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Building values take into account all buildings, whether or not they changed hands. The slowing increases in values suggest that while office and apartment fundamentals are improving, they aren't rising as fast as prices have -- or as much as buyers expected. The slower appreciation indicates "investors may be wary of the economy's ability to sustain the ongoing recovery in the real-estate space markets and [concerned] that higher interest rates may push up capitalization rates," says Lloyd Lynford, chief executive of Reis. Investors proved especially willing to pay substantial premiums over value for office buildings. They paid a premium of 25.8% in Q1, the highest premium since the index started in 2003, compared with 23.4% in Q4. The average price paid for an office building was $177.31 a square foot in Q1, compared with $170.98 in Q4, according to Reis. That is the highest average price since Reis started its value index in the first quarter of 2003. Still, office-building values rose more slowly during Q1, as NOI lagged. Rents collected by landlords have fallen 47% since peaking in 2000, to $15.42 a foot in 2004 from $28.92, according to tenant representative firm Studley's Effective Rent Index. "The interesting thing for office is you've seen the values rising but if you look at different markets, you see net operating incomes falling," says Raymond G. Torto, principal and chief strategist of Wheaton Research. Mr. Torto says net operating incomes are falling in office buildings in markets such as Chicago, New York and San Francisco. "That's reflective of the fact they had big run-ups in rents five or six years ago, and those leases are rolling over and rolling down to market rents today," he says. Investors appeared less exuberant about apartment properties. The average price paid for an apartment was $88,759 a unit, down from $91,222 a unit in Q4. Apartment buyers paid a premium over value of 22.1%, down from a premium of 26.5% in Q4. Cap rates for office buildings remained flat at 7.5% while cap rates for apartment properties fell 20 basis points to an average of 6.4% in Q1, according to Reis. "Even though we're seeing recovery in occupancy in rents in office and apartments, it is slow to modest at best so therefore prices are going up faster than the operations are improving and that compresses cap rates," says Hessam Nadji, managing director, research services, with Marcus & Millichap Real Estate Investment Brokerage.
Four top executives leading retail real estate companies offered their views on both the opportunities and the challenges that lie ahead. Revealing their expectations for malls and shopping centers are Martin Debrovner, vice chairman at Weingarten Realty; Stephen Sterrett, CFO for Simon Property Group; Thomas McGuinness, president of Inland Western Management, part of the Inland Real Estate Group; and Daniel Hurwitz, executive vice president at Developers Diversified Realty. What is your outlook for the retail sector this year? SPG-Sterrett: Retailers across the board are seeing strong sales growth. It's really a pretty healthy sector. The bankruptcy rate among retailers remains low, and many of the retailers we work with have store expansion plans. DDR-Hurwitz: Our outlook is very positive and is primarily fueled by the demand we're seeing from retailers for more space. What's benefited us is retailers who previously only showed interest in other types of venues, such as regional malls, showing interest in open-air malls. Our tenant roster has been expanding on a regular basis. There's been a robust leasing environment for open-air space for the past three to four years, fueled by positive comparative store sales by big-box and moderate-size-box tenants such as Wal-Mart, Target and T.J. Maxx. That's given them the ability to continue to grow and look for external growth opportunities to complement their internal growth strategies. IRC-McGuinness: Interest rates have gone up a little bit but not enough to make a material difference to the consumer. We've seen that the American consumer doesn't seem to be affected by rising gas prices. We're expecting that the retail sector will do very well this year. How do you see mergers affecting the mix of retailers in shopping centers and malls? DDR-Hurwitz: It's hard to say how these mergers will all shake out, but where there is dislocation, there is also opportunity. We've viewed consolidation positively. Historically, it's created stronger retailers, with better market share and stronger margins. Time will tell on these recent mergers, but clearly there is the opportunity to take two relatively unhealthy retailers, from a market share and retailing perspective, in Sears and Kmart, and make one healthy, strong, vibrant retailer. The jury's still out, and it depends on how Kmart and Sears, and May and Federated, leverage their real estate, operations and merchandising to benefit the consumer and ultimately the shareholder. The opportunity exists for something very exciting. IRC-McGuinness: The Sears/Kmart merger affects us more than the Federated/May deal. We don't have a large mall component. We see the (Kmart/Sears) merger as a benefit to us. The new entity is going to go for the Target crowd, as opposed to the Wal-Mart crowd. Anytime you don't have to compete with Wal-Mart, that's good. It's going to combine the best of Kmart — the Martha Stewart line — and the best of Sears — the Craftsman tools, the Kenmore appliances and Land's End. The Kmart/Sears stores are going to be in more of the Kmart format. SPG-Sterrett: Tenants come and go. It's a tough business, and it's always evolving. Retailers are trying to gain scale by these (merger) activities, and if that makes the sector healthy, that's positive. Five to 10 years ago, many retailers who entered the arena were undercapitalized. Now, the trend is established retailers who are opening new stores to appeal to different customers. Abercrombie & Fitch is a great example of that, with their Hollister Co. and Ruehl stores. Do you see the trend in mergers continuing? DDR-Hurwitz: I do. There will continue to be transactions in the department store sector. Retailers have to continually reinvent themselves and provide consumers with a reason to be. Unfortunately, many retailers have been unable to create an environment that defines them, and as a result, they have no reason to be. That doesn't mean, though, that they don't have assets, whether it be real estate or product lines. As many retailers examine where the value of their company rests, it rests in the pieces rather than the whole. Toys 'R' Us is an excellent example of that. Retailing is intensely competitive, it isn't protected by patents, so retailers continually need to update and refresh themselves. Some are successful at that, and some are not. The ones that are, the winners, will absorb the market share of the ones that are losers. It makes us a healthier industry. IRC-McGuinness: You're not going to see the grocery operators doing much, although there is a rumor that Kroger may do something with Winn-Dixie in Florida. There will be more mergers in some of the bigger boxes and department stores. These retailers are trying to reposition themselves, recreate themselves. WRI-Debrovner: I don't see mergers happening among the major grocery chains. We've seen some in the drugstore sector, with Eckerd being taken over, but nowhere near the magnitude of the mall-type operations. The mergers have not had an impact on our product type. I would think that, from a mall standpoint, some of this (merger activity) is good because mall players are getting back space and there's a tremendous demand for the big boxes in the malls from a lot of the players. At one time, the mall operators didn't want some of those stores in there, but they have recognized that Costco and Wal-Mart and Sam's Club make an awful lot of sense as merchants in their product type. Do you see further consolidation among retail real estate players? SPG-Sterrett: We've seen so much consolidation over the past three to four years, I can't see much more happening. I read a report recently that stated that 85% of A- and B-class malls in the USA are owned by public companies. I think the great wave of acquisitions is over. DDR-Hurwitz: It depends on the sector. We've been a major consolidator, between our merger with JDN and Benderson. We also acquired assets from Caribbean Property Group, in Puerto Rico. So in the past two years, we've done more than $4 billion of consolidation. In the open-air sector, there are myriad private owners. It's a fragmented sector, so there will continue to be asset consolidation, not necessarily company consolidation. The mall business is different, because a disproportionately large share of the desirable regional malls are controlled by the large public REITs. IRC-McGuinness: I see consolidation continuing. It provides companies economy of scale, purchasing power, and expands leasing opportunities they can offer to their tenants. There's a lot of benefit to being bigger. I clearly see that trend continuing in the future. How has aging baby boomers affected retailing and retail real estate? SPG-Sterrett: That shift has been reflected in mall development over the past decade. The mall used to be the place to buy women's clothes, shoes and jewelry. The tenant base at the typical mall is so much more diverse now. There are fitness centers and restaurants and movie theaters. We're building more open-air malls, which we feel is more inviting to an older audience. Shoppers can go outside, relax, grab a cup of Starbucks coffee. IRC-McGuinness: The open-air centers, the lifestyle centers, play to an aging population. You park right in front of a store, go in and shop. It's not like a mall, where you're carrying bags from one store to another, up and down escalators. There was the thought in retailing that open-air malls wouldn't do well in very hot- or cold-weather climates. That hasn't proven to be true. These centers do well in the middle of the summer or the middle of the winter. The 45-to-55 age bracket has the greatest amount of disposable income and isn't totally worried yet about retirement or social security. In many cases, the kids are in college or graduated from college. You're going to see more retailers going after that demographic. Clearly, the teeny-bopper, ready-to-wear apparel retailers have been hurt by Kohl's, Target and Wal-Mart. There are very few retailers, at this point, going after the mature market, but you're