JOHN C. CUSHMAN III
Acceptance of the real estate investment trust as an investment vehicle has exceeded everyone’s expectations and driven current prices to levels far above initial offering prices.
But surprisingly, real estate fundamentals have little to do with why many REITs today are selling at a premium to their IPO price.
Analyzing underlying building characteristics in many REITs indicates that product quality ranges from poor to marginal. Underwriting standards, although much improved from the 1980s, are uneven as Wall Street strains to service all of this new business.
This excitement with REITs is being fueled by money from the fast-growing mutual funds and pension funds (including 401k’s) that view real estate as a defensive hedge against the volatility of the overheated equity markets.
Pension funds have announced to the world that they are “underallocated” in real estate, notwithstanding the fact that they got their “clocks cleaned” during the last cycle. These large fund managers are attracted to the high dividend yield, the prospect of appreciation, the “perceived” liquidity and the belief that REIT management objectives are aligned with theirs.
I firmly believe that huge mistakes are destined to be repeated and I am searching for a financial instrument to “short” certain REITs in the 18-to-24-month time frame. Once “funds from operations” (FFO), which is essentially cash flow, falls below analysts’ expectations, do not be surprised to see a free fall for the entire industry group.
So what will we watch out for in the future as the REITs expand their presence in the Los Angeles real estate office market?
– Premiere Quality. The premiere quality Southern California office REIT does not yet exist, although it is coming. The REITs that own the well-located, institutional-grade product in the less-forgiving downtown market and the high-end, institutional-grade office buildings in the strong and highly forgiving suburban submarkets like Century City will be at a competitive advantage in attracting and retaining the credit tenants at the highest rents.
– Management Skills. In some cases, the new institutional owners are relying on “financial-guys” lacking experience and unable to go “toe-to-toe” on some very basic and fundamental real estate issues. This is a concern to prospective tenants and certainly should be of concern to the shareholders.
– Fundamentals. Although Los Angeles clearly welcomes the aggressive pursuit of real estate assets by REITs, which is contributing to increasingly escalated prices, some REITs are buying merely to place capital. As noted above, the long-term survivors will buy the best product at the best location and at the right price. They will have the highest level of tenant retention and achieve the highest rents through multiple cycles.
– The Customer. A REITs’ customer is the tenant who leases the space and provides the cash flow. Those REITs, with their primary focus on the shareholder and on Wall Street, will be the first to be liquidated or be acquired by another REIT.
– Marketing Strategy. Some have implied that commercial brokers will all soon be employees of the REITs. Perhaps they believe that the market will just come to them. My only comment is that those owners that treat the brokerage community with cooperation and respect will be rewarded with enhanced shareholder value.
– Capital Costs. Since REITs must distribute 95 percent of their cash flow, they may have difficulty funding the necessary costs associated with re-leasing, including core and shell upgrades and tenant improvement costs.
To raise this capital, the REIT does not have many choices. It can increase its leverage, which is a problem, or issue new shares, which will dilute the existing shareholders.
– Growth and Consolidation. The pressures are so great for REITs to grow and, as existing asset prices get bid up so high, REITs will have to buy each other. In doing so they will eliminate redundant costs and enjoy the resulting value creation. The big question is, Who will survive?
– Development. At some point in the not-to-distant future REITs will only be able to find real yields in development. This stuff is risky and difficult to carry since it takes two to three years before cash flow is realized. Those REITs that undertake development without the most experienced development talent will be caught in a death trap. Can they exercise restraint?
No question that as an industry REITs are here. However, it is interesting to look back only a few years and consider that 90 percent of the REITs were formed to bail-out owners who were “upside-down” due to overleveraging.
Stan Ross, vice chairman and managing partner of E & Y; Kenneth Leventhal Real Estate Group, coined the term “dueling 11s” (section 11 vs. Chapter 11, also known as “go public or go broke”). The cyclical nature of our business trends has always exposed weakness, and it will not be until we emerge from the next cycle that any of us will know which REITs, if any, will own Los Angeles in the long-term.
John C. Cushman III is president and CEO of Cushman Realty Corp.