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Looking Out for Shareholders

Not only are REIT boards of directors working harder than ever to achieve the delicate balance between monitoring financial controls and offering insight on corporate strategy, they're also getting paid more to do so, a new compensation study shows. Median REIT board compensation has more than doubled in the last five years, spiking to $100,825 in 2006 from $45,000 in 2002, according to FPL Associates Compensation in Chicago (see chart).

In the past, serving as a corporate director was viewed as a cushy income generator. The stereotypical director attended a quarterly board meeting, listened to executives talk about the corporation's bright future, and got a pretty penny for participating.

Today, however, the role of director is a much more serious job. Directors not only offer their business expertise to help grow the companies they serve, but they also provide oversight to ensure that corporations comply with the Sarbanes-Oxley Act (SOX), which requires companies to follow strict financial controls.

When boards fail to govern properly, the consequences can be severe, as the recent financial problems of the Mills Corp. demonstrate. The Arlington, Va.-based shopping mall developer was acquired in April by a joint venture of Simon Property Group Inc. and Farallon Capital Management LLC after the U.S. Securities and Exchange Commission announced an investigation into Mills' accounting practices in 2006.

Some experts argue that stronger board oversight would have effectively reined in Mills' CEO, Larry Siegel, who was accused of pursuing an expansion plan that outpaced the company's ability to finance new projects. He stepped down from Mills in late 2006, and the company announced in early 2007 that it was restating five years of financial records.

Though experts say Mills is an exception in board performance, many REIT boards still face challenges. Their roles are still evolving, and directors may be tested if the commercial real estate market begins to struggle, or when the families who took many REITs public turn over the reins to new leadership over the next decade. At the same time, there are disagreements over whether directors' pay has increased enough to attract the best and brightest to REIT boards.

Directors in action

What's the purpose of the board of directors in today's SOX-dominated business world? First and foremost, their charge is to make sure the corporation is run for the benefit of its shareholders, says Paul D. Lapides, a professor and director of the Corporate Governance Center at Kennesaw State University in Kennesaw, Ga. To that end, directors need to keep an eye on the performance of REIT management and offer advice in a range of areas, from big-picture corporate strategy to internal systems.

According to the National Association of Corporate Directors 2005 Public Company Governance Survey, the average outside director spent 190.9 hours on board duties compared with 155.8 hours in 2003. Those numbers are probably representative of REITs, too, says Lapides.

Scott Wolstein, chairman and CEO of Developers Diversified Realty (DDR), a shopping center REIT based in Beachwood, Ohio, says boards need to be diligent without “going overboard.” For instance, when DDR was weighing the possibility of entering into a joint venture on a few developments in China, management presented the idea to the board for consideration and was somewhat surprised at the board's response.

“We were looking at it as an isolated transaction,” recalls Wolstein, “but the board felt it was inappropriate to invest in China unless it was part of a plan that committed to long-term strategy in the market. That was good advice, and it changed the way we looked at the transaction.” As a result of board input, DDR has declined to do one-time development projects in China and will pursue opportunities that fit into a broader development program for the company.

Unlike other industries that have experienced financial scandals fueled in part by rubber-stamp boards, the REIT world has rarely seen such implosions. “REITs have been run very well,” says Stephen Blank, senior fellow of finance at the Urban Land Institute in Washington, D.C.

Blank, who has served on a number of REIT boards, says governance of REITs is on a par with, if not better than, any other industry in the country. “There have been no governance scandals in the real estate industry — none of the things that SOX was passed to try to cure,” he says.

William J. Ferguson, co-chairman and co-CEO of FPL Advisory Group in Chicago, which advises real estate companies on corporate governance, agrees that there haven't been many major REIT meltdowns, but says it's too early to determine whether that's because of strong corporate governance. “The industry has been pretty robust, and we haven't run into super difficult times,” he says. “I don't think we'll know how well the governance systems are working until we run into challenging times.”

Powerful performers

REIT returns have been impressive, outperforming the broader equities market in recent years. In 2006, REIT total returns of 34.35% more than doubled the return of 15.79% for the S&P 500, and nearly quadrupled the return of 9.52% for the Nasdaq, according to the National Association of Real Estate Investment Trusts in Washington, D.C. That marked the seventh straight year the U.S. REIT index outperformed all other equity benchmarks, NAREIT says.

As REITs have boomed in the past decade, their boards have evolved, explains Ferguson. Many REITs went public with owners who had no experience running public companies. “I don't think a lot of CEOs had a great idea on the role of the board, or the type of backgrounds to fill board roles,” he says. “CEOs hadn't been accountable to anybody before. They tended to put on the board people they knew and trusted, and who generally wouldn't rock the boat.”

That's changed. The average REIT board size is nine directors, and in the past 10 years many boards have experienced turnover among directors. As that's happened, says Ferguson, both boards and CEOs have become more cognizant about the role of the board and what backgrounds fit best, and they're recruiting people who may be outsiders.

Despite those improvements, the professionalism exhibited by REIT boards of directors is hardly uniform. “I wouldn't say they're all the picture of corporate governance,” says Ferguson. “You have to go REIT to REIT.” Good governance doesn't depend on company size or market capitalization, he says, but on the strength and will of the CEO.

