For REIT investors, these 8 corporate governance factors carry the most weight in their investment decisions

By Dean Starkman

Now that the shouting about corporate governance has quieted somewhat in the broader business world, REIT professionals have been assessing their own industry's scorecard on the subject and turning to a fundamental question: when it comes to governance, what really matters?

		CGQ in Detail See how listed REITs and REOCs compare to corporate America

The REIT industry over the last few years has had the luxury of examining the question of governance from a safe distance as it watched the collapse of Enron, Worldcom, Adelphia and the rest, while suffering no significant corporate meltdown among its own ranks. Indeed, whatever governance problems might exist among REITs have been overshadowed by the group's powerful financial showing—a sterling 19.7 percent total return annually over the five years ended April 30, 2005 for the NAREIT Composite REIT Index—while broader markets careened downward. On top of that, independent investor advisory firm Institutional Investor Services rank REITs among the top two industries in terms of corporate governance, according to its Corporate Governance Quotient (see chart).

The REIT industry sailed through the scandals with so little damage that some observers are warning against complacency.

"Given this terrific backdrop, are we riding for a fall?" asks Lehman Brothers' top REIT analyst David Harris. "Is there a little too much hubris?"

But most REIT investors know that strong financial results can cover plenty of sins and that governance issues can turn from a dry theoretical debate to a real problem in a hurry. Governance, after all, doesn't matter—until it does. Few cared, for instance, that Taubman Centers Inc. (NYSE: TCO) included in its corporate rules a provision for staggered elections of its board of directors. But investors cared plenty after Simon Property Group Inc. (NYSE: SPG) launched an unsolicited takeover offer for the company that eventually foundered in 2003 on that very issue, among others. Also in 2003, shareholders' power to unseat a sitting member of the board of directors became the key issue when Chairman Emeritus John Williams launched a proxy contest for control of the company he founded, Post Properties Inc. (NYSE: PPS). Shareholders, given the choice, turned aside Williams' bid, but most observers agree the Atlanta-based apartment developer emerged from the fight with governance rules that greatly improved the company's transparency and accountability.

What Matters Most

Indeed, conversations with REIT investment pros reveal that governance plays a significant role in the real world of investing, even if professionals disagree on which governance elements are most important, how much emphasis to place on visible, checkable elements of good corporate governance—destaggered boards, director independence, the absence of poison pills—and how much on an investors' intuitive sense that managers and directors will do right by shareholders.

Hamid R. Moghadam, chairman and CEO of AMB Property Corporation (NYSE: AMB), the San Francisco-based industrial REIT regarded as a corporate governance model, rightly notes that governance is especially important for REITs, an industry in which many of its leading companies were founded—and remain dominated—by charismatic leaders who in the coming years will be stepping down.

"Everything we do here is for the long term, the legacy," Moghadam says. "Governance is your insurance policy on that. If you have good, transparent governance, then a company can have all kinds of people come and go."

While few investors will make investment decisions based solely on governance issues, good governance can help a company (or industry) stand out from peers and, ultimately, can provide an investor with a certain amount of comfort in their investment decision.

To that end, here are eight of the governance issues that REIT veterans believe matter most in making investment decisions.

1. Compensation
How much a CEO and his lieutenants are paid is significant as an expense item, but also for its symbolic value, a proxy for the question: who's really driving the REIT, managers or directors? Pay scales that are out of whack with corporate norms often are a symptom of deeper governance problems, investors and others say.

"Nine times out of 10 governance boils down to compensation-related issues," says Larry Portal, a partner in the Schonbraun McCann Group, a national real estate consulting firm. "Boards, management and shareholders are all very sensitive about compensation issues."

How much is too much? That's a qualitative question in the eye of the investor. According to the 2004 NAREIT Compensation & Benefits Survey, which includes data from 2003, the average total remuneration for the 92 REIT CEOs participating in the survey was $2.1 million.

In a 2003 study of 19 of the largest REITs, real estate research firm Green Street Advisors Inc. found that a REIT CEO's average compensation was $3.9 million in 2002, up 20 percent from the year before. Interestingly, the Green Street analysis also found that during the study's limited time frame of two years, executive compensation correlated negatively with performance. That is, the higher the executive's pay, the lower the company's total return. The study found that every additional $1 million in CEO compensation had the effect of reducing total return by an additional 2 percent a year. Whether that holds true over the long run awaits further analysis.

Rick Romano, vice president and portfolio manager at Prudential Real Estate Investors, says the main concern isn't necessarily how much an executive is paid, but making sure that executives' and shareholders' interests are aligned. One key test, he says, is whether executives receive a significant amount of their compensation as stock, which ties compensation to overall financial performance, or options, which could tempt managers to take risky measures to boost short-term performance.

