Maximizing compensation through value creation

Healthy industry segments bode well for rewards but greater formalization is still taking hold on the compensation front.

This year within the real estate industry there was a lot of activity in the area of compensation. Not surprising, given the healthy level of activity the real estate industry in general enjoyed this past year. 1996 was, for the most part, a very bright year for real estate. Virtually all industry segments have, to some extent, recovered from the abyss of the late 1980's. Market stabilization manifested itself through the continued return of investment dollars and growth of capital placed.

Private Real Estate Firms (Developers and Full-Service), ever cautious regarding maintaining and increasing their profit margins but anxious about rewarding key contributors, have grown to a level where they can no longer function with their current entrepreneurial-styled compensation plans. Many have realized that more formalized programs which can ensure both external competitiveness and internal equity among positions and capitalize on their firm's strategic advantage are essential at this time of competitive rivalry.

Compensation programs within most Investment Advisory Firms and Insurance Companies remain formal in nature and conceptually well developed. Independent investment advisers continue to pay well in the good years and lay off in the bad years, quite the opposite of their insurance company counterparts. Yet, ensuring market competitiveness of base salary and incentive compensation is appropriate within both industry segments. Moreover, aligning the appropriate performance measures and standards for incentive payout continues to be a focus of discussion among investment advisory firms today. Managing and balancing the interests of the firm and their clients will drive future compensation programs.

While the REITs continue their pace towards larger market capitalizations and greater total shareholder returns, compensation for senior management remains a controversial issue. The future of the REIT industry is still unknown. The foretold wave of mergers and acquisitions within this industry hasn't quite come to fruition. Many would say this industry segment is one in its infancy. Others contend that the REITs are in a state of old age and decline Realizing the limited value of stock options, alternative forms of long-term incentives are appearing in greater frequency. Those REITs with carefully crafted long-term incentive plans are showing analysts and investors that they expect to survive the long-haul and that they have a plan in place to reward the achievements that will allow them to do so. Performance-based stock plans driven by total shareholder return will undoubtedly win out.

Although the economy was strong this past year, interest rates were higher than anticipated. Nonetheless, the Homebuilders continue to thrive in a market shots on labor supply and high on local competition. Not unlike the private developers of the 1980s, the publicly traded homebuilders of the 1990s will realize as they grow in size that more formalization and standardization is needed with respect to their human resource policies and practices. Obtaining the appropriate market compensation data will help these builders keep their costs consistent with their competition while employing the best talent available.

Since the real estate market has recovered to a great extent and in many cases is showing accelerated growth, firms are wise to step back and assess their human resource practices to ensure that they are appropriate for this new environment. Three years ago "star" professionals may not have been able to find viable new employment alternatives but given today's healthy environment, you can be guaranteed that someone is ready and willing to make them an offer. Yet, due to the leverage of incentive pay that has occurred over the past few years, only the performance of these professionals and their potential new firms will ultimately determine if an offer is economically more attractive than their current situation.

Value Creation

When examining career opportunities, one issue for real estate professionals to consider is, "Within which industry segment is my function most closely associated with the firm's value creation process?" The answer to this question may provide an individual with the key to maximizing compensation dollars for the services they can provide. From the organization's perspective, understanding multiple industry segment's pay practices is the only way to competitively reward highly mobile talent.

Determining which functions contribute the most to the value creation process is a difficult endeavor. Clearly, each individual has an impact on the ultimate success or demise of its respective firm. Real estate companies are consciously or unconsciously acknowledging the impact a particular position has on value creation through their compensation programs. Yet, this is very much dependent on the nature of the industry segment and the strategic objectives of the firm in question.

A brief example of how the nature of the industry segment can influence compensation can be illustrated as follows: Value for the firm is created within the investment advisory industry by achieving superior investment returns on the assets under management as well as increasing the number of assets under management by the firm. Therefore, although many functional areas ultimately aid in this process, marketing, acquisitions and asset portfolio management are most often associated with value creation. This is substantiated by the fact that compensation levels for these functions are, in most cases, superior to that of other functions within Investment Advisers.

An equivalent influence on the compensation of various functions than industry segment is a firm's specific strategic objectives. In many cases, functions that are closely aligned with value creation in an industry are also closely aligned with value creation in a specific firm. Deviations, however, do and should occur if consistent with the firm's strategic objectives. For example, a firm may be operating in an industry segment that has in recent times derived much of its value through the acquisitions function, such as REITs. Yet, a particular REIT's strategy might include goals that can only be met through a high volume of new developments or advantageous capital structures. Within this REIT, development and capital market functions may be receiving compensation at or above that of acquisitions.

Based on discussions we have had within the industry this past year as well as FPL Associates' proprietary database of compensation information, we have identified functions which appear to be most closely aligned with the value creation process within the private real estate (developers and full-service), investment advisory, insurance, REIT and homebuilder industry segments. The tables accompanying these pages display the market competitive base salary and total annual cash (base plus annual incentive) compensation data for these positions by industry segment. It is important to note that selecting the appropriate peer group of organizations is essential when comparing compensation levels. The data shown approximates "market median" practices for real estate firms. This data should be utilized to provide a helpful overview of the real estate industry compensation practices.

