By Lynn Novelli

Washington Real Estate Investment Trust relies on a diverse portfolio, local focus and smart investments to stay ahead of any negative market trends

Editor's Note: This is another in our series of articles profiling companies in the publicly traded real estate industry. Portfolio runs profiles like this one on companies that have shown leadership, innovation or resourcefulness that we believe our readers will find of interest.

It may be a common industry expression, but it is something Larry E. Finger, senior vice president and chief financial officer of Washington Real Estate Investment Trust (WRIT), believes in strongly. "Real estate is a local business. We believe that local operators will always be more market savvy and operate properties more efficiently than national ones," he says.

Of course not every company follows that philosophy, but it has served WRIT well for 40 years. All 58 properties in WRIT's $1.3 billion portfolio are located within a two-hour drive from company headquarters in Rockville, MD. Working exclusively within this limited geographic area, WRIT has achieved 35 consecutive years of increased earnings per share, 30 consecutive years of increased dividends per share and 28 consecutive years of increased funds from operations (FFO) per share. Among 16,000 publicly held companies, WRIT is one of only five with a comparable record, according to the company.

Keeping It Local

Washington REIT's regional focus is not the only factor that has contributed to the company's long track record of success, but it's certainly right at the top of the list, according to chairman, president and chief executive officer Edmund Cronin. "We know the general market [in the Washington, D.C.-Baltimore region] personally, and we can evaluate what is going to happen in any particular area," he explains. "We know where we want to be and what type of property we want in each sub-market."

In fact, WRIT never has purchased a property that a majority of the REIT's senior officers had not personally inspected. WRIT's management believes they can be more hands-on with properties on a daily basis and manage costs more closely than if they were further away. When opportunities or problems arise, being within driving distance "makes the decision-making process easier," adds Cronin.

On a day-to-day, practical level, Finger makes the argument that a tight geographic focus contributes to efficiency in operations and maximizes revenues. "What's important is how large you are in a local market because you spend money with local contractors," he says. "And local contractors are more willing to negotiate with companies that have a large, local presence."

Out of 16,000 publicly held companies, WRIT is one of only five that has achieved 35 consecutive years of increased earnings per share, 30 consecutive years of increased dividends per share and 28 consecutive years of increased funds from operations (FFO) per share.

Analyst Joel Goodman of Legg-Mason Wood Walker, Inc. agrees that WRIT's local strategy gives the REIT a competitive advantage. "They are very focused in terms of where their properties are located," he says. "In the Washington- Baltimore area, they are [among] the local sharpshooters."

Picking a (Geographic) Winner

By circumstance or design, Washington REIT's founders in 1960 (the company went public in 1961) selected an ideal locale for their business. The Washington, D.C.—Baltimore region is, hands down, the best long-term real estate market in the country when measured by practically any yardstick, according to Finger.

For starters, the Washington-Baltimore region is a leading high-tech and biotech employment center in the U.S. Nearly 40 percent of high-tech sales in the region are to a single customer–the U.S. government—which means great stability in the technology sector. By comparison, just 5 percent of high-tech sales in the volatile Silicon Valley are to the feds.

Overall, federal spending represents 33 percent of the Washington-Baltimore area's gross regional product and has increased steadily every year for the last two decades. This year, federal spending in the region is predicted to increase 3 percent, and the overall economic growth of the region is expected to be more than 4 percent, outpacing national growth for 2001.

Additionally, Washington-Baltimore is an international financial center and Washington Dulles International and Baltimore-Washington International airports rank first and second in passenger growth in the country. When unemployment nationally reached 4 percent in March 2001, it was less than 2.5 percent in the Washington-Baltimore region. For the first half of 2001, the area was third in the country in year-over-year employment growth, according to a Salomon Smith Barney report.

Finger summarizes the Washington-Baltimore area's economy as a unique blend of service companies and high-tech growth companies, anchored by the federal government's presence. "It's a great combination for good times and bad," he says. "Our location in and around the nation's capital is a critical element of how we have achieved our growth streak."

Over its 40-year history, WRIT has sustained its impressive record of success through five recessions and three real estate meltdowns—and 2001 is no exception. "We are not immune," Finger stresses, "but we are weathering the downturn well because of our [geographic] market."

Celebrate Diversity

That's not to say that WRIT is unaffected by market dynamics, according to Cronin. "Yes, some areas within our market may become soft in one sector, for example, the office sector in the Dulles Corridor in northern Virginia. To us, that means we may stay in that [regional] sub-market, but [we may also expand] in another sector such as multifamily."

