The New Paradigm: Shifting Strategies Midstream

By Jonathan Morris, Jones Lang LaSalle

As the commercial real estate markets change gears -- quickly in some markets -- senior management at several public REITs are reevaluating their approaches.

As the commercial real estate markets change gears – quickly in some markets – senior management at several public REITs are reevaluating their strategies. What had been a bread-and-butter business of buying, leasing and owning suburban office and industrial assets now might look like treading water. What had been a plan for market diversification – with portfolio holdings in 5-10 separate metro markets – now may have become a logistics quandary and a drag on growth from the more sluggish markets. Nationally, we have bifurcated markets – some are growing rapidly, others are not.

Several REITs are considering a change to their focus. In some cases, a move to urban markets makes sense, especially if their portfolio is in the vicinity of a major metro.

A strategic shift requires several key elements. Here is a look at four of them: 1) commitment; 2) expertise of, and in, the target markets; 3) execution; 4) transparency.

Commitment

REIT management has one principal goal: maximize the enterprise value of the company for the benefit of all shareholders and stakeowners (the subtle difference being OP Unit owners, preferred stockholders and all creditors). If, in the REIT management’s opinion, a shift to a different strategy makes sense and can successfully be accomplished, then a commitment from the CEO down must be made. Reducing holdings in one geographic location to increase in another, or changing property types, say from suburban office to urban office, takes time and skill. The metrics of each market are very unique and the skill set required to succeed in a new venue may be much different than the core markets in which the REIT has spent most of its time and resources.

Expertise

When shifting locations, market expertise is critical. Getting one’s arms around a new market is a matter of having the proper tools: extensive and exhaustive research, and the ultimate capital allocation and structure. Moving from suburban to urban office presents an entirely new set of metrics along with qualitative measures such as tenant base, rental rates and expense and tax components. Moving from suburban Washington DC metro to downtown Washington for example, entails a minimum of a $10 per-square-foot delta in operating expenses and taxes. Nominally, it entails a $15 per square foot foot to a $25 per square foot component. However, the net effective rental rates plus anticipated growth in both rents, occupancy and ultimately values might support the shift and enhance the company’s performance – and drive down its cost of capital.

Execution

Changing strategies or even modifying them slightly comes under intense scrutiny for a public company. Before indicating any change, a thorough vetting internally is required, using all types of what-if’s along with analyzing the change in the capital structure – the goal being to reduce the cost of capital to align with lower cap rate transactions. Urban gateway markets do provide several enormous benefits: 1) barriers to entry; 2) favorable debt terms; 3) attraction of prospective JV partners; 4) future portfolio valuation trajectory; and 5) discussion and buzz in the community which can be positive.

Transparency

From concept to execution, all matters relating to REIT operations, initiatives and strategy are well received when discussed and disclosed in myriad venues and through multiple networks. From signaling the consideration of a strategic shift through an earnings call, NAREIT presentation or analyst one-on-ones (or all three), it is critically important to both get the message out and support the message with some meat on the bone. Change is good, as long as your constituencies are aware of the Company’s intentions and actions.

The overall performance of the REIT sector since the dark days of spring 2009 has been terrific. The REITs that own, develop and acquire urban assets in gateway markets have benefitted from the gravitation to those markets by tenants and investors of all stripes. With significant barriers to entry, a complex set of variables and markets that require a unique set of skills, the urban markets reward those REITs that have focused on these cities, and will continue to outpace secondary and tertiary markets. The difference in this cycle is that the growth curve for urban versus suburban is dramatically greater and, as mentioned above, tends to cast the REIT in a new light, providing access to cheaper capital and more options for that capital.