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REITs Feel the Heat

Public companies must grow. Their stockholders demand it. In 1999, REITs seemed to reach a plateau in their ability to grow. Industry observers suspect the condition will persist throughout 2000.

The problem is as old as business itself: It takes money to make money. And REITs, through a convergence of events, are finding itdifficult to raise the capital required to generate new capital.

REITs have two options when it comes to building shareholder value. First, they can shine up existing centers to build sales, and eventually profit from increased rents. But that takes time as well as capital.

The second method brings swifter results: acquire new assets by developing new properties or buying existing properties. Acquiring new properties offers a fast track to growth. But once again the process starts with access to capital.

For REITs in most retail categories, raising capital poses difficult, if not insurmountable, problems.

Anthony Downs, a senior fellow with the Brookings Institution in Washington, D.C., lists four tools traditionally used by REITs to raise money.

"First, you can issue forms of stock and pursue private placement investments," he says. "Second, you can increase your debt ratio by borrowing money. You can build internal cash flow and use that as a source of capital. Finally, you can form joint ventures with other companies."

Downs as well as a number of retail REIT executives believe the current financial position of most REITs today effectively eliminates the first two options. At the end of 1999, most REIT stocks had fallen in price to levels that make new stock issues unwise.

Take, for example, the 12 largest REITs specializing in malls. Those REITs as a universe saw their stock prices fall by 23% during 1999, says Keith Honnold, director of acquisitions in the Boston office of Chattanooga, Tenn.-based CBL & Associates. "This has had a tremendous impact on capital as it comes from stock," he says.

The reasons for low REIT stock prices, according to virtually all observers, have nothing to do with the quality of the REITs themselves. For the most part, their business fundamentals remain strong; at the store level, consumers continue to buy.

Investors simply don't care for REIT stocks in today's market. "REITs are income stocks," Downs says. "Their primary ability is to produce a steady flow of income through dividends. Their real property value is not going to go up in value at the same rate of the high technology companies favored by investors today."

Because REIT stock prices are low, new stock issues would dilute the holdings of current investors and create pressure for them to sell, which would lead to another round of stock price declines.

Trying other stock options This difficulty has led acquisition experts at some REITs to consider the opposite of selling stock: buying it back. "Two or three REITs have announced this strategy," Honnold says.

Under this strategy, a REIT would have to wait for stock prices to rebound, sell the stock back into the market, and use the capital appreciation to finance growth. "But where do you get the capital to buy back your stock?" Honnold asks. "If you use a bank line, you increase the debt-to-capitalization ratio," on the hope of a near-term rise in stock prices.

And borrowing isn't easy for a REIT today. "Many mall REITs acquired properties with debt before going public," Honnold says. "When these companies completed their initial public offerings, their debt-to-capitalization ratios ranged between 30% and 40%. Those companies who went on to buy more properties with debt since going public - and all have gone public since 1993 - have had to raise their debt ratio to make those acquisitions."

A debt-to-capitalization ratio is debt as a percentage of a public company's market capitalization. When stock prices fall, debt-to-capitalization ratios rise. In the REIT world, falling stock prices have caused debt ratios to skyrocket to unprecedented levels. At the end of 1999, for example, CBL & Associates, which owns 140 properties including 30 enclosed regional malls, saw its ratio rise to 61%.

CBL is no different from other mall REITs. "The industry as a whole has seen debt creep up to a level such that borrowing additional funds on assets isn't a viable alternative," Honnold says. "Wall Street doesn't like debt-to-capitalization ratios over a certain level, and their benchmark appears to be around 60%. Mall REITs that haven't slipped above that level are probably approaching it."

This doesn't mean that a REIT cannot borrow. That depends on the company's relationships with lenders and existing covenants in lines of credit. The problem is that a company with a debt ratio higher than 60% risks the wrath of its shareholders if it continues to borrow. When shareholders sell, debt ratios rise and the problem grows more intractable.

REITs capitalize on their strengths The third tactic for raising capital - by way of internal growth - presents problems as well. One would assume that a capable REIT is already managing properties to produce maximum returns. How much more can tighter management squeeze out?

Internal growth may have another angle to it. Honnold suspects that some REITs are preparing to implement a related strategy. The idea involves selling non-core assets and using the proceeds to buy non-core assets from other owners. The trick lies in matching property acquisitions to particular REIT strengths.

