When is Bigger Better for Real Estate Companies?
How much do economies of scale tip the balance of power in favor of larger REITs
By Darlene Bremer

Size does matter. Whether it is the grandeur of resort hotels, the abundant portions at many restaurants or the lavishness of Hollywood's latest blockbuster, there is a perception, for better or worse, that bigger is better. But how does this translate to an investor looking to explore the benefits of investing in real estate stocks?

Many industry analysts assert that larger real estate companies benefit from economies of scale unattainable by smaller companies. The generally accepted assumption is that these large companies, merely by virtue of their size, will generate economies of scale through the reduction of operating expenses, ease of raising capital and a broader depth of management. Greater and greater size, however, should not be a company's goal. REITs need to balance size against achieving the best cost savings possible. The ultimate lure to attracting investors is not the size of a company, but how well its stock performs.

Defining Economies of Scale

Economies of scale can be achieved in a variety of ways. Operating economies of scale are driven by either revenue management or expense savings, according to Chris Haley, managing director for Wachovia Securities. "For instance, a company with a larger portfolio can make the intensive capital investment in installing and maintaining a state-of-the-art revenue management software system, allowing it to better price rental units appropriately to minimize vacancies and maximize occupancy," Haley says.

"The most obvious economy of scale for a large REIT is in operational efficiencies," says Richard Jeanneret, partner, real estate practice for Andersen, LLP. The larger the company, the lower its costs are as a percentage of whatever measure the company chooses to use. "For example, insurance becomes cheaper for larger REITs because they have more volume to price," Jeanneret says.

Larger real estate companies gain financing advantages through an easier time raising debt preferred or equity capital. "Their larger size helps these REITs' management teams execute unsecured financing in the debt market," Haley says. Additionally, the larger REITs are generally able to raise preferred capital at a lower cost because of their higher liquidity as compared to smaller REITs. And a greater percentage of the larger REITs have a debt rating, which allows them to potentially reduce their preferred borrowing costs from 25 to 100 basis points, relative to a non-rated company. Finally, the larger portfolios, particularly in the office, apartment and industrial sectors, can leverage such functions as engineering or janitorial services over multiple assets in a single market. "Larger REITs can hire a single team to offer services throughout the multiple assets in the market, allowing the company to spread its asset management costs across a higher number of buildings or square feet," Haley says. In addition, larger companies generally have management teams with a deeper breadth of experience, as well as the resources to hire more experienced people.

However, can these economies of scale be achieved in all sectors of the real estate industry? "In theory, it is possible in all sectors," Jeanneret says. The 10 largest equity REITs in terms of total market capitalization, he explains, represent all but one of the various commercial real estate sectors. "The exception is the hotel sector, only because it is more difficult for hotels to operate under the REIT structure," Jeanneret says.

Haley, however, does not believe that economies of scale can be achieved throughout the real estate industry. "The apartment, office and retail sectors have to balance potential cost savings from size with service levels and customer relations," he says. On the other hand, the storage and industrial sectors, for example, gain positively from focusing on cost reduction through economies of scale.

How Big is Big?

Part of the problem in determining how prevalent economies of scale are is agreeing on what constitutes a "big" real estate company. Perhaps the most telling metric most observers look at is market capitalization. According to Jeanneret, the 10 largest REITs each have at least a $3 billion market cap, and there are another five or six companies that have around $2 billion each in market capitalization.

Haley believes that the line that defines "large" REITs is about $2 billion in market cap, at least as far as REIT-specific investors are concerned. For those investors that are not REIT-specific, Haley says the required market cap is closer to $5 billion. "Size, however, is not driven solely by revenue or by the number of assets a REIT has, but by the number of tenants, number of units, or the square footage a REIT has," he says.

In fact, some of the larger REITs themselves don't even talk about market capitalization when they discuss size. "A REIT's size is not determined by a specific dollar amount, but rather by its domination of a sector or a market within a sector," says Steve Sterrett, chief financial officer for retail REIT Simon Property Group. Doug Linde, chief financial officer for Boston Properties, Inc., says that if a company has multiple offerings, multi-million square footage and various options for tenants, particularly in the office sector, then that particular REIT would be considered large.

