by Leo Subler
REITs' use of private equity—primarily from joint ventures and private placements of common and convertible securities—has been a hotly debated topic ever since the industry lost access to the public equity market in 1998. The debate centers on whether private equity has a positive or negative effect on the REIT industry.
First, let's dispense with a common notion—that REITs suddenly turned to the private equity market when the public markets dried up in mid-1998. In fact, REITs were already there.
According to the National Association of Real Estate Investment Trusts (NAREIT), private equity securities issuance by REITs actually peaked along with public issuance in 1997 and 1998, when REITs raised $2.9 billion and $4.3 billion of private equity respectively. One of the largest private placements of equity securities by a REIT occurred in March 1998 when, following the sale of Beacon Properties to Equity Office Properties Trust, Alan Leventhal capitalized his new office REIT, Beacon Capital Partners, with a $420 million private equity securities placement.
Nor was there a shortage of joint venture (JV) activity prior to 1998. AMLI Residential Properties Trust designed its business strategy around co- investing with JV partners. Between 1994 and 1998, AMLI funded upward of $500 million of acquisitions and development through JVs. In one of the largest JV transactions, General Growth Properties, Inc. and Developers Diversified Realty Corporation formed separate joint ventures to fund the $1.8 billion purchase of Homart's mall and shopping center portfolios. Simon Property Group, Public Storage, Inc., Duke Realty Corporation (formerly Duke-Weeks Realty Corporation), Crescent Real Estate Equities Company and FelCor Lodging Trust Inc. were just a few more of the REITs that raised equity through JVs.
When you look at all the "alternative equity sources" for REITs, including private placements, joint ventures and capital recycling, and consider how long developers and real estate managers have been using these vehicles to fund their operations, it's actually the public market that is the "alternative equity source." It is not that REITs suddenly turned to private equity when the public markets dried up; it is that public market activity overshadowed private market activity from 1993 to 1998.
A Matter of Opinion
After the spotlight shifted to the private market, two camps formed with opposing views on its merits. In one camp was Wall Street. Analysts generally frowned upon joint ventures, criticizing them for complicating the balance sheet, reducing visibility, distracting management and creating conflicts of interest. Investment bankers discouraged REITs from private equity offerings, arguing that shareholders were put at a disadvantage because of the secrecy surrounding the securities' issuance and the preferential terms received by institutional investors.
| "It's a great way for REITs to raise equity. It comes with lower issuance fees, quicker execution, it's more flexible and you don't need a road show. What's not to like?"
|
But private equity also had its supporters, among them many prominent REITs and institutional investors. In September 1999, Duke Realty (then Duke-Weeks) privately placed $150 million of common stock with ABP, the largest pension fund in Europe. When asked about the stock market's response, chief financial officer Gene Zink says, "we got killed."
"We thought we did it for all the right reasons," he adds. "We had just completed the Weeks acquisition and our leverage was a bit higher than we liked coming into 2000 and what we correctly anticipated would be a slowing economy. We had known ABP for years. They had a reputation as a long-term investor that grew their positions over time; they were sophisticated and were willing to pay a fair price."
Duke-Weeks' stock was trading close to NAV, the transaction was completed without a discount to its market price and there were negligible transaction fees. "But the market didn't care," Zinks says. "It didn't matter what the reason, the market didn't want to see REITs issuing equity at that time." Duke-Weeks' stock price fell the day following the offering and the company was later subject to a critical analyst report. Still, Zink feels "it was a great transaction."
Overall, Zink says Duke Realty's experience with private equity "has been excellent."
The company has structured a number of JVs with institutional investors, including a $739 million disposition joint venture with JP Morgan Fleming Investment Management and General Motors Asset Management that closed in October 2000. Concerning predictions that private equity will fall by the wayside if the public equity market returns, Zink says, "I don't think it will make a difference, at least not for us."
Chris Marr, CFO of Storage USA, Inc., feels that "regardless of the state of the capital markets, there is a place in every REIT's capital structure for private equity." Storage USA has tapped the private equity market on several occasions. In 1996, Storage USA privately negotiated a commitment from Security Capital to purchase $220 million of its common stock. In 1999, Storage USA entered into $400 million of acquisition and development JVs with GE Capital. Also in 1999, the company sold a majority interest in a portfolio of stabilized properties to a $144 million JV formed with Fidelity Investments.
