Public vs. Private: White Paper explores the issue

Publisher's Note: It has become the question of the day: Is it better to be a public company (REIT) or a private one? Is bigger necessarily better? And how can apartment firms survive in an age of industry growth and consolidation?

To help answer these questions, National Real Estate Investor and the National Multi Housing Council (NMHC) recently co-sponsored a "White Paper" written by Dr. Kerry Vandell, Director of the Center for Urban Land Economics Research at the University of Wisconsin-Madison, the Tiefenthaler Chairholder of Real Estate and Urban Land Economics, and former Chair of the Real Estate Department.

Based on a presentation at NMHC's 1998 Annual Meeting in Boca Raton, Fla., Dr. Vandell, one of the nation's most respected real estate economists, provides a review of the dramatic and fast-paced changes occurring in apartment finance and ownership.

His report, Strategic Management of the Apartment Business in a "Big REIT" World, provides an up-to-date and comprehensive road map to the changes facing today's sophisticated apartment industry professionals and for a broader audience of real estate executives and industry analysts. Dr. Vandell articulates a strategy for apartment owners and investors seeking to successfully maneuver through the maze of management options present today, including offering several suggestions to apartment companies on deciding whether to grow, diversify, go public, organize as a REIT or sell to the highest bidder.

Dr. Vandell reviews the empirical evidence supporting two dominant, but conflicting, views of the future of apartment ownership. Advocates of the first, the "Swallow the World" view, believe consolidation in apartment ownership will continue unabated until the industry is ultimately dominated by only the largest and strongest of the REITs. Contrarians, and supporters of the "Limited Consolidation" view, counter that disadvantages of size more than offset the advantages beyond a point and that the market will instead reach a steady state in which mergers and acquisitions will ultimately be balanced by initial public offerings (IPO) and spin-offs.

The following are selected excerpts taken from Dr. Vandell's paper.

Two views of the future There are two important sets of questions associated with the real estate capital market dynamics described above. The first set has to do with how these dynamics will play out in the future. More specifically, what will be the overall growth rate in capital committed to the commercial real estate sector, including apartments, and what will be the changing sources of that capital? What does this changing mix mean with respect to the nature of commercial real estate investment vehicles? Will they become increasingly dominated by a small group of large, publicly traded REITs or operating companies primarily making use of the public bond and stock markets to raise capital? Or will the size of these firms be capped, as diseconomies of scale and lack of focus tend to overcome the advantages of size? Will new "niche" players continue to enter and maintain their presence because of special expertise?

The second set of questions relates to how the answers to the first set will affect strategic management decision-making by managers of apartment firms. Will they continue to focus on growth and new acquisitions, as they have in recent years, in order to enhance earnings and drive their share price continuously higher? Will there be dramatic consolidation, as the smaller, weaker firms merge or are acquired by the stronger, larger firms? Will they seek out assets in other market sectors, either functionally or geographically, or both; or will they instead become increasingly focused? Will they succumb to a "corporate mentality" that focuses on standardized quarterly performance reports at the expense of long-term growth opportunities? Will they gain corporate management types at the expense of their "deal making" and "entrepreneurial" talent? Will the small privately held apartment entrepreneur be squeezed out of the middle, resigned either to sell out to the acquisitive big REIT or become one himself?

Over the last year, two competing views have emerged that provide their own answers to these questions. The first - the "Swallow the World" view - postulates that consolidation of the market will continue unabated, ultimately to be dominated by only the largest and strongest of the REITs. The second - the "Limited Consolidation" view - counters that the disadvantages of size more than offset the advantages beyond a point and thatthe market will instead reach a steady state in which mergers, acquisitions, and failures will ultimately be balanced by IPOs and spin-offs. In the following paragraphs, we shall describe these contrary positions, and then follow up with an assessment of which is right, according to recent evidence from empirical studies, theory and practice. Finally, we will use our findings to articulate a strategy for apartment owners and investors seeking a way through the maze of management options present today.

Summary conclusions Dr. Vandell goes on to weigh the evidence concerning economies of scale, the degree of industry consolidation, portfolio diversification and market dominance, management incentives and adequate pricing of risk by the public markets, to conclude that neither view of the future of REITs seems to hold true in the extreme. The study predicts that consolidation is likely to continue for several years after which two types of successful apartment companies will emerge: Aggressive large national owners and more geographically focused regional companies.

* The apartment REIT market is neither "public" nor "concentrated" relative to other "capital-intensive" industries.

* By and large, the perception of rapid securitization and consolidation is not supported by the facts. While public equity capital is definitely being substituted for private capital, the pace of substitution is moderate.

Additionally, excluding the dynamics of a relatively small group of aggressive REITs, the overall level of ownership concentration is low and is also increasing at only a moderate rate.

* The evidence on economies of scale among REITs is mixed. Scale economies are strongly present only in general and administrative (G&A) and management costs, both of which make up only a small part of total costs. They are weak among operating costs, which are larger, and may even provide diseconomies above a certain level. The real unknown is the degree of scale economies in the cost of capital.

* REITs are characterized by the presence of a number of adverse management incentives, although fewer than in the recent past. The fact that they remain suggests market imperfections exist and present opportunities for arbitrage by savvy investors.

* With respect to portfolio diversification and market dominance, even though there are clear differences in portfolio diversification strategies across REITs of different size classes, there is little clear evidence that they matter in the sense of affecting pricing.

* Preliminary empirical evidence indicates that "bigger" may not be "better" beyond a point, mitigating against continued growth and dominance by a small number of mega-REITs within the market.

Copies of the study are available from the NMHC by calling Kim Duty at 202-974-2300.

1. Apartment market is neither "public" nor "concentrated."

2. Perception of rapid securitization and consolidation is not supported by the facts. Overall concentration of ownership is quite low and also increasing at only a moderate rate.

3. Scale economies are mixed.

4. REITs are characterized by a number of adverse management incentives.

5. Little clear evidence that portfolio diversification impacts REIT pricing.

6. "Bigger" may not be "Better" beyond a point.

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