contact 310/983-8017.