Resurgent REITs

Managers at three companies share the secrets to their success.

After surviving a rocky ride on Wall Street in 1998 and 1999, the REIT industry now is welcoming a resurgence of double-digit returns in 2000.

Returning investors have helped spark a long-awaited rally in the REIT sector. "REITs have done well this year for a variety of reasons," says Ross Smotrich, a REIT analyst and a managing director at New York-based Bear Stearns & Co. Inc. "Our sense has been that large institutions and pension fund investors have been increasingly interested in buying stocks in the REIT sector in 2000."

Depressed REIT stock prices have certainly created some attractive values for bargain hunters. Interest in REIT stocks also has picked up in recent months due to broader market volatility, notes Smotrich. Investors are starting to shift out of shaky tech stocks and into real estate investments due to their perceived stability.

"The underlying real estate supply and demand fundamentals are quite strong, and we expect them to remain that way for the foreseeable future," says Smotrich. Such factors have combined to create a favorable climate for REITs. The average one-year return for equity REITs hit 20.61% as of Sept. 29, a dramatic increase over the three-year return of negative 0.83%, according to the National Association of Real Estate Investment Trusts (NAREIT), Washington, D.C.

But those gains pale in comparison to some top-performing REITs, whose returns have soared upwards of 40%, 50% and even 80%. Managers at three leading REITs - Essex Property Trust Inc., Mission West Properties Inc. and FelCor Lodging Trust Inc. - recently talked to National Real Estate Investor to discuss some of the growth strategies that are producing these impressive results.

Mission West Properties As of Oct. 6, the one-year total return for Cupertino, Calif.-based Mission West Properties was a whopping 82.7%. The stock price has jumped from a 52-week low of $6.88 per share to a high of $14. The primary driver behind that impressive performance can be summed up in two words - Silicon Valley.

"The real key is that we are in the best real estate market in the world - Silicon Valley," says Carl Berg, Mission West chairman and CEO. Not only does the REIT capitalize on an ideal geographic market, but its tenant roster also reads like a listing of who's who in technology. The five largest tenants in the portfolio include big-name firms such as Microsoft Corp., Apple Computer, JDS Uniphase, Amdahl Corp. and Cisco Systems Inc.

Mission West specializes in acquiring, marketing, leasing, and managing research and development (R&D) facilities. The R&D class of property is designed for both R&D and office uses, and in some cases buildings also include space for light manufacturing operations with loading docks. The company's current portfolio spans 86 buildings totaling 5.9 million sq. ft.

Mission West's phenomenal performance is due to a combination of rent increases at existing properties and ongoing development - both of which are expected to continue to fuel growth over the next three years, notes Berg.

Rent growth is an integral part of Mission West's current and future performance. The company's entire portfolio consists of triple-net-lease tenants, and about 75% of tenants renew their leases on an annual basis. The high percentage of renewals means that there are limited expenses related to remodeling, broker commissions or vacancies, and the REIT is able to capitalize on rent increases as lease terms expire, notes Berg.

About 490,000 sq. ft. of space within the existing portfolio will be up for renewal in 2001, and another 850,000 sq. ft. of leased space will expire in 2002. Mission West expects to sign new leases on those spaces with rents that are 85% higher than the current U.S. average of $1.40 per sq. ft. per month, says Berg.

Development partner Mission West has one of the largest development pipelines in the REIT industry. Currently, 1.6 million sq. ft. of projects are in various stages of planning and development. However, Mission West does not develop any of its properties. Instead, the privately owned Berg Group serves as Mission West's development arm.

"Our development company really only works for the REIT," says Berg, who is known in Silicon Valley for his ability to create value as a real estate developer and a high-technology venture capitalist.

In 1998, the Berg Group acquired a shell company that allowed it to roll its real estate development into the publicly traded company. Stock began trading on Mission West Properties in fall 1998 at about $6.75 per share and has been on the rise ever since. As of Oct. 9, the company was trading at $13.25 per share.

The two entities have a complementary arrangement to develop and acquire R&D properties. Typically, Mission West purchases a building from the Berg Group after it is developed and fully occupied. Essentially, Mission West buys the new properties at cost plus 10%.

The arrangement provides the REIT with an outstanding development pipeline, as well as giving it significant control of land and new development in the Silicon Valley market, says Berg. Through its relationship with the Berg Group, Mission West owns or has control of 25% of the land currently zoned for R&D facilities in Silicon Valley.

