A case for a turnaround in this struggling sector
In December, investment guru Warren Buffett auctioned off his wallet for charity. It drew $210,000 – not so much for the leather as the content: a secret stock tip. That pick was for a real estate investment trust (Reit) called First Industrial, and the news set the whole industry ablaze. The Morgan Stanley Reit Index rose almost 4 percent that day. Over the next month Reit stocks continued to rise more than 12 percent, and their IROs began to think their long-awaited recovery had arrived.
The recent activity not only shows how a cult of personality can sway the market, but also just how much investors in the US like Reit stocks once they notice them. And what is there not to like? Strong fundamentals, double-digit dividends, steadily appreciating assets, record-low vacancies... The investment characteristics don't get any better than this.
Or do they? Despite all the activity, the average Reit is still trading at a 20 percent discount to its net asset value. Prime real estate has become expensive everywhere except on Wall Street.
Buffet's stunt succeeded, however, in drawing attention to the industry. And as any real estate IRO will tell you, there's no bigger challenge than getting the market's attention.
Rollercoaster ride
The recent history of Reits has been a roller coaster ride. From 1990 to 1997 the sector's market capitalization rose from $8.7 bn to $140 bn. Then it took a sharp turn downward. The credit crunch, unfavorable legislation and the threat of rising interest rates all played their part. Mostly, though, investors pulled funding to reinvest in the technology sectors. In 1998 and 1999 real estate stocks fell 33 percent.
Jeffrey Caira, senior Reit analyst at Boston fund manager Tucker Anthony, believes that until then, investors had been buying Reits for the wrong reasons. 'Reits were being touted as growth vehicles. I don't believe they were, are or ever will be growth vehicles,' he says. 'There had been periods of time when they took advantage of inefficiencies in the pricing of real estate and exhibited, relatively speaking, strong growth. But by the beginning of 1998 they had reached a level that was unsustainable.'
Ironically, the last two years also mark the time of highest efficiency among real estate companies. As IROs ploddingly explain, the industry's downward spiral belies its strong operations. 'When you feel good about what's going on at the company level and you're trying to reasonably convey that message to your shareholders, it's definitely a challenge,' admits Spieker Properties' IR coordinator, Karen Morris. 'They see the stock price slipping away day by day, and they see the returns their friends or co-workers have received in some of the sexier stories, and they wonder whether they've made a smart investment in a Reit.'
Compared to technology, there's nothing sexy about real estate. 'You buy a building, you lease it up on a long-term basis and you collect the rent. It's a long, slow process,' says Boston Properties' director of IR, Elaine Quinlan. 'Our investors need to be much more patient than those investing in the tech sectors.' She reminds her shareholders that the industry as a whole, not the company's own performance, has held their stock back; and that tech stocks' dividends can't compete with Reits.
This is the perennial selling point for US Reits, which are exempt from corporate taxes, provided they pay out 90 percent of profits in dividends. However the traditional audience for income stocks has declined as investors have fled in search of growth. Real estate IROs know they must combine high yield with high visibility and actively target new investors.
Caira suggests real estate companies should seek more retail owners. He says that as individual investors grow more active in the markets, they will play an increasingly important role in the sector. They are the perfect candidates for a value and income stock. And, as the baby boomers approach retirement, they will need to find good yield-producing investments. 'I would argue that a retail investor is an important target for Reits, whether that's through a mutual fund or directly,' he assesses.
Melissa Marsden, vice president of IR at Prologis Trust, concurs. 'We've become much more active in our meeting schedule, our targeting, our approach to attracting retail investors. We've modified our dividend reinvestment plan, added some features like direct stock purchase, and a host of activities to try and increase visibility.'
Convincing the retail investor, however, may not be easy. For starters, there's FFO, or funds from operation, issue. FFO is the standard gauge of Reit performance. While most retail investors understand earnings per share, few know – much less understand – FFO. 'Usually a Reit will pay a dividend that is actually higher than its earnings per share,' explains Elaine Quinlan, 'and a lot of retail investors think, How can you continue to pay out a dividend that's higher than your net income? They don't really understand that dividend comes out of cash flow. FFO is a measure of that cash flow.'
Even if they get past this issue, retail investors tend not to see the bright side of Reits. They see no brand recognition, no clear industry leader, no recent strong performance. There isn't even an industry consensus of what business model to uphold. The issues are not black and white, although IROs may be tempted to simplify matters for the sake of retail investors.
Sheila Stoltz, vice president of Cohen & Steers Capital Management, cautions companies against overselling themselves or making claims they cannot keep. 'We'd prefer Reit management to just stay the course and try to work as efficiently in a down cycle as possible,' she advises. Simplifying matters to lure investors may work in the short-term, but will inevitably get complicated as the industry continues to change.
Accelerated change
The European real estate markets are also undergoing accelerated change. As the euro raises the transparency level from region to region, institutions are making more cross-border real estate deals. Until now Reits have not existed in Europe, though the emergence of pan-European indirect property investments may create entities similar to Reits.