going to see more going for that segment. WRI-Debrovner: We're less sensitive (to an aging population), because the type of product our merchants are selling is basic consumer necessities. I'm less concerned about changing demographics than I am about us, the neighborhood centers, competing with the Super Wal-Marts and the Super Targets, and how to get people into your shopping center with that tremendous competition. Supermarkets in Florida or Tucson, Ariz., which have large retirement communities, pretty much sell the same products as supermarkets around the country. What kind of outlook do you see for development? SPG-Sterrett: There aren't many areas that can support construction of new, 1 million-square-foot regional malls. We are building malls in Jacksonville, Fla.; the Naples, Fla., area; and Austin, Texas. Those are areas that are enjoying significant population growth. Austin is one of the fastest-growing cities in the country. By and large, though, there isn't going to be a lot of new regional mall development on the East Coast and in the Midwest. DDR-Hurwitz: I see the redevelopment trend continuing and accelerating. There are malls that, while they have outstanding locations and serve the market on a regional basis, have an outdated physical plant and an outdated tenancy that needs to be remerchandised. The good mall companies are doing that through aggressive asset management, pursuing tenants that are not traditional mall tenants such as Target, Bed, Bath & Beyond or Wal-Mart. In some cases, the physical plant isn't salvageable, and a new mall will be built that's more appropriate to today's shopping trends. Redevelopment will continue, because entitlement has become more difficult. Backfill locations have become more attractive. We have a very active development and redevelopment group. In many cases, there will be more opportunities for redevelopment. IRC-McGuinness: There will be some development, but a lot more redevelopment. For example, there are a lot of malls that have a lot of empty Montgomery Wards. The trend is that those stores are being leveled and a lifestyle or open-air component added. What's also been happening is that malls are adding a lifestyle component adjacent to the mall that the mall owners hope will feed into the mall itself. With department stores merging, leaving a big empty box, and department stores probably not the wave of the future, clearly, something must be done with that space. How extensively must retailers change their mix or format to be successfulas they expand into urban markets? DDR-Hurwitz: In most cases, what they have to do is dramatic. These retailers have been successful operating within a specific footprint. They have to change that to operate successfully in urban environments. It affords them the opportunity to reach an enormous number of people, with a great amount of disposable income, and give them the chance for upside sales, compared to the outer-ring suburbs. Retailers are being very progressive and flexible in designing new store footprints and prototypes, in an effort to succeed in urban markets that are clearly underserved. New York City has great retail, but in terms of national retailers, they are underserved. WRI-Debrovner: A software retailer can pretty much have the same kind of store in midtown Manhattan or White Plains, N.Y. If you're Home Depot, your White Plains store is going to be vastly different from a store on 79th and Second Avenue. That's a problem with any (big-box) retailer moving to any inner-city location, whether they are a supermarket or Home Depot or Lowe's. The retailer has to do a lot of compromising and figure out what items will sell and what won't sell to the urban market.
In fact, the real estate stock research firm has been so successful in pushing its NAV-based approach over the last two decades that Kirby is ready to declare the debate over. Green Street's NAV model, he says, has won. But lately, a growing number of REIT analysts, investors and, especially, company executives, have begun to respond: Not so fast. Led by executives of CenterPoint Properties, this camp derides NAV as a static, even backward-looking perspective that doesn't fully take into account the value-creating power that management provides. This cash-flow camp, let's call it, argues that REITs should be valued as operating companies — no less than manufacturers — that create value through buying, selling, developing and redeveloping. Its favored valuation method is a metric known as discounted cash flow, or DCF. "Real estate has to look at cash flow," says Paul Fisher, president and CFO of CenterPoint. "It's not about where we were or where we are. It's about where we're going to be." The NAV focus "just doesn't work for companies that are dynamic, like CenterPoint." And that goes for Archstone-Smith too, says, R. Scot Sellers, chairman and CEO of the multifamily REIT, an active developer. "It absolutely shortchanges our value," Sellers says. Unique Situation for REIT Investors The target audience of all this wrangling is investors, especially portfolio managers, for whom the question of how to value REIT shares is more than theoretical but goes right to the grinding task of picking stocks and beating indexes. Many industry figures concede that Green Street's NAV-based approach has gained dominance. "In general, I side with the CenterPoint side of the argument," says Damon Andres, portfolio manager for Delaware REIT Fund. "But lately, the whole industry has started to gravitate to NAV valuations." This is a debate that only the REIT industry can have. In most industries, the "market," or book, value, of a corporation's assets isn't particularly useful in valuation. GM is worth far more than the liquidation value of its plant, equipment and inventory. Its manufacturing, branding and marketing skills make up the greater sum of its net worth. REITs, however, are defined by their ownership of commodity-like assets that trade in relatively liquid markets, like perhaps only the gold or oil-and-gas industries. What's more, calculating REIT NAV has become easier in recent years as REIT disclosure has grown more extensive and now includes average rents, vacancies and other details. So finding the rough value of a REIT's real estate portfolio is possible — even if some argue over whether the exercise is useful. The debate isn't black and white. Most investors and analysts use a range of metrics and caution against over-reliance on a single one. A popular way to—roughly—measure REITs against each other is to assign a multiple to a company's projected FFO. Critics say the method is dangerously flawed because, like FFO, it fails to measure the amount a REIT spends on capital expenditures. As remedy for that, some portfolio managers compare REITs by their price relative to projected adjusted funds from operations (AFFO). Another popular method applies a discount rate to projected future dividends. "At some level, valuation of stocks is an art form," says Ross Smotrich, an analyst with Bear Stearns. "There are a number of different approaches. I'm agnostic. We use all these metrics and I try not to be a prisoner of a single one." And even both CenterPoint and Green Street concede some merit in the method favored by the other. Green Street, in fact, performs detailed DCF analyses on each of the 70 companies in its coverage universe. Still, Green Street and its followers insist that NAV should take primacy, while those that agree with CenterPoint insist just as firmly that it should be discounted, if not discarded. Who's right? In a sense, the question boils down to what is the most important element: Is it the buildings or the people who manage them? NAV backers believe it's the buildings. "We believe that REITs first and foremost are a collection of real estate that's been securitized," Kirby says. Not surprisingly, Fisher and Sellers argue that the real value comes in how the assets are managed. "We are real companies," Sellers says. "Like Microsoft is in the software business to make money, we're in the real estate business to make money." A closer examination of the competing methods might help clarify the dispute. Mechanics of NAV A tool as old as REITs themselves, NAV is based on the idea that since buildings make up the bulk of a REIT's value, REIT shares shouldn't trade too far above or below that value. The method breaks down valuation into two simple questions: 1. What's the value of what the REIT currently owns? 2. How much value is management expected to create or destroy? To find the first part, the model divides a corporation's projected NOI by an appropriate capitalization rate, the discount rate used to adjust projected future income to its present value. The discount rate must take into account all economic and real estate risks, including risk-free interest rates, property type, location, quality and age, expected demand growth, supply outlook and the like. Income from a company's suburban office portfolio might warrant an 8.5% cap rate because of perceived weakness today in that sector's prospects, while NOI from a company that owns high-end shopping malls [a sector where NOI and FFO is growing] would merit a 7% cap rate. Even a fraction of a percentage-point difference in cap rates can appreciably change values. The model requires time-consuming research that not every investor can afford. The trick is getting cap rates right. NAV proponents argue their model is grounded in reality since buildings trade every day on the private market, which sets cap rates backed by hard cash. Such data provides a solid foundation for the cap rates that analysts use to value a REIT's portfolio. "Public-market investors who choose to ignore the information conveyed by these thousands of willing buyers and sellers seem to us to be foolhardy," Green Street wrote in a report that outlined its method in 2003. Green Street takes its NAV model a step further. In an attempt to capture the value-creating effects of a company's management and strategy, the firm assigns a ranking on a scale of one to 10 for such elements as insider ownership, geographic and property focus, leverage, conflicts of interest and "franchise value," a qualitative measure of management skill. Critics argue that the second part is subjective and arbitrary, "a black box," as one analyst put it. But even NAV skeptics concede that the model demands at least some attention, especially in setting the outer limits of where a stock should trade. "It's the reality check that separates what's really happening from the noise