Within its defined regional market, WRIT pursues portfolio diversification. The company's current portfolio includes 24 downtown and suburban office buildings, 15 industrial/flex properties, 10 grocery-anchored retail centers and nine apartment properties, a mix that Cronin believes positions the company to weather the current stormy times.

"In addition to regional focus, WRIT's property type diversification is critical to our success," notes Cronin. "Our diversified portfolio will continue to provide WRIT with stable cash flows and protect it from the volatility associated with single property type portfolios."

In 1999 and 2000, office and multifamily were WRIT's top performing sectors, but the market has changed and, in 2001, "multifamily, industrial and retail are all out-performing the office sector," Finger says. This is reflected in second quarter net operating income results that saw the office sector increase 6.8 percent. In comparison, the retail segment rose 9.1 percent, apartments increased 7.2 percent and industrial/flex was up 16.4 percent (due in part to a non-sustainable increase fueled by the Northern Virginia Industrial Park renovation that pushed occupancy up 14 percent and increased rents 33 percent).

For the remainder of 2001, Finger predicts that occupancy in the office sector will slide, but will be offset by steady or rising rates in other sectors. Fortunately, WRIT caters to small office tenants that typically lease less than 5,000 square feet. The impact of losing a tenant of this size has significantly less bottom line impact than that of losing a larger tenant.

The Washington, D.C.—Baltimore region is, hands down, the best long-term real estate market in the country when measured by practically any yardstick, according to Finger.

WRIT's small tenant niche offers other advantages as well, including the ability to obtain higher rents, adds Cronin. "In a rising market, a small space user has fewer options, so we can attract these tenants and achieve higher rates. When the market falls, small space users have less leverage to force steep rent reductions." He adds that small tenants typically have a higher renewal rate and lower tenant improvement costs.

WRIT's vertical integration, including in-house space planners, architects and construction managers, allows the company to cost-effectively subdivide large space into smaller spaces laid out to meet the small tenant's needs. "We can lay out the floors and finish the space less expensively than can a big national operator or local operator that does not have our in-house capabilities," Cronin says.

In fact, WRIT's comprehensive in-house capabilities translate to lower operating expenses across the board compared with those of many other real estate companies, Finger says. He estimates that WRIT's operating expenses and general and administrative costs are 10.6 percent lower than the industry averages in the sectors where WRIT has a presence.

Smart Shoppers

From its inception, Washington REIT made a decision that all acquisitions would be dictated by opportunity and a disciplined strategy, not merely availability of capital. And the company's management team has not wavered from that plan, despite periods of readily available capital fueling rampant external growth.

Finger recalls 1997 and 1998, when "Wall Street was throwing capital at REITs and many were trying to grow at 100 percent to 200 percent." During that two-year period, the REIT industry raised $83.7 billion—or three times more than the capital raised in 1999 and 2000.

But WRIT chose not to participate in the financial frenzy. "We were not willing to grow at that rate because we do not believe properties can be properly evaluated or effectively integrated into an organization at that pace and have it continue to operate well," Finger says. "We simply do not believe a company can grow that rapidly and do it well."

During 1997 and 1998, WRIT raised $171 million, 60 percent more than the $105 million it raised during 1999 and 2000.

The validation of this conservative acquisition strategy lies in the results. In 1997, the REIT industry's overall FFO per share growth was 13 percent. In 1998, the industry results soared to 17 percent before tumbling steadily to 9 percent in 2000. In contrast, WRIT's FFO per share growth was 9 percent in 1997, climbed to 13 percent in 1998 and reached 14 percent in 2000.

"Our earnings growth trailed the industry in those years, but ultimately WRIT came out ahead," Finger says. "In all capital environments, our acquisition strategy and long-term focus will produce growth that is among the highest in the industry, except when Wall Street is funding excessive external growth."

In a typical year, WRIT invests $60 million to $80 million, always with the goal of increasing returns on invested capital, Cronin says. "Our acquisition program is not momentum driven because that can never be sustained," he says. "Ours is more driven by the returns we expect to achieve in three years."

WRIT does not own land for development and is not involved in ground-up development—an activity that Cronin says is "not part of our business plan." Instead, the company looks to acquire well-located assets, especially those that are poorly managed and need new mechanical systems and a facelift. Ideally, a property considered for purchase has the potential to be repositioned in the market with higher rents and lower operating costs.