Positive outlook The competitive advantage achieved with the help of the Berg Group is one reason St. Louis-based A.G. Edwards & Sons maintains a buy rating on the stock. Other components that are likely to keep Mission West among the top-performing REITs include strong management, steady growth prospects and a healthy real estate market. Other strengths include the company's strong balance sheet and an attractive valuation with an estimated 16% discount to net asset value, according to a report by A.G. Edwards & Sons.

Mission West plans to keep its focus solely on R&D properties in Silicon Valley. "We believe that the Internet, wireless, biotech and venture capital communities will propel major growth in Silicon Valley," says Berg. For the past three years, the occupancy rate of Mission West's portfolio has hovered around 100%.

In addition, the Berg Group owns or controls land in Silicon Valley that will allow Mission West to double the size of the company. The supply of buildable sites should keep Mission West busy at least for the next three years. Because of a dwindling supply of land zoned for R&D in Silicon Valley, the REIT plans to start exploring redevelopment opportunities.

Despite volatility in the tech sector throughout much of this year, Berg remains confident in Mission West's position in the Silicon Valley market. The bulk of the REIT's portfolio is concentrated in the low- to mid-priced segment of the R&D market. "That's the beauty of the market position we're in. There is no place for anyone to go lower than where we are at," says Berg.

Essex Property Trust Big returns are no novelty to Palo Alto, Calif.-based Essex Property Trust. As of Oct. 6, Essex posted a one-year total return of nearly 67%. The company has recorded consistently high returns since going public in June 1994, averaging an annual return of 32% over the past five years.

Essex is a self-administered and self-managed equity REIT engaged in the ownership, acquisition, development and management of multifamily apartment communities. Its multifamily portfolio consists of ownership interests in 77 multifamily properties totaling 16,721 units, with an additional 944 units in various stages of development. The properties are located in selected West Coast communities, including Southern California, Northern California and the Pacific Northwest.

The REIT's performance hinges on a core strategy that focuses on supply-constrained markets. "We have always recognized that is probably the single key to success," says Keith Guericke, president and CEO of Essex. "It doesn't matter how good an operator you are, or how good your product is, if there's too much development and too much new competition," says Guericke. The focus on supply-constrained markets relies on a research model supported by the REIT's own in-house research staff. For example, when Essex first went public in 1994, the company had a large presence in the booming San Francisco Bay Area, largely because Northern California was the first region to recover from the economic recession of the early 1990s. At the same time, only about 10% of the portfolio was located in Southern California.

However, Essex recognized the growth potential that existed in Southern California, and the company targeted properties and submarkets that would benefit from that growth. Now Southern California represents about 50% of the REIT's holdings. "We recognize that different markets have different growth rates and we invest in them differently," notes Guericke.

Target markets Essex constantly is monitoring 23 submarkets along the West Coast. The company's research staff identifies markets that are characterized by job growth and a limited supply of new multifamily and single-family housing stock. "We always look for the imbalance between jobs and housing supply," notes Guericke.

The supply of single-family homes is a key factor in that formula, because significant construction among affordable single-family homes can have a negative impact on the multifamily market. To further safeguard its multifamily holdings, Essex seeks markets that have an added barrier to home ownership in the form of high home prices.

"We like the company and its long-term potential," says John Sheehan, an associate analyst at A.G. Edwards & Sons, which rates Essex as an accumulate, the firm's second highest recommendation among its five ratings. Essex is rated as an accumulate rather than a buy due to its increased stock price. "It's a positive rating, but we recognize the significant appreciation, and the fact that Essex carries a higher valuation relative to its peer group," says Sheehan.

The REIT benefits from focusing development on the West Coast, where population growth continues to fuel demand for housing. "We believe markets in California, both northern and southern, will be some of the best performing apartment markets in the country in the next few years," says Sheehan. "We also like their management team."

Guericke has been with the organization for more than 20 years, while CFO Michael Schall has been with the company nearly 15 years. "They have a specific strategy and growth plan that has worked well for them, and we think it's going to continue to work for them," says Sheehan.

Internal and external growth Essex draws on both internal and external sources of growth. Funds from Operations (FFO) in the second quarter reached $19.4 million, which was a 16% increase over the previous year. Rental rate growth and high occupancies are helping to fuel this growth.