"We would rather have them own the same security as us, basically," Romano says.

Damon Andres, portfolio manager of the Delaware REIT Fund, adds, "We're for executives making a lot of money as long as they make it for shareholders as well."

Some red flags Andres says investors should watch out for include corporate perks that smack of hubris: corporate jets, new cars, boats and the like. "What are you going to do with a boat?" Andres says.

Another potentially bad sign: compensation packages that are front loaded. "People want to be well-compensated right now, on a short-term basis," says Alex W. Peters, portfolio manager of the Franklin Real Estate Securities Fund. "What's the rush?"

50 Leading Listed REITs and REOCs Ranked by industry CGQ, data as of May 1, 2005
Company Name	Ticker	Index Group	Index CGQ	Industry CGQ
Capital Automotive REIT	CARS	S&P 600	100.0	100.0
AMB Property Corporation	AMB	S&P 400	99.5	99.6
Equity Residential	EQR	S&P 500	99.4	99.2
PS Business Parks, Inc.	PSB	Russell 3000	99.4	98.8
Commercial Net Lease Realty	NNN	Russell 3000	99.2	97.9
United Dominion Realty Trust	UDR	S&P 400	98.5	97.9
Weingarten Realty Investors	WRI	Russell 3000	98.8	97.1
Equity Office Properties Trust	EOP	S&P 500	96.1	96.3
Brandywine Realty Trust	BDN	Russell 3000	98.5	95.9
Simon Property Group	SPG	S&P 500	93.0	95.5
Ventas, Inc.	VTR	Russell 3000	98.2	95.0
AvalonBay Communities, Inc.	AVB	Russell 3000	97.9	94.2
Bedford Property Investors, Inc.	BED	Russell 3000	96.9	92.1
CRT Properties	CRO	Russell 3000	96.8	91.7
Duke Realty Corporation	DRE	Russell 3000	96.5	91.3
New Plan	NXL	S&P 400	94.9	90.9
Developers Diversified Realty Corp.	DDR	Russell 3000	96.0	90.5
Post Properties, Inc.	PPS	Russell 3000	95.3	89.7
Colonial Properties Trust	CLP	S&P 600	94.6	89.3
Apartment Investment & Mgmt. Co.	AIV	Russell 3000	95.1	88.8
iStar Financial Inc.	SFI	Russell 3000	95.0	88.4
EastGroup Properties, Inc.	EGP	Russell 3000	94.7	88.0
RAIT Investment Trust	RAS	Russell 3000	94.7	87.6
BRE Properties, Inc.	BRE	Russell 3000	94.4	87.2
Home Properties, Inc.	HME	Russell 3000	94.3	86.8
American Financial Realty Trust	AFR	Russell 3000	94.2	86.4
Acadia Realty Trust	AKR	Russell 3000	94.1	86.0
LTC Properties, Inc.	LTC	Russell 3000	93.9	85.5
Catellus Development Corporation	CDX	Russell 3000	93.8	85.1
Plum Creek Timber Company, Inc.	PCL	S&P 500	73.6	84.7
Prime Group Realty Trust	PGE	CGQ Universe	99.2	84.3
Trizec Properties, Inc.	TRZ	Russell 3000	93.5	84.3
Rayonier Inc.	RYN	S&P 400	88.5	83.1
Capital Trust, Inc.	CT	CGQ Universe	99.0	82.6
Correctional Properties Trust	CPV	Russell 3000	92.4	82.2
Capstead Mortgage Corporation	CMO	Russell 3000	92.4	81.8
MeriStar Hospitality Corporation	MHX	Russell 3000	92.3	81.4
Camden Property Trust	CPT	Russell 3000	91.7	81.0
Prentiss Properties Trust	PP	Russell 3000	90.6	80.6
Heritage Property Investment Trust, Inc.	HTG	Russell 3000	90.4	80.2
Highland Hospitality Corporation	HIH	CGQ Universe	98.5	79.8
Lexington Corporate Properties Trust	LXP	Russell 3000	88.1	79.3
Shurgard Storage Centers, Inc.	SHU	S&P 600	79.0	78.5
The Macerich Company	MAC	Russell 3000	85.8	78.1
Mack-Cali Realty Corporation	CLI	Russell 3000	85.8	78.1
Health Care REIT, Inc.	HCN	Russell 3000	85.6	77.3
Host Marriott Corporation	HMT	Russell 3000	85.6	77.3
Innkeepers USA Trust	KPA	Russell 3000	85.6	77.3
Nationwide Health Properties, Inc.	NHP	Russell 3000	84.2	76.0
Cousins Properties Inc.	CUZ	Russell 3000	84.0	75.6
Source: Institutional Shareholder Services. Data as of May 1, 2005. Note: ISS does not cover Brookfield Properties Corporation. For more information, visit www.isscgq.com.