According to Workplace Group's director of finance, Mark Taylor, real estate companies will need to be nimble if they want to capitalize on cross-border operations. 'The favorite companies in the last couple of years have been the smaller ones. They have been regarded as more fleet of foot and able to respond to changes in markets.' He says if companies want to maintain support during times of change, they need to have a continuous flow of communication with investors. 'The ones that have been successful are the ones that have been good at communicating.'
Dexterity is one model for pan-European success, but many companies are banking on economies of scale. Australia's juggernaut Lend Lease Corporation, for instance, has done well in recent years. As well as real estate, equity investment and property development, it deals in a number of non-real estate products and services like life insurance and fund management. This type of large, multi-faceted company will undoubtedly become more prevalent if the industry continues to consolidate.
Meanwhile, European businesses are relocating their operations. Melissa Marsden, whose company Prologis Trust designs distribution facilities, says this movement has created high demands in the real estate market. 'With the economic union and a single common currency, we're seeing a significant reconfiguration of the distribution networks,' she reports. 'Instead of a company having nine distribution facilities in nine different countries, it can consolidate its distribution network into three regions and serve all areas optimally without having a physical location in each.' This phenomenon is taking place all over the world, she says, although the effects are most pronounced in Europe.
The global real estate markets represent great diversity for investors. Australia, Germany and France all have markets of low risk and steady returns. In Asia, economic recovery means the prospect of higher returns. While transparency of information in Asia remains low, this can create a great deal of investment opportunity. Hong Kong, in particular, is popular among high-risk/high-return real estate investors. As one global analyst summarizes, 'Europe is for investors; Asia is for cowboys.'
Strategic alliances
While some companies are rewiring old buildings to meet new technological needs, many have realized they can boost value by aligning themselves with service providers. Diane Morefield, senior vice president of investor relations at Equity Office Properties, explains the advantage: 'We have alliances with a number of telecom companies that come in, wire the backbone of our buildings, and give our tenants access to better services.' Most of Equity Office Properties' tenants are too small to get reduced rates on their own. The Reit purchases services in building-sized blocks and passes the savings on to its tenants.
Real estate companies are also aligning themselves with utilities, internet providers, and any other partners who can add to the value of their operations. The US Congress recently passed its Reit Modernization Act, which will encourage these partnerships. Meanwhile, the larger Reits are distinguishing themselves as diversified utility management companies, ultimately selling more services and fewer bricks.
One trend that applies to all markets is that real estate companies are becoming more information-oriented. Gone are the days when they could simply put up a building and post a For Rent sign on it. The markets today are demanding more research, more consultation, more number-crunching and more identification of customer needs. Real estate companies are becoming data management companies. And IROs are expected to have the numbers at their fingertips.
'For IR in any company, getting the message across is important. And understanding your markets is very important. You can't actually be successful if you can't understand them,' Workspace Group's Mark Taylor stresses. 'Most investors are pretty sophisticated nowadays and if they see that you don't really understand your markets, you're going to get rated accordingly.'
Companies are moving towards the model of a one-stop shop for real estate solutions. They will identify the clients' needs, determine the best location, construct the building, wire it to specification and provide bargain rates on utilities. They have to be aware of the megatrends that affect their clients' businesses and provide the services to help them compete in the global economy. Real estate companies are becoming strategic partners for clients and investors alike.
'We think of Reits as being more of a tax-advantaged business structure, as opposed to an industry,' Melissa Marsden explains. 'We think of ourselves as more of a logistics company and a provider of distribution facilities and services. As our service income grows, we think that is a distinction that will be easier for non-Reit investors to grasp.'
Cyclical rotation
Another important aspect of the industry is that it operates on a cyclical basis. Real estate fell in and out of favor in the 1990s just as surely as it will fall back in again sometime this decade. 'I think that for a long-term investor, Reits should continue to be appealing,' Jeffrey Caira predicts. 'If there is any kind of correction in the internet appeal, then there will be a return to the relative stability and safety of the Reits that regularly crank out income and distribute it in the form of dividends.'
The question is, when will the cycle turn back the Reits' way? Diane Morefield seems to think the switch has already begun. 'I think there has been a change in sentiment this year. Both retail investors and large institutional funds are worried about the over-valuations on the Nasdaq. People are looking for more balance in their portfolios and more stable stocks with good growth prospects.'
And what will IROs do in the meantime? According to Elaine Quinlan, they'll do what they have been doing all along – concentrating on telling their story. 'I think it may take a long time for the market to come around,' she confesses, 'but the only thing to do is just keep plugging away.'
During the last few months there has been an atmosphere of hope evident in the real estate industry. This may be the start of an upswing after all. Market indicators are starting to look more favorable. And, of course, having the support of Warren Buffett's wallet doesn't do any harm either.