Occupancy levels within the portfolio are at record highs - averaging about 97%. "As a consequence of that, and all the activity on the West Coast, we have seen market rents grow at very high levels," says Schall. In Northern California, for example, rental rates have increased by as much as 30% in recent years, particularly in Silicon Valley.

External growth is derived from acquisitions, development and redevelopment. This year, Essex expects to spend about $250 million on external growth opportunities. Two-thirds of those projects are acquisitions, all of which involve renovation work, and one-third of the investments focus on new development. "Right now everything we're doing has a value-added component," says Guericke.

The company's strategy, he adds, is to go into A- or B+ markets that show signs of supply constraints, and find B- or C+ properties. By purchasing those kinds of properties and investing $10,000 to $20,000 per unit in renovations, the company expects to produce a 10% to 15% return.

One recent example is the 100-unit Casa Del Mar apartments in Pasadena, Calif. Essex purchased the property for $6.5 million and invested $1.3 million, or $13,000 per unit, on renovations. After 28 months, Essex sold the property for $10.2 million. "By picking the right in-fill market, and doing a rehab, we were able to take a C building and turn it into a B+ building with significantly increased rents," says Guericke.

The REIT hit a new 52-week stock price high of $56.50 per share in late September. Factors that helped boost the stock price dramatically in the past year include FFO growth, as well as dividends that have increased by 10% to 11% each year. "You have those dynamics along with a strong balance sheet, so all of those pieces are in place," notes Schall.

FelCor Lodging Trust FelCor Lodging Trust is enjoying a banner year in the hotel sector. As of Oct. 6, the one-year total return for the Irving, Texas-based REIT was 47.8%. On Sept. 14 the stock price hit a new 52-week high of $23.75 per share.

The company has benefited in part from the high returns sweeping the lodging sector. Year-to-date returns among lodging and resort REITs reached 35.9% as of Sept. 30, according to NAREIT.

With a portfolio of 187 hotels and nearly 50,000 rooms and suites, FelCor is one of the nation's largest hotel REITs. Focusing on the upscale and full-service sector, FelCor is the owner of the largest number of Embassy Suites, Crowne Plaza, Holiday Inn and independently owned Doubletree branded hotels in the United States. The company's other properties include the Sheraton and Westin brands.

FelCor is outperforming its peers in part because of its strong company fundamentals. "The business is doing well, probably better than a lot of people expected," says Thomas Corcoran Jr., president and CEO of FelCor. Despite posting a second quarter loss of $0.64 per share, second quarter FFO hit $80.9 million, or $1.20 per share - a 13.2% increase compared with second quarter 1999. In addition, FelCor already has announced that it expects third quarter FFO to outpace analyst expectations, projecting FFO to reach $1.12 per share in that quarter, which would be a 23% increase over the same period last year.

Growth strategies FelCor is pursuing several avenues of growth to maintain its impressive performance. One effort focuses on expanding the number of rooms among the company's existing hotels. For example, FelCor is adding three floors to a Holiday Inn the company owns in New Orleans.

The REIT also continues to look for growth in its ventures, partnering with such big industry players as Beverly Hills, Calif.-based Hilton Hotel Corp. and Atlanta-based Bass Hotels and Resorts.

One such project involves the $60 million renovation of The Allerton Crowne Plaza on North Michigan Avenue in Chicago. Renovations to the 75-year-old hotel transformed the property from an aged hotel into an upscale, modern facility. The property is owned by FelCor and operated by Bass Hotels, a division of London-based Bass PLC.

In addition, FelCor has scored points with analysts for selling off non-core assets. The REIT recently completed the sale of its Embassy Suites Hotel near Los Angeles International Airport for $24 million. FelCor will earn $2.5 million on the sale of the 215-suite property.

A key to FelCor's performance is a value-added strategy aimed at acquiring and repositioning existing properties. In taking this approach, the company is reaping the benefits of a branding strategy that began in 1997. FelCor purchases non-brand hotels, repositions them and adds brand names. The refurbished hotels with strong brand identities help boost occupancies and room rates.

"That strategy is starting to pay off right now," says Corcoran. Second quarter revenue per available room increased 8.2% among comparable hotels, which included 131 properties. "We continue to have good, strong internal growth from our repositioning and re-branding strategy."

Due to FelCor's impressive stock returns, its strong management fundamentals and its successful growth strategy, Corcoran looks forward to continued success.

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