of what people are yelling at you," says Steve Brown, managing director and portfolio manager at Neuberger Berman Real Estate Funds. "You're not going to see REITs trade at 16 cents on the dollar, and you're not going to see REITs trade at two times value." The boundaries, Brown says, typically range between 80 percent to 120 percent of NAV. William Hauser, portfolio manager with HVB Capital Management, says that NAV is especially valuable in bear markets, when management's value-creating talents are less of a factor. Then NAV analysis provides solid "buy" signals when discounts get too big. "When you are in a bear market, the asset value probably takes greater consideration," he says. "That is your safety net." And it's hard to argue with NAV's impressive record. Green Street boasts that its NAV-backed "buy" recommendations have returned a total of 1,948% between January 1993, when the modern REIT era was underway, and January 2005, a compound annualized rate of 29%. Its "sell" recommendations have returned a paltry 21.5%, or 1.6% compounded annually, in the same period. Over the 12-year period from the end of January 1993 to the end of January 2005, the NAREIT Equity REIT Index recorded a 12.8% compound annual total return. Further evidence of NAV's validity comes from a study published in 2003 and revised in 2004 by three finance scholars, William M. Gentry of Williams College, and Charles M. Jones and Christopher J. Mayer, both of the Columbia University Graduate School of Business. The study tracked REIT data since 1990 and found that simply trading REITs mechanically based on their NAVs—buying at a discount and selling short at a premium—produced "large positive excess returns" of about 1.2% to 1.8% per month, "with little risk." Green Street posts the study on its Web site (www.greenstreetadvisors.com) as evidence of the validity of the NAV model. Case closed? Hardly. Misses of NAV David Harris, senior REIT analyst at Lehman Brothers, cautions that NAV analysis alone can be "very misleading." For one thing, NAV calculations themselves can—and often do—differ depending on who's doing the calculating. At the end of Q3-04, for instance, when Lehman published its last full NAV analysis, the 65 REITs in its coverage universe traded at a whopping 29% average premium; Green Street pegged the premium for its 70-member group at 7.2% — a big difference. And while the two analyst teams cover slightly different groups of companies, Lehman's estimate for Prentiss Properties' NAV was $29.50 per share, while Green Street set it at $34.25, 16% higher, at the same time. The stock traded at $37.92 at the end of the period — pricey by Lehman's standards, attractive for Green Street, after factoring Prentiss' value-creating potential. Differences over what NAV to award a company usually boil down to the use of different cap rates, which, argues Kevin Lampo, an analyst with Edward Jones, can in fact be quite subjective. "You can spend all day on what cap rate you use," he says. Lehman's Harris also argues that pegging NAV becomes especially tricky at "extreme points in the cycle" such as now, with cap rates for many property types at historic lows. A shift in cap rates could send NAV estimates spinning, he says. Still others worry that NAV models tend to miss the value creating skills of management. CenterPoint's Fisher couldn't agree more. He says that CenterPoint and other activist REITs use properties much in the way manufacturing companies use raw materials, adding value through development, redevelopment, leasing, financing and other methods and selling it when most appropriate. The company churns through about 20% of its portfolio a year, he says, which makes NAV analysis a moving target. It also misses an essential element of the company's value, which is to create profits over time through gains on sale. Fisher dismisses NAV as "liquidation value," a metric that doesn't make sense for going concerns and would never be applied to Boeing, GM or other companies whose plant and equipment offers few clues to their intrinsic worth. "Far and away, the dominant driver is the spread between what we sell and what we buy and how much we turn," he says. "The real nub of valuation is cash flow—the green stuff." The Deal on DCF The DCF model, which is widely used to value companies in industries across the economy, can also be broken into two main tasks. The first tries to accurately project a company's cash flow growth in perpetuity. The second applies a discount rate to those earnings that captures what the investor could expect from a risk-free investment, plus risks inherent in the enterprise—managers' skill, property type, market characteristics and the like. In theory, if a current share price is trading lower than the warranted per share value produced by a DCF analysis, an investor should buy. Fisher and others cite as evidence of NAV's problems and DCF's merits the record of CenterPoint itself. The company has confounded Green Street and many other analysts by trading, for years, at a huge premium to NAV. Green Street has been recommending that investors sell CenterPoint since the summer of 2001. Its shares nearly doubled over the next three and a half years and closed the end of 2004 at $48.50. In a report last October, for instance, Green Street pegged the premium at a whopping 49%, and continued with its "sell" recommendation. "They've had a sell on our stock since we traded at $23," Fisher says. "How good can a model be when they've been telling their investors to sell us?" HVB's Hauser agrees that CenterPoint throws a wrench into NAV theory. "CenterPoint trades at this absolutely ridiculous premium," Hauser says. "You say, ‘This is really scary.' But it's always traded at this premium, and the market has effectively adjusted. It's a perfect example of how the market has done a good job of moving above and beyond NAV." ING's Ferguson notes that a number of companies besides CenterPoint have emerged that aggressively manage their assets to add value, making a strict NAV-based analysis problematic. Among these he includes AvalonBay, ProLogis and SL Green. Others make a similar case for Vornado and General Growth Properties. "If you didn't think about management, you'd be pretty off the mark in thinking about those companies," Ferguson says. Of course, even DCF apostles agree that the model has its flaws. Poorly estimated discount rates—modest errors in guessing future interest rates or a company's risk profile—can wildly affect valuations. And Kirby has ready answers to all NAV criticism, particularly to the charge that it is "backward looking," which he calls, "a naïve gripe." Cap rates used in deriving NAV by their nature anticipate future earnings of property, he says, and are by their nature forward looking. And so the debate continues. Which valuation metric is the best approach? Kirby and Fisher have made up their minds, but it is up to investors to decide for themselves which camp to join.
“The aphorism that a rising tide lifts all boats may be rooted in nautical truth, but it does not translate easily into a philosophy of real estate investing,” says Lloyd Lynford, president and CEO of Reis. In reality, scores of major office markets are still limping, and some won't make a full recovery for several years to come. What's misleading is that frontrunner markets such as New York City and Washington, D.C. effectively skew the average. Here's why: Manhattan, with its 358.2 million sq. ft. of office market space, accounts for 10.3% of the 3.5 billion sq. ft. of national office market space. That's the single biggest chunk of office space in the nation. Reis tracked 1.3 million sq. ft. of positive leasing absorption in Manhattan during the first quarter of 2005. Manhattan wasn't the only market on the positive side. Among the top 64 markets in the nation, 44 recorded positive absorption in Q1. Among the 22 weakest markets were Detroit, with -372,000 sq. ft. of leasing absorption and Kansas City, with -377,000 sq. ft. The upshot for tenants is that in strong markets they are renewing their leases early, while the getting is good. Elsewhere, tenants are simply riding out their lease time until the price of renting bottoms out. Some markets, including the likes of Washington, D.C. and southern California have already priced the recovery into their rents (see chart below) while others are finding it harder to hike rents. “Chicago is one of the weakest office markets in the nation, but we're still getting more and more inquiries for space there,” says Bob Bach, national director of research at Grubb & Ellis. Another laggard in terms of rental growth is Seattle. Bach says that Seattle turned the corner on vacancy rates between the end of 2002 and the beginning of 2004. Indeed, Grubb & Ellis data shows metro Seattle vacancy rates falling from 18.4% to 14.4% over that same two-year period. But the Pacific Northwest's largest metropolitan area is still struggling to bring office market rents up. Job growth, particularly in the professional services sector, will help Seattle landlords win back some much needed control. Over the past 22 months, roughly 3.1 million jobs were created across the country. A full 609,000 of those jobs were created in the professional and business services sector, which typically requires office space. While the month-to-month gains may be uneven, an average of 178,000 new jobs were created per month between February 2004 and 2005. The good news extended into March, when the unemployment rate fell 20 basis points to 5.2% — its lowest level since September 2001. More good news: The amount of sublease space in the national office market also is falling. It hasn't dipped below the nine-digit mark in terms of square feet but it's moving down, says Bach. Grubb & Ellis data shows 146 million sq. ft. of sublease space on the national office market at the end of the first quarter in 2002. Two years later, that number was hovering at 104.9 million sq. ft. That works out to roughly 22 million sq. ft. of sublease absorption per year. At that rate, sublease inventory will dip below early 2000's record low level of 37.1 million sq. ft. by about 2008. “Two years ago we were very concerned about the huge sublease glut, but it's thinned out considerably since then,” says Bach. He believes that the balance of the sublease inventory will be leased due to a market twist: As direct rents get more expensive, sublease rates will start looking better. “There's no question,” says Bach. “An increase in rental rates should help thin sublease out even more.”