2. Director Independence
Many REIT investors and other industry professionals put a high value on the presence of directors free of monetary ties to the company they oversee, but they see independence as only the beginning.

"Everybody's definition of independence is very, very strict, but it's a little beside the point," says Richard Salomon, a partner in the real estate and corporate securities practice group of law firm Wolf, Block, Schorr and Solis-Cohen. "They can be impeccably independent, but if they don't know anything, independence is not sufficient. They really need to be sharp, and they need to be knowledgeable."

Charles Lowrey, chief executive of Prudential Real Estate Investors, says that the presence of strong independent directors has become ever more important with the addition of major REITs, including Equity Office Properties Trust (NYSE: EOP), Simon and ProLogis (NYSE: PLD), into the Standard & Poor's 500 and other major indices and the expansion of REITs' investor base to include those who may not be familiar with the stars of the business.

"As REITs become more included in many of these major indices, outside investors might say, 'I have no idea who Steve Roth or Sam Zell is; tell me about these other things, like independent directors,'" he says, referring to the founders of Vornado Realty Trust (NYSE: VNO) and Equity Office.

Lehman's Harris and others warn about the limits to the value of "technical" independence. Many relationships lie outside the reach of the categories dreamed up by rule-makers—golfing buddy, former supplier, family friend.

"You try to look at their backgrounds, what they're bringing to the company, business, financial and investing strengths," Harris says. "But this is really a subjective judgment of human qualities. You can be too mechanistic about this, and that leads you to place too much weight on technical independence."

3. Destaggered Boards
Having different classes of board directors elected during different years was once viewed as an innocuous method of ensuring stability at the top. Not anymore. The presence of so-called staggered, also known as classified, boards is taken by many investors as a clear sign that a company has hung out a "Buyers Not Welcome" sign.

Mike Kirby, a Green Street principal, finds them "obnoxious," and notes that the outcome of Taubman Centers' battle with Simon could well have gone the other way had Taubman Centers had a destaggered board.

AMB's Moghadam agrees that the destaggering of boards is among the "check-the-box stuff" that is actually important. A staggered board is "a great way of saying 'No' to a buyer that's made an offer for your company," he says. AMB's board has been destaggered since its 1997 initial public offering.

Overall, the REIT industry has lagged on this front, but there is progress to report. When Green Street did its first governance survey in 2003, the presence of staggered boards and other so-called entrenchment devices led to 51 of 68 REITs receiving an "F," or failing governance grade—a judgment even Kirby concedes can seem "harsh." In the following year, however, nine public real estate companies and their shareholders voted to destagger their boards, including such major players as Reckson Associates Realty Corp. (NYSE: RA), Developers Diversified Realty Corporation (NYSE: DDR), Regency Centers Corporation (NYSE: REG), Pan Pacific Retail Properties (NYSE: PNP), and Starwood Hotels & Resorts (NYSE: HOT). That brought the destaggered total to 34 of 68 companies in the Green Street universe at the time.

"We've identified this as the single best governance change a company can make," the firm wrote in its 2004 report. Since then, still more companies have dropped this defense, including two apartment companies, Archstone-Smith (NYSE: ASN) and AMLI Residential Properties Trust (NYSE: AML), in addition to industrial giant ProLogis.

Self-storage REIT Shurgard Storage Centers, Inc. (NYSE: SHU), which has traditionally scored near the bottom of governance rankings, was the latest to propose to destagger, in April of this year. That's considered particularly significant in Shurgard's case, since it took investor criticism in 2000 for turning aside overtures by industry giant Public Storage, Inc. (NYSE: PSA).

It should be noted that the emphasis on this narrow checklist item is not universal. Delaware's Andres says his fund can forgive the flaw in an otherwise well-managed company.

"Would we like someone to destagger? Yes; is it going to kill us? No," Andres says. "We can deal with it. There are shareholders who pound the table on this kind of thing. We never really fell into that camp."

Average Real Estate Governance Score Rises Publicly traded real estate companies continued to perform very well compared to their peers across corporate America, according to Institutional Shareholder Services' Corporate Governance Quotient (CGQ). Despite the fact that the nominal ISS CGQ ranking for REITs in the current period actually improved when compared with data as of Sept. 15, 2004, REITs fell one notch in relative rank only because utilities improved even more. Compared to the prior ranking, the CGQ index for REITs went from 25.9 percent above the average in the prior ranking to 26.3 percent above the average in the current ranking (when the average actually improved 1.2 percent as well). The nominal CGQ index for REITs also increased 1.6 percent in the current period when compared with the prior period. At the start of May, Capital Automotive REIT (NASDAQ: CARS) was the highest-ranking REIT with a perfect CGQ of 100 percent. Of the 217 listed real estate companies ISS tracks (the vast majority of which are REITs), 48 REITs posted a CGQ rating in excess of 90 percent compared to their index peers. Each company has two scores: One relative to an index (S&P 500, S&P 600, S&P 400, Russell 3000 or the CGQ Universe) and one relative to an industry. The scores are percentiles and range form 0 percent to 100 percent. To calculate each company's score, ISS gathers data based on more than 60 issues in eight categories, and applies its formula to reach a CGQ rating. As illustrated in the chart below, the real estate industry outperforms the "all companies" group in the majority of categories. The differences are greatest in the areas related to transparency and accountability.