"For example, our (CBL's) expertise includes leasing, our ability to understand markets in second-and third-tier cities, and in redeveloping or repositioning properties," Honnold explains. "Maybe another REIT has particular skills in asset management, bringing in goods, services and utilities in a more efficient manner."

Because not every REIT has the same expertise, an acquisition strategy may involve virtual swaps of assets between two REITs. A REIT with leasing and repositioning skills could buy a center matched to its expertise, and sell a non-core center that another REIT might have better luck managing. If the deals remain more or less capital-neutral, both REITs would find themselves with an avenue for growth. Rationalizing REIT portfolios in this way seems to be a workable strategy, but it will take time to make the deals worthwhile.

Making the most of partnerships Perhaps the most realistic acquisition strategy for a cash-strapped REIT is finding a cash-rich joint venture partner and undertaking off-balance-sheet projects.

Many REITs have indeed implemented this strategy. Southfield, Mich.-based Ramco-Gershenson Properties Trust formed a joint venture in September 1999 with InvestCorp International Inc. in New York City. InvestCorp focuses on an investment strategy of buying companies it believes to be undervalued.

The InvestCorp strategy is in keeping with Ramco-Gershenson's historical approach to the community and power center market. "Throughout the 1990s, we focused on acquisitions that we could add value to over the term of our ownership," explains Dennis Gershenson, the company's CEO. "While we have always believed that the assets we buy are accretive as of the day we buy them, what we are really looking for is the ability to add our expertise and do more with the asset."

In today's environment, however, lack of capital denies companies such as Ramco-Gershenson the ability to use its expertise to build shareholder value. The joint venture with InvestCorp offers a potential solution in the form of off-balance-sheet investments. "This idea is a real plus for REITs," Gershenson says.

Under such a strategy, the lion's share of an investment comes from a third party lending specifically on the asset, which the joint venture owns. Most of the equity comes from the joint venture partner, allowing the REIT to leverage a small amount of capital into a deal with large potential returns.

"If I bought a $10 million center on balance sheet, 50% might be my equity and 50% might be debt," Gershenson says. "If I bought this property at a capitalization rate of 10%, I would get a 10% return on the asset, maybe a little higher because I would be using my own debt.

"In an off-balance-sheet joint venture," he continues, "where the venture leverages 70% to 75% in debt, and 75% of the equity comes from my joint venture partner, I will generate a cash flow, redevelopment fees, asset management fees property management fees and other fees. Those fees will increase my return to 20% to 35%."

A joint venture structured in this way also provides a pipeline of properties for a REIT should stock prices rise, continues Gershenson. At that point, the REIT might buy out of the joint venture and add the asset to the balance sheet.

Cleveland-based Developers Diversified Realty Corp. uses a similar off-balance-sheet joint venture structure to build instead of buy. In 1999, for example, the company bought one property in Arizona and planned development for nearly $1 billion in properties that are now either now under construction or already completed.

According to Jim Schoff, the company's vice chairman and chief investment officer, acquiring properties during the 1990s made sense because it was possible to find deals in which the cost of capital - both debt and equity - did not exceed the cap rate for the property.

"Today, the cost of capital is 11% to 14%," he says. "For example, put two parts of equity capital into a deal at 12% and add one part of debt at 8%. Add those together, and you get 32%. Divide by three, and the blended rate of capital for the deal is almost 11%. If you're going to buy a property at a 10% cap, and capital costs 11%, you're losing money."

When building a center, however, the yield is typically 12% cash to cost return. "If a property costs $50 million to build, I should get a 12% return or $6 million in cash flow," Schoff continues. "If my $50 million costs 11%, I'm still making out. And someday, when interest rates fall and my stock price goes up, my overall cost of capital will be less and I can take that debt out."

Acquiring other REITs Not all REITs find the current economic environment so challenging. Jacksonville, Fla.-based Regency Realty Corp. has grown steadily and almost solely through acquisitions since going public in 1993. The company has grown from $360 million to $2.5 billion by acquiring other REITs that specialize, as does Regency, in neighborhood centers. The firm's largest acquisition came in the form of a 1999 merger with the $1.1 billion Pacific Retail Trust.

Today, Regency owns 216 properties across the country. Its stock price stands at $20.50, only slightly lower than its 52-week high of $23, and its debt-to-capitalization ratio stands at 37%.

"We've done well," says James Buis, managing director, who is based in Regency's Dallas office. "I think a lot of it has to do with what we specialize in and where the industry is in the real estate cycle. Our focus is neighborhood centers, which is considered the strongest and safest place to be when there is a downturn."