While the Pentagon's announcement is a blow to an office market that is only now recovering from the technology bust, the effect goes deeper than lost leases. Brokers, building owners and others say it marks a fundamental shift in how the commercial real estate game will be played in Arlington, Alexandria and Falls Church. For decades, brokers and investors have built careers on a dependable stream of calls from Defense Department officials looking to plant another military office near the Pentagon. Developers have erected buildings with that in mind. Investors have pushed up prices, especially in these past few years of war and heightened security, partly out of confidence that the Defense Department's demand for space would stay strong. Now, a basic piece of the equation has changed. Particularly in Arlington and Alexandria, where the defense presence is most concentrated, "every block" will feel the effect, said Joe Delogu, a principal at Spaulding & Slye Colliers, a major commercial real estate firm. "Defense is an area that had grown and now it's going to become a part of the industry that is shrinking. We won't have as fast a pace of growth." Brokers had, for example, been courting the National Geospatial-Intelligence Agency, which was hoping to find about 2 million square feet of space so it could consolidate its offices from Bethesda and Reston into a single spot, probably outside the Capital Beltway. Now the agency is slated to move to Fort Belvoir, and for those brokers the courtship is effectively over. It is unclear how long it will take for the Pentagon to move its employees out of Northern Virginia. Brokers expect the process to take several years, which will at least allow time to adjust. Still, the numbers alone stand to change the Northern Virginia market. The Pentagon leases about 4 million square feet of Arlington's 31 million square feet of commercial office space. The fact that such a major tenant is leaving, even gradually, will likely stabilize rents, or cause them to fall as landlords try to fill open spaces. It will mean costly renovations and marketing efforts for investors whose buildings have long been filled with government tenants. Patrick Mahady, executive vice president at CB Richard Ellis, is a property broker who specializes in leasing to government agencies. He said the Pentagon's moves will affect almost every part of his business. "If you have a huge hole in the market because the government is moving out, you've got landlords who have to pursue backup tenants and that's going to mean lower rental rates," he said. Charles E. Smith Commercial Realty [part of VNO], for example, will have tenants leaving from 17 buildings, vacating about 1.7 million square feet of space leased to the Defense Department. Company President Mitchell N. Schear said that the overall strength of the Washington market will help the company absorb the loss of the Pentagon as a customer. There is concern, however, that as government agencies leave, private contractors will follow. If an agency is moving out of Arlington, a contractor is not going to stay there. They're going to follow the agency out to where it goes. That could be a boon for the outer suburbs, around places like Fort Meade in Anne Arundel County and Fort Belvoir in Fairfax County, where many of the employees from Crystal City and Arlington are slated to move. "This paints a dire picture for folks in Northern Virginia, but it plays right into our hands," said Chris Waller, a vice president at Garrett Development, which is based in Stafford County and owns 6,000 acres of land that is largely undeveloped in western Loudoun, Stafford and Prince George counties in Virginia. "We like where we're sitting because we're holding all this land," Waller said. For those developers trying to either retain or recruit Pentagon business, building to meet the new security standards is going to be costly, developers point out. Shatterproof glass and reinforced columns, the types of improvements the Pentagon now demands if its employees are to stay in dense urban areas, can add as much as $30 or $40 to the average $150 it costs to build a square foot of office space in the region. "There's going to be a cost either way for the government because they'll have to pay to retrofit buildings . . . that are closer into the city and don't meet the standards they want, or they'll move farther out and buy the land and have a buffer," said John Shooshan, chairman of Shooshan Co. of Arlington. His company built a 330,000-square-foot building in Ballston for the Office of Naval Research, which has expensive security requirements. For years, area developers have bought land or planned to redevelop buildings in markets closer to the District, thinking that planners wanted to see more dense development around Metro stops. Now they worry if they'll be able to get government tenants in those spots. "We buy land around Metro stops in Arlington because it's insulated and you're often looking for those government agencies and their contractors," said J. Quinn Rounaville III, a leasing broker at JBG Cos., a developer in Chevy Chase. "If they're going to pull out of Arlington, that pulls a lot of people out. With a large glut of space on the market, it's going to make it tough for anybody." The defense agency's departure from close-in markets could also affect whether companies invest in new buildings, or in ones that may be offered for sale in the future. "It might affect pricing slightly of what investors are willing to pay for a building if they think they'll have a major tenant moving out in a few years," said Robert M. Pinkard, chief executive of the Cassidy & Pinkard firm. "People aren't buying bricks and mortar when they buy buildings," said Mahady, a broker who represents landlords with defense agencies as tenants. "They're buying the cash flow to the buildings. If the cash flow isn't there or it's greatly diminished, the value of the building goes down. It's going to take a while for the market to take this blow."
So why should investors trust Rogers and not the conventional wisdom? One reason might be the success of his fund. Over the past five years, Rogers' fund has been up 18.7% annually, 21 percentage points better than the S&P 500. TheStreet.com checked in with Rogers to see if there are any other reasons why investors should take his word when it comes to REITs -- and rates. When interest rates dropped last month, REITs regained a lot of what they lost in January. What's the true relationship between interest rates and REITs? Over the long term, there is not a very high correlation between the two. You need to desegregate short term and long term, because we are going through a period right now where the market has a different characteristic. We've had five years of good performance, so investors are wary of a downturn. And we have a lot of nondedicated investors who came into the market looking for yield, and as a result, the REIT market has become hypersensitive to all macroeconomic news, including interest rates. Also, with regard to interest rates and real estate, there is a more fundamental link which goes back to why interest rates increase. Interest rates increase because the economy is improving and there is a focus on managing inflation. Improving economic and inflationary periods have both traditionally been good periods for real estate, because it benefits from rising prices and rising rental rates. And real estate has traditionally been a good hedge against inflation. So when you get beyond the short-term rate movement and look at what's causing rates to rise, that's typically a good sign for the real estate market. Where are REIT valuations right now? Valuations in the REIT market over the past 12 to 18 months have gotten stretched between their long-term average and historical peak valuation levels. In April 2004, the market sold off in large part because of concerns over valuation. In January 2005, after the REIT market had been up 30% over 2004, there were concerns about valuation. And those concerns combined with portfolio rebalancing led to the selloff in REITs in the first quarter. So are valuations more reasonable now? Given the selloff in January, combined with increasing prices in the direct real estate market, which are having upward pressure on REIT net asset values, we are seeing much more reasonable valuations in the marketplace today. How are the fundamentals of the REIT market? We believe that the fundamentals in the real estate market bottomed in the midpoint of 2004 after being depressed for two to three years. Since then, we are seeing real estate fundamentals slowly improving along with the general economy. We expect to see fundamentals continue in a positive direction for the next two to three years. The rate of that improvement depends to a large extent on the improvement in the economy, especially job growth. How does the craze in residential real estate carry over to the REIT world? It's a good idea for investors to segregate the single-family housing market and the commercial real estate market which includes office, retail industrial and apartments. Those are two very different markets. That said, the low-interest environment has fueled the home-buying marketplace. And in turn, that's had a negative impact on the apartment rental market. The other big factor that impacts the apartment rental market is job growth. As the economy continues to expand and as job growth increases and as interest rates continue to rise with an improving economy, that should push more people into the workforce, which means more people will be renting apartments. And that means less people will be buying homes, because they will be less affordable. Basically, the number of apartment renters will increase as it becomes too expensive to buy a home. But that's a gradual process. Which cities are hot in commercial real estate? When you talk about geography and cities, you have to be careful, because the market is different for different product segments. However, it's fair to say that the markets that have done better recently are those with high barriers to entry. In other words, it's those markets where it's more difficult to build or more difficult to provide new product. As a result, those have traditionally been your coastal markets -- the East Coast, the Northeast and the California coastal markets. In contrast, the lower-barrier-to-entry markets, like the Sun Belt markets, have lagged. OK. So what are some of your favorite names? On the apartment side, two of the names we like in the high-barrier-to-entry coastal markets are AvalonBay and Archstone-Smith. These are well-managed companies with high-quality portfolios. On the office side, the names that we like include Boston Properties, S.L. Green and Corporate Office Properties. Once again, these are all office properties with a big focus on high barriers to entry, high business markets -- like Washington, D.C. and New York -- that are leading the recovery. The old saying in real estate is that you first look for location, location, location. What do you look for in a REIT? We try to stay fully invested across all the property sectors. And where we try to add value is by trying to identify the best-performing stocks in each of the sectors rather than making a big bet in any one sector. So we try and stay fully diversified to keep our market risk low. In addition to all the quantitative metrics that we use, we focus on three fundamental metrics: strong management teams, a competitive advantage relative to their peer group, and thirdly, we look for companies with a demonstrated track record.