Feedback from the Equity Securities Community
Bill Morrill, who oversees REIT securities investments at LaSalle Investment Management, feels that a private placement of equity securities "has obvious advantages for REITs...It's a great way for REITs to raise equity. It comes with lower issuance fees, quicker execution, it's more flexible and you don't need a road show. What's not to like?" he asks. Morrill is also pleased with the performance of his private equity investments, which include Spieker Properties, Inc., CenterPoint Properties Trust and AvalonBay Communities, Inc. As of May 31, 2001, all three ranked among the top 10 REITs in terms of total return over the most recent three-year period. Spieker Properties was acquired by Equity Office Properties Trust in July 2001.
Tony Manno oversees $2.2 billion of third-party investments in REIT securities for Security Capital Research & Management. Manno says, "what REITs give up to private investors is well worth the access to capital." Security Capital's private equity investments are typically made in the form of convertible preferred stock, bear a dividend at a slight premium over the REIT's common dividend, and contain change of control, debt service and fixed charge covenants which, if violated, trigger a kick up in the dividend. Security Capital has made long-term investments on behalf of its clients in Apartment Investment & Management Co., Charles E. Smith Residential Realty Inc., Urban Shopping Centers and Westfield America, Inc., among others. Even though three of the four have since been acquired, Manno was pleased enough with his investments to carry them over into investments in their acquirers.
Despite private equity securities' advantages, there is still a right time and a wrong time to issue equity. According to Green Street Advisors' Jon Fosheim, "If it does not make sense for a REIT to do a stock offering, whether it's public or private is irrelevant. The exact same economic principles rule for securities convertible into common equity."
Greg Whyte of Morgan Stanley Dean Witter believes there are certain instances when REITs might be justified in raising equity even if the market is telling them otherwise.
| "If it does not make sense for a REIT to do a stock offering, whether it's public or private is irrelevant. The exact same economic principles rule for securities convertible into common equity."
|
"A REIT's stock price reflects only known information," says Whyte.
If a REIT has an inside track on an incremental investment that will enhance value for its shareholders, "then it is justified in looking to the market to raise equity to fund that investment. " As an example, Whyte cited Boston Properties, Inc.'s October 2000 stock offering, proceeds from which funded two attractive new development projects.
Since 1998, private equity securities issuance dropped off significantly along with public equity issuance. According to NAREIT, private placements of common and convertible preferred stock by equity REITs declined from $953 million in 1998 to $474 million in 2000. Still, private equity placements accounted for approximately 30 percent of total common and convertible preferred stock issuance in both years.
Equity in Joint Ventures
JV activity, in contrast, did not suffer the same decline. Based on data compiled by SNL Securities and the author's research, it appears that institutional investors committed no less than $2.5 billion of equity toward joint ventures with REITs in 1998, 1999 and 2000. JV activity was off to a slow start in 2001, however, due in large part to the slowdown in acquisition and development activity that accompanied the downturn in the economy.
According to Fosheim, "JVs are a whole different animal—typically no equity is being issued by the REIT. It simply has an equity partner in a real estate deal." As such, REITs have more freedom and suffer less scrutiny raising equity for JVs than they do issuing stock. But Fosheim maintains JVs make sense only if, on a risk-adjusted basis, the REIT's investment provides a sufficient return over its cost of capital. If a REIT overpays for an asset, whether in a JV or otherwise, in the long run management is destroying value.
Over the past few years, REITs have found plenty of JV investments capable of creating value for everyone involved. Fred Carr of buy-side research firm Penobscot, says JVs are "not a zero-sum game...they can be a win-win for everyone." Storage USA's Marr, who moderated a panel discussion on JVs at a recent NAREIT conference, agrees: "Pension funds get their 11 percent return, REITs leverage their management fees and earn a 14 percent return and they both share in the asset's appreciation." As long as JVs produce economics such as these, they will continue to create value for REITs and their shareholders.
The Private Equity Argument Resolved
Even the equity analysts seem to have come around on private equity. Whyte views private equity as "just another means of accessing capital available to REITs." He makes the point that the cost has to be evaluated against the cost of alternative capital sources and the investment opportunities available in the market. "You can't make a categorical statement about private equity being good or bad. You have to make an independent judgment based on the individual circumstances involved."
Thus, private equity itself is neither a "good thing" nor "a bad thing." What determines its merit is when and how REITs choose to use it. If REITs' superior earnings performance over the past few years is any indication, the combination of REITs and private equity appears to have been a very good thing for the industry, indeed.
Leo Subler is a managing director in the financial advisory practice of FPL Associates.
