Lack of Leverage Lends Strength, REIT Week Panel Maintains

The bad news is, the United States is in a Great Recession and the commercial real estate market is likely to feel continued pain during the next two years as corporate cutbacks result in weaker fundamentals. The good news is, the public equity markets have been improving in the past few months, with returns bouncing back substantially and multiples back down to more reasonable levels as the market has responded to REIT success at raising capital through secondary offerings. In fact, the re-equitization of the market—with about $12 billion worth of common stock raised–has been extremely helpful to the market, observed Ken Rosen, chairman of Rosen Consulting Group, offering opening remarks during the general session “The REIT Approach to Real Estate Investment” at NAREIT’s REIT Week conference in New York City yesterday. Goldman, Sachs & Co. managing director Michael Graziano then moderated a discussion that led from leverage to behavioral issues to whom to blame to how companies and the industry can best emerge from current difficulties. The theme throughout: The market has overleveraged, it will rethink that approach and do business differently—and eventually it will forget and repeat its mistakes. But given the depth of this recession, change will probably last longer than one cycle. “The real estate industry still struggles with its coming of age,” observed Mike Kirby, chairman & director of research at Green Street Advisors Inc. He expressed a belief that there is no reason real estate companies can’t change their thinking from that of a small-time investor to the zero-debt mindset of a Microsoft Corp. or Cisco Systems Inc.—especially REITs, which lack access to the tax advantages of using debt financing. While AMB Property Corp. chairman & CEO Hamid Moghadam disagreed, expressing a belief that there is room for REITs, at least, to operate with higher leverage, he said his own company aims for around 30 percent. But he also pointed to fixed-charge coverage as a better measure against which to gauge performance. Rosen agreed, noting that measuring the fixed-charge coverage ratio against normal income is a stronger approach, since leveraging against changing cap rates presents an incorrect picture. In any case, he added, low-leverage companies have historically outperformed others over the long run. Problems in industry mindset remain: To date, only 10 to 20 percent of real estate executives think lower leverage levels are necessary, Kirby noted. And Moghadam pointed to private investment managers’ reluctance to relinquish the debt that allows them to offer investors above-20 percent returns—a level Rosen termed as well above what should really be only in the low teens even with leverage. “And that’s enough return,” he said. “If you want more than that, you’re gambling.” Dividends should be given greater emphasis, he maintained, warning that aging investors are going to prefer cash flow over growth. As the industry strives to recover, the public markets will be an important source of capital, just as they were in the early ‘90s, Kirby said, while Federal Capital Partners managing partner Thomas Carr (the one-time head of CarrAmerica Realty Corp.) pointed to the huge opportunities re-equitization will provide for public companies, since they will be in a better position than the even-more-levered private investors. There may also be more mergers and acquisitions but ultimately more REITs as companies go public for the first time or return to the public markets with much lower leverage levels than those with which they went private, the panel maintained. And who is to blame for the recession? While those named as culprits included Alan Greenspan, lenders as a group and even the tendency of real estate people with access to cheap capital to take advantage of it, ultimately “people just got mesmerized by the returns,” Rosen said, predicting that there will be re-regulation and a new system put in place to oversee lending.To hear NAREIT economist Brad Case’s views on REIT performance, click here to log on to CPN TV and click on From the Field.