In comparing six-month periods, PPR found planned construction of rental apartments increased the most, rising 49% from November to April to 154,097 units, from the previous six months. Planned construction of retail space such as malls and shopping centers rose 23% to 275.1 million square feet. Planned office construction rose 12% to 222.9 million square feet. Warehouse construction planned fell 17%, showing developers either had less confidence or more restraint. Olivia Fowlie, senior real-estate economist with PPR, says that with high prices being paid for properties, in some cases it's cheaper to build than buy. In its outlook on real-estate investment trusts, Moody's Investors Services noted that a few REITs have started the risky practice of building speculatively, constructing buildings with no tenant in place. Apartment markets that have the highest amount of space entering the planning phase over the past six months include the Washington, D.C., area, including Northern Virginia and Maryland; and Charlotte, N.C. The office markets identified as most at risk include Nashville, Tenn., and Sacramento, Calif. Palm Beach County, Fla., is considered at risk for too much construction of office and apartment product. California's Inland Empire ranked high on the risk list for the amount of planned apartment, retail and warehouse construction.
More than half of the leasing in Q1 took place on the Westside, as that district continued to recover from the dot-com implosion in the first part of the decade. Vacancy rates there fell to 11.8% from 16.8% a year earlier. "There's a huge absorption trend in that market," said Joe Vargas, senior managing director of Cushman & Wakefield. The surging entertainment industry is responsible for a large portion of the growth, he added. So far, the tighter market has had little effect on rents. Westside landlords asked for $2.62 per square foot per month, an increase of 4 cents from the year before. Countywide, rents stayed flat at an average of $2.05. Vargas said that landlords were cutting back on such concessions as free rent and discounted parking, however, and that rent increases would soon follow at the rate of 7% a year for the next three years. "We have had sustained growth over the last two years," he said. "I can't see any slowdown in sight." Vacancy in downtown Los Angeles, the second-largest market after the Westside, fell to 16.3% from 18.3% a year earlier. Rents were flat at $2.05 a square foot. The San Fernando Valley is improving too: Vacancy fell to 9.5% from 12.5% in the last year. Office landlord Michael Adler has raised his asking price to $2.05 a square foot from $1.90 for his properties in the Valley. He sees much of the growth coming from existing tenants. "Companies are finally hiring," said Adler, president of Woodland Hills-based Adler Realty Investments. "Everyone was reluctant to expand during the last recession, and now they have used up the space they had from their last expansion" period. Vacancy rates in Burbank, Glendale and Pasadena slipped to 11% from 15%, and empty space in the Wilshire Center was reduced to 11.7% from 15.6%. "There is a lot of momentum in the market," Vargas said. The worst market was near Los Angeles International Airport, where vacancy ticked up almost 2 percentage points to 31.6%.
But some real estate specialists say the condo conversion market has become so overheated, especially in places like South Florida and Las Vegas, that many developers could find themselves unable to sell their condo units - and possibly in default - if interest rates rise and the pool of potential buyers dwindles. "Condo converters are paying above market rates, above what the rental value of the building would be," said Robert M. White, the president of Real Capital Analytics. If all the units do not sell, leaving the building with an undesirable mixture of tenants and condo owners, he added, "the lenders will have a tough time getting their money back" and developers will have "the headaches of having to manage renters and owners both." Sales of apartment buildings to condo converters reached a record $13.3 billion last year, up from $3 billion in 2003, according to Real Capital Analytics, which tracks sales of at least $5 million. Since January 2004, 103,000 apartments have been sold to converters, the firm said. In metropolitan Washington, buildings intended for conversion sold for an average of 88% more than other apartment buildings, according to the research division of Marcus & Millichap, a national real estate investment brokerage company. In Northern New Jersey, condo converters paid about four times as much as buyers of buildings that will remain as rentals. In Northern Virginia, as in South Florida, there is little difference between what converters are paying for apartments and the market price for a condo, leaving little room for profit, Mr. White said. Many condo units are sold to investors looking for an alternative to the stock market. Real estate specialists estimate that speculators and other investors account for as much as 60% of condo sales in Florida, and one-quarter or more of the sales in places like Washington and Chicago. "Investors are buying blocks of units, four or five at a time," said John Jaeger, a vice president at Appraisal Research Counselors, which focuses on Chicago's housing market. "We see that quite a bit." He said that typically only 15% of the tenants in an apartment building wind up buying their units. Developers like the Related Group of Florida are taking steps to curb speculation by, for example, requiring a 20% deposit so that the investor will not be likely to walk away from his or her condo unit. "No one can buy more than two units, and we carefully screen and cross-check with our other projects," said Joyce Bronson, a senior vice president. Sometimes an apartment building changes hands even before or soon after construction is completed. Last month, Vornado Realty Trust agreed to sell a new 452-unit apartment building at 400 North LaSalle in downtown Chicago to a venerable local developer, Draper & Kramer, for $126 million, or about $278,000 a unit. Vornado said its gain would be $30 million. Jim Freko, a Draper & Kramer vice president, said his company planned to install hardwood floors but otherwise does not need to spend much to convert the building, which was completed last year. An average 900-square-foot unit will be priced at about $360,000, he said. These days, he said, condo converters have come to expect lower returns than they have been used to. "You see a lot more converters stepping up to the plate, whether experienced or new, and they are getting more aggressive and pushing up the prices you need to pay," he said. But, he said, as long as interest rates remain low, the conversion trend is likely to continue. Fueling the spurt in condo conversions is the widespread availability of financing, not just from banks but also from other lenders willing to make up the difference between the bank loan and the actual cost of purchase and construction. Competition among lenders is so feverish that some developers can get away with putting very little of their own money at risk, mortgage brokers say. "There are promoters putting deals together who are taking out their own equity and replacing it with other people's equity so that they are getting a percentage of the transaction with no money in it," said Robert Kaplan, a senior managing director for South Florida for Holliday Fenoglio Fowler, who helps arrange financing for such deals. Until now, Wall Street investment firms have issued their own condo conversion loans but have not sold them on the secondary market as mortgage-backed securities. But in what real estate specialists said was another sign of the expanding availability of debt financing for this type of property, Credit Suisse First Boston has just finished marketing a bond to institutional investors that was backed by $1.5 billion worth of mortgages for apartment buildings and other properties being transformed into condominiums. By taking many apartments off the market, condo conversions have actually helped raise apartment occupancy in some areas, said Lloyd Lynford, the president of Reis. The average vacancy rate in the top 64 metropolitan markets at the end of March was 6.6%, down from 7.1% the previous March. The average in the 1990's was 4.9%. Apartment companies, whose performance is correlated to job growth as well as interest rates, are the weakest of the REIT sectors. This has led Equity Residential Properties Trust and Post Properties, another apartment REIT, to enter the conversion business themselves. The success of these efforts has prompted other apartment REIT's to consider following suit. But many converters coming into the market are inexperienced developers in search of quick profits, said Kenneth Rosen, a real estate professor at the University of California, Berkeley. "A lot of untested people are getting into this," Mr. Rosen said. "It's the place where people think they can make fast money today. That's the real problem."