Despite a history of growth through acquisitions, the company has backed away from buying and turned to development. "This year, we'll develop approximately $300 million of product," Buis says. "Cap rates in our segment are way down. That has made it expensive to buy and more rational to develop."

Regency finds itself unconstrained in terms of stock price and debt-to-capitalization ratio. As a result, the company can grow in whatever direction it chooses, however it chooses.

It's an enviable position.

While REITs' acquisition strategies are often related to the whims of Wall Street, private shopping center owners can make their own rules. Investors are reading between the lines of sales figures and capitalization rates in hopes of finding value-added acquisitions.

"Specific cap rates and price per sq. ft. criteria are truly only relevant if you're buying strictly based on yields. I'm looking to create my own value," says Andrew Hascoe, president of Purchase, N.Y.-based Bryant Development Corp. Bryant Development's most recent acquisition was the late-1999 purchase of a 1.4 million sq. ft. portfolio of eight shopping centers in Austin, Texas. All of the properties are in densely populated neighborhoods with below-market rents.

Equity Investment Group in Atlanta is another firm focused on buying grocery-anchored centers with some upside. Such value-added opportunities include the potential for below-market rents, expansion opportunities and outparcel lot sales. For example, Equity purchased Northeast Plaza in Atlanta last fall, due in part to the opportunity to fill 150,000 sq. ft. of vacant space.

"It looks like the good opportunities will be fewer in 2000," says Bob Sutton, Equity's vice president of acquisitions. The biggest challenge is that many investors have identified the same criteria, he adds.

"We want some opportunity for growth. We don't want a fixed-income property for the next 20 years," agrees Joe Edens, chairman of Columbia, S.C.-based Edens & Avant. The company targets stable grocery-anchored centers that possess reasonable prospects for growth. In December alone it acquired 11 shopping centers, located in strong growth markets in Florida, South Carolina, North Carolina, Tennessee, Pennsylvania and Rhode Island.

Edens & Avant's "Necessity Retail Center" portfolio encompasses more than 200 shopping centers in 18 states east of the Mississippi. The newest acquisitions expand the company's retail GLA to more than 21.5 million sq. ft. "We feel awfully strong about necessity retail and have been involved in both development and acquisition," Edens says.

Grocery-anchored centers are the property of choice among many investors because of stable performance and strong traffic patterns. But not just any food anchor will do. Edens & Avant targets grocers that are in the top three for market share in any given community. The company also values proven concepts. "We don't like to reinvent the wheel," Edens says. "We don't like properties where the food grocer is pioneering."

A dominant grocer anchor is also one of the top criteria for Bryant Development. The shopping center doesn't always have to be state-of-the-art, but it does have to be anchored by a grocer that possesses dominant market share, Hascoe agrees. Other key components include neighborhood or community shopping centers situated in prime "Main and Main" type locations with no nearby vacant land for new development.

In addition, investors need to tie property acquisitions to a larger geographic expansion plan. Part of Edens & Avant's strategy involves building a critical mass of properties in geographic regions, allowing tenants to be in centers throughout the firm's portfolio. For instance, if Edens & Avant builds a relationship with a retailer in one of its centers, there might be opportunities to place that retailer in some if its other centers within the same geographic region.

"We've got an awful lot of markets where we want to gain a greater presence, and some that we're not in that would tie in with our existing geographic distribution," Edens says. Other pertinent factors for Edens & Avant include buying centers in areas with strong population growth, above-average household incomes and a healthy economic environment.

Bryant Development follows a similar strategy aimed at assembling regional concentrations of properties that help make operations more efficient. For example, the firm's acquisition of the Pennsylvania Public School Employees' portfolio in late 1999 created a stronghold of properties in the Austin metro area. Bryant will continue to look for similar group acquisitions in the future, as well as shop for properties in regions where it already owns shopping centers, such as in South Carolina.

"We don't necessarily focus on an area and then look at shopping centers in that area," Hascoe says. "We usually look for the availability of product, and then focus in on an area."

Once properties have been identified, Bryant Development looks for growth-oriented communities characterized by dense populations. The company was drawn to Austin because of the city's business diversity and growth, its status as the state capital, an expanded international airport and a state university. Austin also has one of the nation's largest concentrations of semiconductor firms, and it is a growing seat for Internet communication businesses.

"We look at a diverse marketplace," Hascoe says. "We don't normally walk into a marketplace where there is a single factor to employment."

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