Negotiating Better Deals

Regardless of where you draw the line of what constitutes a "big" company, there are certain advantages that come with size. In negotiating a variety of deals, larger companies have various advantages over their smaller counterparts. "Larger REITs have the internal processes already in place that enable them to provide potential business partners with more detailed reporting and/or acquisition analyses," Haley says.

According to Andersen's Jeanneret, it is the larger REITs' lower cost of equity that gives them the leverage to negotiate deals. "For example, a large retail REIT would have more leverage with retailers and be more price competitive because of its lower costs," he says adding that a large retail mall operator would more likely be national in scope and able to offer tenants more locations.

In addition, smaller companies may be perceived by potential business partners as being a higher risk, compared to a larger company with a strong balance sheet and record of performance. "Smaller companies more often must incorporate a greater number of financial contingencies into contracts," explains Rich Horn, president of Duke Realty Corporation. However, the larger REITs don't always have the upper hand when it comes to negotiating business deals. "The lines of communication involved in the required reporting steps within larger REITs can potentially delay the process of finalizing an acquisition with a tight timetable," Haley says. In this instance, a local, more nimble, market player may have the advantage.

Actually, since much of the real estate industry is local, the larger a real estate company becomes, the less entrepreneurial it may be able to behave. "A particularly large REIT, or any type of company for that matter, may not be able to develop the local relationships that actually help when negotiating deals," Horn says.

Gaining a Financing Edge

Another advantage large REITs seem to have is an easier time obtaining financing. "Large REITs have a greater number of financing choices and are better able than their smaller counterparts to quickly raise money," says Haley, who also believes that the larger companies also generally receive better rates.

Simon's Sterrett agrees that the size of a company can be a key factor in attracting financing. "Larger REITs have higher levels of financing needs that attract banks, which want to broaden their lending relationships," he says. The bigger REITs' higher liquidity also tends to make lenders and equity holders see them as more stable. "Lower rates, however, are based more on performance and operating strategies than on size," Linde says.

According to Horn, more established REITs can obtain corporate financing rather than rely on mortgages on individual pieces of property. "Corporate financing tends to be more efficient and cheaper," he says. Horn has also found working for one of the leading real estate companies that it is easier to get a larger line of credit, allowing Duke Realty to more quickly process the substantial transactions needed to buy and develop its properties.

There seems to be one disadvantage of being a bigger company when it comes to financing, and that is the need itself to raise significant amounts of funds. "The more a real estate company grows, the more capital is needed and it may become difficult to get all financing needs met by one bank. Therefore, a large REIT must develop various strategic relationships with more than one or two institutions," Sterrett says.

In addition, many of the expenses inherent in owning and operating real estate do not drop just because a REIT achieves a certain size-and many costs actually increase. Steve Rogers, president and CEO of a smaller REIT, Parkway Properties, Inc., cites, for example, assessed local taxes, utility charges, management fees, salaries, repairs and maintenance costs, and national insurance costs.

Attracting Investors

The ultimate test for how beneficial any economy of scale is lies with whether or not it helps a company attract investors. Since institutional investors usually buy large blocks of shares, the bigger a REIT is, the easier it is for them to buy in and sell out of the stock. "The more market capitalization a REIT has, the less significant the affect is on the stock price of the blocks of stock purchased by institutional investors," Jeanneret says. In addition, larger companies with good performance records are more likely to attract investors who have not previously made forays into the real estate sector.

In general, size also provides a certain level of name recognition, making it easier to get investors to even investigate the performance record of the company. However, the track record of large-cap companies, in terms of three, five, or 10-year total returns, is actually behind the performance records of the smaller-cap companies. "This is partially driven by the fact that many of the large-cap REITs have been formed through mergers and acquisitions, which historically do not carry excellent performance records in the U.S.," Haley says.

Regardless of size, it is a company's depth in a market that has become more important to investors and analysts. "The investment community has developed a greater comfort level when examining this market depth, rather than just relying on the market-cap size of a company to determine investment potential," Haley says.

A well-financed company that is well capitalized and has a good track record of performance is the one that will be followed by more analysts, giving investors more access to information and an improved understanding of the company. In the end, the investor, in theory, looks at the opportunities that economies of scale offer to see if the company has good growth potential.