Earlier this year, Post Properties announced the creation of a new taxable subsidiary (called Post Services) which will build and convert condos in key markets across the country. The condos will be marketed under the brand name of Post Preferred Homes. At present, the apartment REIT has four condo projects underway: a ground-up construction in Alexandria, Va.; and three conversions, one in Dallas, one in Tampa, and in its home city of Atlanta. For Post, developing condominiums is a way to expand its multifamily product offerings and leverage its brand equity to capture new customers—and retain existing residents who like the Post lifestyle, but are eager to own. "For a long time, residents of ours have consistently asked about buying Post units," recounted David Stockert, Post's president and CEO. "It strikes us as not making sense that we only target residents who want to rent. Post is focused on the high end, so many of our customers leave to buy a home. We are now trying to capture that market segment." Additionally, entering the for-sale market means Post will no longer have to leave money on the table when it sells to condo converters—who may pay $125,000 or $130,000 per unit and then sell these same units to consumers at $185,000, said Rod Petrik, managing director in the Baltimore office of Legg Mason Wood Walker Inc. "What Post is looking to do is to take that additional piece of [profit]" by converting the units itself, noted Petrik. Indeed, as transactional income, condominiums have the potential to add significantly to the company's bottom line. David Rodgers, a research analyst with Cleveland-based KeyBanc Capital Markets, estimated that Post—which earned almost exactly $300 million in total revenues in 2004—will sell about 125 units, or $20 million, in condominiums this year; and $22 million next year. And condo developments could yield a gross profit margin of 15 to 25 percent for the company, Rodgers estimated. Eventually, income from the for-sale sector could account for as much as 10% of Post's FFO as production increases, Stockert estimated. While condo development and conversion is unquestionably the industry's trend du jour, Post said its foray into the for-sale sector is not simply a response to today's interest-rate-driven demand for condos or other short-term factors. If all goes according to plan, condominium development for Post Properties is here to stay. While apartment development and ownership will remain Post's core business, the company expects, going forward, to increase its production of condominiums. It will have four or five projects, or about 1,000 units, of varying combinations of conversion and new-build condos under development every year. In Post's view, it isn't just interest rates that are driving the current condo craze. The company believes that demographics and lifestyle trends are creating a permanent market for condominiums. For example, the increasing numbers of non-traditional households are creating a demand for living in urban areas with retail and cultural amenities nearby. At the same time, greater affluence is making the way for a shift to homeownership, said Stockert. "The greatest growth in the next 10 years will be in non-traditional households. We will have more empty nesters and [young] professionals who will be the ones to be more interested in the condo lifestyle," said Stockert. "This has been a natural evolution for Post," added Thomas Senkbeil, Post's EVP and chief investment officer. "In-town living is becoming more popular. The shift [in housing patterns] is as much from single-family to multifamily as from renter to owner." For now, Post will be focusing its development and conversion efforts on those markets in which it already has a major presence: Washington, D.C., Atlanta, Tampa and Orlando, Fla. and Texas. "We hope that in each of our cities, we can offer a range of product offerings," said Stockert. And within these core cities, the REIT's strategy is to build or convert in submarkets that limit housing choices to condominiums—because of particularly high urban density or because of prohibitive single-family homes prices. "There are new urban neighborhoods, developed in the last 10 or 15 years, in which multifamily condos is the only way to own a home," said Stockert. Stockert cited the example of Atlanta, "where high-density urban neighborhoods and condominiums are really now the prevailing housing type." The target market for Post's condo product is the affluent segment of the population: Those who earn more than the middle market, but not the truly wealthy, the top 1 percent of the market that Donald Trump's properties target. "What we are trying to hit is not the middle market, but neither is it the super high end—which we do not believe is a deep market," said Stockert. "We are not aiming so high that we get a shallow customer base. [We are targeting] an affluent customer base, and we believe there is a deep pool of affluent customers. This is consistent with how we handle apartments." In terms of amenities and design, Post's condo product will place a great emphasis on the sound attenuation, the cast iron piping and the concrete construction that is favored by buyers—as opposed to the woodframe construction typical in apartments. Features such as hardwood flooring, stainless-steel appliances, granite countertops and balconies will be standard. Amenities will include swimming pools, underground parking, fitness centers, outdoor gathering areas and Internet access. In a number of ways, Post Properties is arguably very well positioned to develop condominiums. The REIT already possesses some of the nation's most condo-appropriate properties and sites. Post already has solutions in place for one of the greatest challenges of developing condos: namely, "finding sites that allow you to place the product in the right location," observed Bill Donges, president and CEO of Lane Cos., another Atlanta-based company that develops both apartments and condominiums, "And Post has some fantastic locations for condos," said Donges. Various aspects of Post's vaunted skills in apartment development can also be leveraged in its venture into the condo business. For example, one of Post's areas of greatest expertise, said KeyBanc's Rodgers, lies in "knowing the market and finding quality sites" — a skill that comes in handy for condo players. Of course, there are risks involved in developing condos. Much as Post can apply some of its skills in developing top-quality apartments to its for-sale projects, condos are in other respects a totally different ballgame. "Converting condos and selling them is a different business from operating apartments," said Donges. For example, in condo development or conversions, it is critically important to engage with an experienced sales and marketing team extremely early in the planning stage to determine the product from a pricing and amenities standpoint. Well aware that it is new in the field, Post Properties strategy calls for partnerships with experienced local condo developers and the hiring of third-party condominium sales and marketing specialists. "Our view is that it is advantageous to use their expertise. And depending on the pace of action, we prefer hiring general contractors to bring expertise and capabilities on an as-needed basis," said Senkbeil. Post is also limiting itself to smaller projects of 150 units or fewer to mitigate risks. Speaking of risks, Roger Tutterow, chairman of the department of economics and finance at Georgia's Kennesaw State University, cautioned that many of the condo buyers that Post attracts are renters moving to homeownership for the first time—precisely the type to be especially affected by any rise in interest rates. However, he noted, growth in the empty-nester niche should somewhat offset any slowdown in the migration to homeownership. Post is also entering the condo market after almost a decade of record-breaking price increases in condos nationwide — and a few years' of intensive development. So there is also always the possibility, faced by all condo developers, of a condo glut in markets nationwide. In this regard, the analyst Rodgers said he views Posts' condo ventures as relatively low-risk: The condo developments are also underwritten as apartments "so that if the condo market sours, the unsold units can still be rented out as apartments" and generate an acceptable yield, he explained. In any case, if Post Properties' expectations pan out—that there is indeed a structural lifestyle shift across the country to in-town condominium living—then condo sales may well be more immune to interest-rate increases and overbuilding than they ever have been in the past. Related: Apartment REITs' Condo Plays Spur Concerns
"For the new projects that we are currently building today, we are looking very hard and have incorporated a residential element into most of those projects," said Stephen Sterrett, CFO of Simon Property Group. Simon's Coconut Point, which will be located on the southwest coast of Florida, will include 275 condominiums. Simon may add residential units at Phipps Plaza in Atlanta. Like many other mall operators, Simon is developing new projects calling for "open air" shopping center design. Some are called "lifestyle" retail projects that recreate streets, with retailers facing the outside. Many of these projects, which seek to create their own "downtowns," already exist, such as Federal Realty Investment Trust's Santana Row in Palo Alto, California. More interestingly, mall owners are looking for opportunities to add substantial amounts of residential components when redeveloping or expanding already existing malls. They're hungrily watching for department store closings in their malls as a chance to use the space for residential construction. "When and if the May-Federated merger results in us recapturing some department store space, that potential reuse for an existing department store building could very well be vertical residential," Sterrett said, referring to the pending merger between May Department Stores and Federated Department Stores. General Growth Properties said that in addition to adding a Neiman Marcus and Nordstrom to its Natick mall in Boston, it is considering two residential condominium towers to complement the project. In Hawaii, General Growth will add rental housing at the Victoria Ward properties. The company may build a large residential project as part of the redevelopment of Landmark Mall in Alexandria, Virginia. "We're only looking at it in markets where we see the demand is there," General Growth CEO John Bucksbaum said, during a recent call with analysts. "In Las Vegas, we have opportunities to do residential projects, particularly with the Fashion Show project," he said. "There are a number of centers that we're looking at this with." Consumer spending, the backbone of the U.S. economic recovery, has made retail real estate one of the best- performing sectors. Demand for prime locations in strong upscale malls has been heated. With that said, how do the mall owners dedicate space for residential development when retail space is in such demand? "That's the trick," Sterrett said. "What's the highest and best use for a relatively scarce asset, which is the land that we have available?" In the regional mall business, the shopping centers are fairly evenly spaced apart. Each has its own trade area. Said Sterrett, "To the extent that we have satisfied most of or much of the retail demand in a particular market by our mall, are there other commercial uses that we should be looking at to intensify the land use at that particular location?" Friedman Billings Ramsey analyst Paul Morgan said mall companies add residential development to boost their funds from operations. Although condominium sales don't usually contribute to FFO, this revenue can boost the amount of cash that can fund the company's core retail real estate position. "Where you have density and income, and you have the opportunity to do a larger redevelopment or a ground-up development, I think it can make a lot of sense," he said. "If you just happen to have extra land and somebody else is putting up condos, that's a short-term prospective. I would be concerned if that took off in a major way." Most malls don't go beyond three levels because shoppers don't usually go above that, Sterrett said. Residential development lets mall owners get cash from higher floors. "Instead of doing two levels of retail and being limited to 100,000 square feet of additional retail," Sterrett said, "you could do 15 or 20 stories of multifamily. In fact, the higher floors are most desirable because of the views."