As of August, WRIT has made two acquisitions in 2001, a small apartment complex and an office building, totaling approximately $46 million. By year's end, Cronin expects the company to invest another $20 million, and he targets $60 million in acquisitions for 2002.

Maximizing Revenue

A key to selecting a property for acquisition in any sector is the potential for value-added capital improvements that will allow rent increases upon completion. WRIT is not afraid to put capital into a run-down property with a great location and upside potential to transform it into a desirable space. The result has been a robust 12 percent to 15 percent return on invested capital.

The plan is to "transform a property through capital improvements into something better than what it was when we acquired it," Finger says. WRIT relies on its in-house specialists to add office space, reconfigure existing space, improve the property aesthetically or update it mechanically so that it can command a higher rent.

WRIT's capital improvement program at Northern Virginia Industrial Park, which helped fuel that 16.4 percent increase in second quarter FFO, illustrates the value-added strategy. WRIT purchased the property for just over $30 million in 1998. At that time the cash return on investment was 8.6 percent, the park was 83 percent leased and rents were 15 percent to 25 percent below market.

After $3 million in capital improvements, including paving the parking lot, painting the buildings, new signage, lighting and general repairs to the property, the industrial park's profile is remarkably different. The park is now 97 percent leased, average rent has increased by 33 percent, and the ROI in 2001 is projected to be 12 percent.

WRIT currently has five other projects in the value-added pipeline, including two shopping center renovations, two apartment property expansions and an office building addition. Estimated cost for these projects is $50.6 million and the average projected ROI is 14 percent.

The WRIT management team thinks creatively when it comes to maximizing revenue, seeking profits from every possible venue, including the roof. Washington REIT rents roof space on its buildings to cell phone and Internet companies for antenna placement. Although most real estate companies use a third-party antennae management company, WRIT has found that having an in-house antenna specialist is the best way to handle rooftop rentals.

The company has a GPS citation for every building it owns, so matching locations to gaps in cellular grids is simple. With antennas averaging $15,000 a year in rent, it's also profitable. Of the $1.8 million in annual revenues from antennas, "every penny drops to the bottom line," Finger says.

Conservative Capital Structure

Washington REIT accomplishes its goals of maximizing revenue and returns while maintaining a very conservative financial position that supports long-term decision making. WRIT's debt to total market capitalization is 29.5 percent in an industry where that figure typically "drifts north of 40 percent," Legg-Mason's Goodman says. "Although they have access to capital resources on the debt and equity side, they use it expeditiously. They also do a nice job of making sure they have no big hiccups in terms of maturities in a single year."

Goodman refers to the fact that WRIT's average loan maturity is 8.5 years, and the amount due in any one year is always $60 million or less. But there is more to WRIT's solid capital structure than careful debt management, says Finger. "In regards to our capital structure, what we don't do is as important as what we do," he says. WRIT's "Don't Do" list includes forward equity transactions, unit investment trusts and technology venture investments, approaches that the management team believes "do not make good sense from a capital structure standpoint," Finger adds.

Investor Analysis

Washington REIT's solid financials have earned the company the respect of analysts, says Goodman. Integral to the company's outstanding performance is its management team and their level of expertise, knowledge and ethics, he notes. "They are very straight shooters, extremely ethical, and that is borne out in terms of the REIT's performance and how they have met Wall Street's expectations."

The one potential financial negative on WRIT's short-term horizon is the number of leases scheduled to expire this year, he adds. "Depending on WRIT's ability to re-lease them, the situation could have a negative short-term impact." Based on this possibility, Legg-Mason in August 2001 downgraded the stock from "strong buy" to "buy."

However, Goodman believes it will be only a temporary change, considering WRIT's history of re-leasing properties even in recessionary times.

The bottom line, he says, is that "we like the stock for the long term because their balance sheet is strong. We believe they will continue to increase dividends."

That is what WRIT's shareholders, 72 percent of whom are retail, want to hear. Historically, the stock appeals to investors looking for safety in earnings and dividend growth, and many of WRIT's shareholders are long-term investors who have participated in the company's earnings and dividend growth for many years.

"To an investor, looking at the company's history, its portfolio diversification, focus on a region as strong as the Washington-Baltimore [area] and seeing increasing dividends every year with nominal downside risk—this is the place to put your money," Cronin says.

He considers it his personal mission to continue WRIT's record of increasing earnings, dividends and share value. "The trick," he says, "is to do it every year, and do it better."

Lynn Novelli is a freelance writer based in Novelty, OH.