Functional Analysis

Chief Officer While the chief executive officer and chief operating officer positions continue to be crucial to the success of every firm, clearly, the investment advisors and REITs ability to thrive and survive going forward will be dependent primarily upon the chief executive officer and .chief operating officer's ability to create a presence and a following in the capital markets. Private real estate firms that have more discretion in their compensation decisions and that typically present a greater risk than more institutionalized real estate industry segments, pay top dollar incentives to chief officers when performance warrants. Chief Officers of public homebuilders that have built a national presence continue to receive some of the most healthy compensation packages around. During the past year, key issues relative to compensation for these two positions continue to include, the establishment of severance agreements (particularly in instances of change of control), performance based long-term incentive programs, and for REITs in particular, professional manager versus founder compensation comparisons.

Finance The availability of capital has increased in the past three years but so too has the competitiveness of the market trying to access it. The emphasis placed on finance by investors, particularly in the public market, has influenced the compensation packages of senior level positions within this functionality. Today, the true value of the seasoned financial professional is recognized by most every savvy real estate deal maker and public company manager around. REITs that have fared well thus far owe much of their success to the chief financial officer or head of capital market's ability to effectively communicate with industry analysts, investors and consultants and successfully manage the corporate capital structure. For these reasons, REITs and investment advisors alike offer fruitful compensation packages to talented financial professionals with a proven track record. During this past year there have been situations where financial or capital market positions have received compensation packages greater than that of general management positions.

Acquisitions Acquisitions is one of the more highly sought after and volatile areas of expertise today. Top-notch acquisitions professionals are finding that they are in high demand in virtually every real estate industry segment. Investment advisors, REITs and private real estate firms with the capital to spend are particularly eager to have the right talent in place now to make the deals happen. High demand in a labor market short on proven acquisitions professionals keeps this function paying top dollar. Key issues of concern relative to compensation include balancing the dollars placed and the dollars available as well as the dollars placed and the number of deals executed in relation to business unit and individual incentives earned. As with many volatile production positions, variable pay and continued employment are strategic issues that overwhelm this function. High earnings for two to four years may be a tradeoff for a more secure environment.

Asset Management Maximizing net operating income and creating value within an asset are key revenue production functions within most real estate industry segments. Large independent investment advisors, private real estate firms and insurance companies will pay top dollar for asset management talent that can consistently increase the value being created within their assets. The value of the asset(s) and the extent to which the asset manager is involved in the leasing, property management and dispositions of the asset(s) also influences the compensation packages of these professionals. The future of this function's pay however is driven by balancing the short term financial needs of the firm with the long-term economic interests of the client or property owner.

Portfolio Management Portfolio managers who can balance the highly demanding expectations of their fund's investors and produce a consistent return are of great value to investment advisors. The extent to which these professionals manage large complicated portfolios and interact with investors determines the level of appropriate compensation. Performance against industry indexes will be the barometer for future compensation in this function.

Development The creativity and insight of the land development professional is crucial to the success of the publicly traded homebuilder and private developer. Large homebuilders as well development companies, put heavy emphasis on a professional's ability to create new opportunities. REITs who are looking to stay in the game for the long haul have also realized that a careful balance between acquisitions and new developments is the way to build a healthy portfolio of properties that will appeal to investors in 1997 and beyond. Private companies are once again building compensation packages around project equity for these key professionals.

Construction Much like development, construction professionals today are most closely associated with the value creation process within the public homebuilders and to a lesser extent, the private developers and the REITs. Construction professionals that can help keep first time buyers loyal to the name are essential to the success of the homebuilder today. REITs and private developers heavily involved in development may also have construction positions on staff or may employ mid-level construction professionals who serve as the firm's general contractor. Talented construction professionals who can ensure the cost, timing and quality of construction projects that are built are being compensated at a premium. As with acquisitions professionals, tradeoffs are frequently made between current income versus stability of employment.

Property Management Property management positions that both generate new business and deliver quality services for existing clients, provide a steady source of revenue for private developers and full-service firms. These firms rely on this income to fund development deals that generate revenue on a more cyclical basis. Moreover, REITs with talented property management professionals are finding it easier to maximize their NOI and provide superior growth in funds from operations. These firms provide the best opportunities for property management professionals today.

Leasing Leasing and investment sales functions continue to provide a major contribution to the bottom line of most private real estate firms. Retail REITs also rely on this functionality to secure prime retailers that will attract shoppers and their purchasing power. The leasing and investment sales functions continue to derive the majority of their compensation in the form of incentive pay. Topnotch professionals with solid track records are some of the highest paid professionals in the industry. Nonetheless, the majority of professionals earn compensation at or just slightly below their counterparts in other functions. Tenant representation leasing professionals continue to maximize their compensation through incentives that allow them to generate huge commissions.

Base Salary Increases

Given the 1990s trend towards pay-for-performance, base salary increases within most industries have been minimal for the past several years. Aside from market reactions to a shortage of talent, few, if any, industries are offering average base salary increases of 5% or greater. In 1997 and beyond, most increases in total compensation will continue to come primarily through various forms of variable pay. The table below summarizes the two-year trend for base salary increases within five segments of the real estate industry.

In sum, key forces, such as the stock market, the labor market, interest rates, tax laws and inflation, will continue to impact executive compensation in 1997 and beyond. So too, a function's ability to create value for the firm will serve as a major determinant of the compensation dollars earned.

Whatever the design, programs for 1997 should be easy to understand and should carefully incentivize the individual, and functional team to achieve goals that will collectively ensure the success of the organization both today and in the years to come. As always communication is the key to any well crafted program's success.

Where is the value being created?

Carl Bruno is a partner and Patty Mitchell is an associate with Ferguson Partners Ltd., Chicago. For further information about Ferguson Partners' executive compensation study, contact the firm at (312) 368-5040.

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