Kimco's move follows news that Equity One is branching further into mixed-use developments from its base in retail. Currently, Equity One, which traditionally develops and manages community shopping centers, is in a joint venture with Amprop Development Corp. to develop the 155-acre mixed-use Sunlake Development near Tampa. Equity One and Amprop will develop the office and retail components together, but are also looking to add a housing component to the project. In a recent column in Retail Traffic, Doron Valero, president of Equity One talked about his company's diversification plan and how he expects it to add value: "A mixed-use development can become the center of a neighborhood, having guaranteed traffic from the residential component," he explained. Simon is also seeing more potential in the mixed-use format. Recently, the company announced Version 5.0, a new design program for its regional malls, where it will add residential, hotel and office components to its malls. Kimco did not provide specific details on how many properties it will convert or if the properties will become mixed-use centers or purely residential. Kimco did not make executives available for further comment. However, Cooper said the company has looked at several New York area properties for possible conversion. Kimco may also team with a local developer and add residential components to other properties in such hot markets Miami, according to an analyst note from KeyBanc Capital Markets. "It doesn't surprise me that the company is thinking outside of the box at the end of the day to maximize the value of the real estate they manage for their shareholders," says David Aubuchon, an A.G. Edwards & Sons Inc. analyst. "It appears that they are looking at specific assets that may translate well from retail to residential." Higher interest rates mean that the marginal building doesn't get built, and nothing kills real estate quicker than supply. If you want to understand competition, imagine owning an office building and somebody puts up an office building right across the street from you. You're going to be competing on rent, on space, on everything. That's what kills real estate, new supply. Higher rates slow supply down. So higher rates in the long run are not bad news for REITs. (Andrew Davis, manager of the Davis Real Estate Fund, Wall Street Week 5-20) Fitch Affirms BBB Rating Of First Industrial Realty Dow Jones Newswires 5-23 Fitch Ratings has affirmed the 'BBB' rating on $1.3 billion of senior unsecured notes due 2006-2032 of First Industrial. Additionally, Fitch has affirmed the 'BBB-' rating on FR's outstanding preferred stock. The Rating Outlook remains Stable. The 'BBB' ratings continue to reflect FR's good asset quality of A/B industrial properties with a nationwide geographic presence. FR continues to maintain a very diverse base of tenants with the top 20 tenants contributing only 12.3% of annualized lease net rent for the period ending March 31, 2005. Additionally, First Industrial maintains a diverse investment strategy across the entire spectrum of industrial asset classes. With 848 total in service assets, the company's largest concentrations lie in the bulk warehouse and light industrial categories, representing 38.3% and 35.8%, respectively, of base rent as of March 31, 2005. These two categories combined represent 74.1% of base rent up 300 basis points from the year-ago period. The company's recurring EBITDA (excluding gains on sale and income from discontinued operations) coverage of total interest expense, as well as Fitch-calculated fixed-charge coverage hovers at the low end of the industrial peer group averages. Excluding gains, the company's total interest coverage ratio has averaged 1.8 times and Fitch-calculated fixed-charge coverage has averaged 1.2x for the past two years. Fitch notes that additional earnings support of total interest expense, as well as fixed charges is available from the company's gains on sale of real estate, not included in the above metrics. Considering current market fundamentals and overall economic forecasts, Fitch anticipates increases in the company's coverage ratios as improvement is experienced in core rental revenue. Fitch recognizes that First Industrial's business strategy includes gains on sale of real estate, which in a market that has a strong bid for industrial assets is a positive for the company. Over the past few years, this contribution to the company's earnings has grown. In 2004, the company reported over $98 million in gains, including gains on sales in their unconsolidated joint ventures versus core rental revenue of $320 million. That being said, Fitch continues to identify this income as volatile and less dependable than core recurring rental revenue. Fitch will continue to monitor closely the relationship of core rental revenues versus gains on sale of real estate. From a balance sheet perspective, the company's leverage is slightly higher than its three-year average of 51.8%. As of March 31, 2005, the company recorded total debt as a percent of total undepreciated book capital of 53.2%. When adding preferred stock, the company's debt plus preferred ratio increases to 57.5%, which compares favorably to its historical average of 59.1% due to some recent refinancing of preferreds. The company's overall effective leverage (total debt plus preferred) is higher than the industrial REIT peer group average of 52.6% as well as the broad REIT BBB peer group average of 51.1%. Additionally, the company has 96.3% of its real estate as unencumbered which Fitch views as positive as this allows for some downside protection for both bondholders as well as preferred stock holders. Finally, the company maintains a majority fixed rate debt structure which insulates the company from increasing interests. As of March 31, 2005, only 10.1% of the company's total debt was subject to variable rates. First Industrial Realty is a $3 billion REIT focused on the acquisition, ownership, management, development, and redevelopment of industrial properties. FR's portfolio exhibits a nationwide geographic presence consisting of 867 properties, encompassing 66.3 million square feet. FR is focused on 25 domestic markets with its primary markets including Denver (9.0% of rental income), Detroit (8.3%), northern New Jersey (8.1%), Dallas/Forth Worth (8.0%), and Minneapolis/St. Paul (7.9%). S&P Outlook: Post Properties Revised To Stable Dow Jones Newswires 5-17 Standard & Poor's Ratings Services today revised its outlook on Post Properties to stable from negative. In addition, the 'BBB' corporate credit ratings on Post are affirmed. The rating actions affect roughly $472 million in rated debt securities. "High-quality assets, improved occupancy and diversity, and expectations for slowly but steadily improving apartment fundamentals should contribute to better stability of cash flow and coverage measures. Post has manageable capital needs and sufficient financial flexibility. While coverage measures are below average for the rating, they are stable, and modest improvement is expected," explained Standard & Poor's credit analyst George Skoufis. Credit weaknesses include Post's concentration in Atlanta, Ga., its recent foray into condominium conversion and development, and dilutive asset sales, which contribute to a persistent, but manageable, dividend shortfall. The stable outlook is supported by more stable apartment fundamentals following four years of negative same-store results. One-third of Post's NOI is derived from healthier markets, which should provide greater stability to property-level performance and cash flow, and ultimately to coverage measures. Furthermore, while Post's disposition activity is dilutive and exacerbated a dividend shortfall, it has improved the quality of the portfolio and culled out older and more weakly located communities, and further diversification efforts should benefit the portfolio and cash flow. Standard & Poor's expects that over time, Post will manage its fixed charge coverage to a level comfortably above 2x. Fitch Assigns 'BBB' to BRE Properties Business Wire 5-13 Fitch Ratings has assigned a 'BBB' rating to the recent offering of $150 million 4.875% five-year senior unsecured notes issued by BRE Properties. Proceeds will be primarily used to repay outstanding variable-rate line balances on the company's unsecured bank credit facility. Additionally, Fitch affirms the 'BBB' rating on approximately $848 million of unsecured senior notes of the company due 2005-2014. Additionally, Fitch affirms the 'BBB-' rating on the company's preferred securities. The Rating Outlook is Stable. Pro forma for the offering, the company's debt service coverage ratio (EBITDA/total interest expense, including capitalized interest) for the last 12 months (LTM) ended March 31, 2005 decreases slightly to 2.46 times (x) from pre-offering calculated 2.55x. The decrease in coverage is a result of refinancing $150 million of debt from a Fitch-calculated LTM weighted average variable interest rate of 3.20% to a 4.875% fixed rate. This coverage metric continues to be adequate for the rating category. This debt offering reduces the company's exposure to variable-rate debt and terms out line of credit borrowings with longer term debt, which Fitch views as a credit positive. The company's debt leverage as of March 31, 2005 was 50.2% of undepreciated book capital. This leverage measure compares favorably to the company's three-year average of 50.4%. Including preferred stock, debt leverage plus preferred equals 59.1% of undepreciated book. This metric, while down from 04 levels, is higher than the company's three-year average of 57.2%. Both leverage metrics remain sufficient for the rating category. Additionally, with a 2010 maturity on this bond, BRE was able to further ladder their debt maturity schedule, placing this bond in a year when they previously had $0 of unsecured debt maturing. Excluding the company's line of credit, BRE has just under 4% of its total debt maturing in 2005 and 2006 combined. In 2007, the company has $200 million of unsecured debt maturing, or 15% of total debt (including $14 million of secured debt) as of March 31, 2005. BRE develops, acquires, and manages apartment communities with a strategy to locate assets convenient to its residents' work, shopping, entertainment, and transit in supply-constrained Western U.S. markets. BRE directly owns and operates 85 apartment communities totaling 24,006 units in California, Arizona, Washington, and Colorado. The company currently has nine other properties in various stages of development and construction, totaling 2,339 units, and joint venture interests in two additional apartment communities, totaling 488 units. As of March 31, 2005, the company's same-store portfolio had average occupancy of 93.8%, with average market rent of $1,125 per unit. The