When CEOs are strong-willed and entrepreneurial dealmakers, REIT boards are more likely to be competent but supportive of CEOs. “In those cases, the boards aren't going to let the CEOs do anything egregious,” says Ferguson, “but CEOs will get pretty free reign to run the business as they like.”

One strong indicator of good corporate governance is the number of mergers and acquisitions in an industry, says Lapides. It's a very hard decision for directors to say they should sell a company or take it private, he says, because directors could have a predisposition to keep the company in a holding pattern so they keep their jobs. The volume of REIT mergers and acquisitions shows that boards are willing to risk losing their jobs to act in the best interests of the corporation and its shareholders, says Lapides.

Pay is a relative issue

REIT directors are receiving higher compensation, but their pay still lags behind that of directors in broader corporate America. “Three to four years ago, directors were paid very low,” says Larry Portal, partner in charge of SMG Advisory Group, a New York firm that advises companies on board compensation. “Now they're probably at levels commensurate with their responsibilities.”

In 2002, the median compensation for REIT directors was just over $45,000. That figure covered directors' cash retainers, the amount of annual equity awards (stock payments), and board meeting fees, but not committee fees, says Jeremy Banoff, senior director of FPL Associates Compensation, a Chicago affiliate of Ferguson's FPL Advisory Group. In 2006, the median compensation, as reported in 2007 proxies, was $100,825. “REIT directors are now catching up with the broader Corporate America,” says Banoff.

The National Association of Corporate Directors says median pay for directors of medium-sized U.S. corporations in 2006 was $112,760, excluding committee fees, slightly higher than FPL's figure for REIT directors.

Still, comparisons of REIT director compensation to that of the rest of Corporate America don't account for the differences between how REIT success is measured. “The size of most other public companies is determined by sales volume,” explains Ferguson, “and in the REIT world it's by market capitalization, so there's not an apples-to-apples comparison.”

Despite the imperfect comparison, some still complain that the compensation of REIT directors is low. “While I recognize compensation in the REIT industry has gone up, I think boards are very underpaid for the responsibilities they've been asked to discharge,” says James J. Hanks Jr., a partner at the Baltimore law firm of Venable LLP who advises several dozen REITs on corporate governance.

“I don't think compensation is low,” says DDR's Wolstein. “It's many, many times what it used to be, and it's got high enough that it has an impact on our earnings. If you plotted our board compensation on a graph, it's probably accelerated faster than management's compensation, so I'm not playing any violins for them.”

Challenges on the horizon

As the industry matures, REIT boards will face challenges. There's still tension over who should serve on boards. “We focus on that issue much more than we used to,” says DDR's Wolstein. A big question is whether REITs should include board members not involved in the real estate industry but who have corporate governance experience.

“They might be squeaky clean in terms of conflicts of interest, but not helpful in terms of advising,” says Wolstein. Ferguson believes at least half of the board members need to know something about real estate. “You can't afford to spend five years teaching somebody about the business,” he says.

DDR has opted for a mix of industry and non-industry directors. “We have a unique combination of some really highly respected people who are in our business day to day and people who aren't in our business and aren't knowledgeable about real estate, but who have corporate governance experience,” says Wolstein. “It really requires both to have an effective board.”

Ferguson says REIT boards also need to improve succession planning. “They're probably doing an OK job, but not a great job,” he says. Succession planning takes a lot of work, he emphasizes. Boards need to identify what the next CEO will accomplish and who's qualified to succeed.

They also must assess the weaknesses of the next CEO in order to build the necessary skill sets. “Some boards haven't done succession planning before,” he says, “or the CEO just says, ‘I have my person.’” In fact, many REIT mergers and acquisitions are prompted by the failure of CEOs and boards to plan for succession. “That's more typical than you think,” he says.

Finally, Lapides says directors need more training. “Because directors have had excellent careers in business and correctly see themselves as successful and wise, they're generally overconfident in their skills.” Lapides says that the skills necessary to be a champion of corporate oversight are quite different than the business acumen that experienced CEOs, CFOs and COOs possess.

DDR is one REIT that's ramped up director training. It now conducts an annual board retreat where the board and management spend a few days together, not just an afternoon, says Wolstein.

DDR also brings in third-party facilitators to every board meeting “who can add value on issues of corporate governance and educate our members on our industry,” he says. At one meeting, representatives from an auditing and consulting firm educated the board on investment opportunities in India. At another, experts on corporate governance talked about the board's role.

Building a strong board has never been easy, and it'll continue to remain more an art than a science. “There's so much potential liability and scrutiny that being offered a directorship isn't the slam-dunk decision it used to be,” says Wolstein. “To attract the people you want and have a board that's truly effective, being a director must be stimulating, it must enrich directors' business experience, and it must allow them to network with other people on the board. Money won't be enough of a draw anymore.”

G.M. Filisko is a Chicago-based writer.

All public companies REITs
Average board retainer - cash $39,164 $31,864
Average board retainer - total value $44,608 $30,080
Average base pay* $70,208 $61,080
Average long-term pay* $90,285 $77,890
Average total pay* $160,493 $125,161
* Pay level received by a “typical” director, such as a director who serves on the audit and compensation committees and attended all meetings of the board and those committees and received all indicated stock grants
Source: Institutional Shareholder Services
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