company breaks its investments out into four regions with Southern California contributing 51% (to NOI), Northern California (24%), Mountain/Desert (13%), and Pacific Northwest (12%). S&P Affirms 'BBB' Mack-Cali Realty Corp Credit Rating press release 5-05 Standard & Poor's Rating Services today affirmed its 'BBB' corporate credit rating assigned to Mack-Cali Realty, impacting $1.3 billion in senior notes. The outlook is stable. "The affirmations acknowledge the company's conservative financial position, stable occupancy rates, and focused operating strategy," said Standard & Poor's credit analyst Linda Phelps. "These strengths are tempered by continued softness in many of the company's markets, some lease expiries over the next two years, and concentration of assets in the state of New Jersey." Mack-Cali's operating results and occupancy levels remain relatively stable despite challenging market conditions in many of its core markets. Although the company faces some near-term pressure on rental rates and occupancy with expiring leases, Standard & Poor's believes the impact to Mack-Cali's overall financial position is unlikely to be significant given a well-managed balance sheet and relatively conservative dividend policy. Standard & Poor's will, however, continue to monitor the progress of the Meadowlands Xanadu project as the ultimate outcome and impact to the company remains uncertain. S&P Affirms 'BBB' Ratings On United Dominion Realty press release 5-09 Standard & Poor's Ratings Services today affirmed its 'BBB' corporate credit rating assigned to United Dominion Realty Trust. At the same time, ratings on the company's senior unsecured notes and preferred stock are affirmed. The affirmations affect approximately $1.5 billion in senior unsecured debt. The outlook is stable. "The affirmations reflect the improving quality of a competitive multifamily portfolio as well as coverage measures that have benefited from a series of favorably priced capital markets transactions," said Standard & Poor's credit analyst Tom Taillon. "Recent acquisitions, although expensive and predominately debt financed, have improved the REIT's geographic mix and should enhance cash flow stability in the future. This should partially offset volatility relating to the impact of rising interest rates and United Dominion's significant component of variable-rate debt." Management's ongoing efforts to reposition the portfolio should continue to enhance the company's competitive position and provide an increasingly stable income stream. Recent signs of improved conditions in the apartment sector should further support coverage and profitability measures appropriate for the corporate credit rating. Moody's Sees REITs as Stable and Could Improve Reuters, 5-10 The credit rating on U.S. real estate investment trusts and operating companies is stable and could be positive in 2006, depending upon the property companies' use of debt, reliance on fee-based income, and market leadership, a Moody's report said on Tuesday. For the past two years, as interest rates sank, real estate investment trusts, or REITs, and real estate operating companies, have enjoyed the high prices real estate has commanded, despite the floundering underlying assets, such as office and industrial property. This helped push up the price of the stocks of REITs and real estate companies. And with an expanding economy, the fundamentals of most real estate classes are picking up. "An important question is whether real estate has reached an inflection point where the performance of the underlying real estate is finally improving, but the value of real estate, as represented by REIT's stock prices and market cap rates on property assets, as well as the frothy capital markets, start to flatten," the report said. Cap rates are yearly yields, which for the past two years have been getting lower and lower as buildings have fetched higher and higher prices because of a flood of capital. "The top questions facing the industry are whether commercial real estate has peaked as regards to cap rates, and whether REIT stock prices and debt finance terms turn more hostile," Philip Kibel, Moody's senior vice president, said in a statement. Some REITs used the high-priced market to shed properties in non-core markets and reduce debt. Additionally, record-low interest rates have enabled many REITs to refinance their high-interest debt. "The prudence of most REIT managers in the face of considerable business pressure allowed REITs to retain relatively strong credit metrics during the downturn, in marked contrast to previous recessions," Kibel said. However, some REITs used low-borrowing costs to fund expanding development and redevelopment activity, or bought assets with large amount of vacancy on the hopes the vacancy rates would fall. Others entered into real estate funds and joint-ventures, where much of their profit came from fees. "These firms will face liquidity and growth challenges should the real estate market lose some of its fizz," the report said. "The ultimate effects of these structures on REITs' transparency, strategic complexity, true leverage, liquidity and earnings stability can be negative," John Kriz, managing director of Moody's Real Estate Finance team, said. "Firms that have increased their earnings by way of strategies such as real estate funds and joint ventures may find the costs outweighing the benefits." In regards to real estate sectors, Moody's said it based the stable outlook for U.S. office REITs on declining vacancies, rising employment, and a limited supply of new space. Moody's said it believes most office REITs have managed their balance sheets prudently and does not expect this to change. It based its stable outlook for industrial REITs on expectation of moderate leverage, a large supply of unencumbered assets, and firming rental rates and occupancy, supported by an improving economy, which has led to a rise in industrial space needs. Moody's said the multifamily REIT sector's stable outlook reflects improving cash flows and fading tenant concessions following several years in which the sector's fundamentals were hurt by soft employment figures and a tenant drift to home ownership. Moody's expects most multifamily REITs to push harder for higher rents in 2005 and 2006. For retail REITs, Moody's stable outlook reflects healthy balance sheets, leadership by regional malls and continued consumer spending, which has supported retail property values and rents. Rising interest rates and energy prices could challenge the sector later in 2005, as they could curb consumer spending and raise operating expenses. Additionally, a rise in leveraged consolidation among retailers and REITs could also cause rating downgrade pressures. Quick Facts The American Stock Exchange, home of most U.S. ETFs, said short interest in the StreetTracks Wilshire REIT fund represented 57.2% of total shares outstanding, and 124.6% for iShares Dow Jones U.S. Real Estate as of mid-April. Meanwhile, short interest for individual U.S. stocks averages about 2%. (John Spence, Marketwatch 4-27) More REIT Links News Links
Update: Fourth Experiment in Stock Picking 5-31-05 A less than sector balanced portfolio is compared with the average of two REIT index ETF's: ICF [Cohen & Steers Realty Majors - the top 30 REITs by market cap] and RWR [the REIT Wilshire Index]. The first experiment went from Nov 02 to Oct 03, the second experiment went from May 03 to May 04 and the third experiment went from Jan 04 to Dec 04. This experiment has a shift towards being over weighted in Office and having two key holdings - MLS and VNO - and being over weighted on growth REITs [MLS, VNO, ARE and OFC] and under weight on value [like HR, CRE, HME and UDR]. This experimental portfolio starts off with a possible disadvantage - both MLS [at 7.41%] and UDR [at 7.87%] had large gains in December [and thus stretched valuations] just prior to the start of these stats. It is probably true that valuations were stretched all year. And four of these stocks [MLS at 50.72%, DDR at 38.25%, VNO at 44.24% and OFC at 44.62%] notably out-performed the ETF's and REIT sector fund average of 32%. So I might expect to give back some [but not all] of 2004's 300 basis point out-performance of this portfolio. Note that this portfolio, while being weighted toward higher growth and lowering yielding REITs, still pays a dividend of $785 per quarter vs. RWR's $655 and ICF's $562. This experiment will not last a year - as planned additions to the portfolio will come in late spring to early fall. Leading candidates for admission at this time are: [1] Mall: SPG and/or MAC; [2] Retail: CARS [200 more purchased @ $33.19 on 4-21], maybe CDR [GARP] or more DDR [growth]; [3] Apts: UDR [value]; [4] Office: KRC [growth], maybe PKY [value] - or maybe none, and go with industrial FPO; and [5] Health Care LTC, VTR or WRS [high growth, high yield, low Price/FFO]. My top three holdings represented right at 50% of the total portfolio - and I want to get this percentage down. I also plan to add to the existing portfolio of MLP/Energy stocks [currently ETP, EDP and XOM] shares in KMP and MMP [strong distribution growth history with good future prospects] and MWE/XTEX [growth]. And I want to start my bank portfolio with large-cap BAC, C, and WFC and mid-cap/regionals ASBC, CBCF, CBSS and RF. This gives me a larger menu than budget - so purchases will have to leak over into 2006. Earnings Guidance & Dividend Changes: OFC gave 05 FFO guidance of $1.78 - $1.85 per diluted share in their Q4 conference call on 2-10-05. The current consensus estimate is $1.84. OFC on 5-19 declared a quarterly dividend of $0.255 per Common Share of beneficial interest [an increase from 24 cents/share]. The dividend will be paid on 7-15 to shareholders of record on 6-30. UDR on 2-16 announced a 2.6% increase in its dividend for 05 to $1.20 per share. ARE on 2-14 updated its 2005 earnings guidance, based on it's view of existing market conditions, to an FFO of $4.78 [vs a current consensus of $4.80]. On 5-11, ARE announced expected 05 FFO/share to be $4.79. AMB on 3-01 declared a regular cash dividend for Q1 of $0.44 per common share. The dividend reflects an annual indicated rate of $1.76 per common share, an increase of 3.5% over the 2004 annual dividend. On 4-12 CARS announced that it raised the company's quarterly dividend to 43.8 cents per share, payable on May 20 to shareholders of record as of May 10. HR on 4-26 announced its forty-seventh consecutive common stock dividend increase. This dividend, in the amount of $0.655 per share, represents an increase of $0.005 per share. The dividend is payable on June 2, 2005 to shareholders of record on May 16, 2005. At this rate, quarterly dividends approximate an annualized dividend payment of $2.62 per share.
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