4. Insider Ownership and 5. Insider Conflicts
The amount of a company's shares held by its officers and directors is a closely watched governance metric. That shouldn't be surprising in the REIT industry given the fact that many founders held—and still hold—large stakes in the business. Most investors and others still see a high concentration of insider ownership as the surest way to align shareholder and managers' interests.

"For managers, it's a very good thing to have a significant part of their net worth in the company," says Prudential's Lowrey. "Then they are sharing the same kind of pain or gain as shareholders."

But the matter isn't always so simple, as Lowrey acknowledges, especially in the REIT business.

Several professionals noted that many founders own securities, known as operating partnership (OP) units, that differ from common shares. What's more, they own those stakes at different tax bases from those of public holders. Investors fear that managers in some cases might be disinclined to sell certain properties—or the entire company for that matter—while shareholders might jump at the same deal.

"You've got these executives with very low cost bases in OP units, and someone comes along and makes an offer," says Ralph Block, senior portfolio manager with Phocas Financial Corporation. "If you're a public stockholder, you may be getting an attractive deal, why not sell it? For insiders, they've got tax issues, and they don't want to sell. The question becomes: will the offer see the light of day?"

6. Disclosure
REIT investors often take for granted one of the industry's strengths, the relative transparency of company operations through thorough disclosure in regulatory filings and the inclusion of supplemental packages that go well beyond the norm for corporate America. The fact is, REITs got this mostly right from the start when most modern REITs went public in the early 1990s, as the industry struggled to overcome an image problem created by the real estate collapse of a few years before.

"Having visibility and disclosure, it's absolutely a large part of what made these stocks attractive in recent years," says William E. Hauser, portfolio manager with HVB Capital Management.

Early REITs' disclosure set a high bar that other new REITs have mostly matched.

"The bar's been set," Peters says. "If you're not among those that match the disclosure standard, you're going to look bad."

Industry Governance Rankings Industry Group	Average Index CGQ
Utilities	67.3
Real Estate	65.8
Banks	62.4
Energy	55.5
Pharmaceuticals & Biotechnology	55.5
Insurance	54.7
Diversified Financials	53.7
Capital Goods	53.7
Health Care Equipment & Services	53.0
Materials	52.5
Average	52.4
Technology Hardware & Equipment	51.4
Transportation	49.8
Commercial Services & Supplies	49.2
Semiconductors & Semiconductor Equipment	49.1
Consumer Durables & Apparel	48.0
Automobiles & Components	48.0
Software & Services	47.8
Hotels, Restaurants & Leisure	47.3
Food & Staples Retailing	46.5
Retailing	45.5
Telecommunication Services	43.8
Household & Personal Products	40.7
Food Beverage & Tobacco	38.8
Media	34.8
Source: Institutional Shareholder Services. Data as of May 1, 2005.

7. Other Entrenchment Devices
These include poison pills and taking advantage, as most REITs do, of state anti-takeover laws. More than half of REITs, for instance, are organized in Maryland, which virtually blocks buyers from accumulating a majority stake without the blessing of the board. Investors view such devices as regrettable but not necessarily deal-breakers. Hauser says he relies more on an intuitive sense that management is dug-in before checking to see what formal blocking devices are in place.

"I can take a rubber stamp and put 'entrenched' on their forehead, and if that's the case, maybe you want to get a sense of what specific kinds of tools and tricks they would use," Hauser says.

Peters says entrenchment devices can be installed or discarded whenever the need arises. The main question lies in the hearts of directors and managers: how seriously will they review a bona fide offer? "If they want to scuttle a sale they can," he says. "They can always pass what they need to pass. It's more talking to management, getting a body language, though you don't really know until that day comes."

8. Wildcard: The Qualitative Question
In the end, investing is not about enhancing corporate democracy, but making money, and many REIT professionals say the broad question of whether a company is well-governed falls within Justice Potter Stewart's trope on obscenity: hard to define, but you know it when you see it.

Those investors that remain skeptics about the importance of corporate governance point out that no one has yet proved that good governance leads to good financial performance—or the opposite, for that matter. Skeptics note that rankings compiled by Institutional Shareholder Services or Green Street often find companies with weak governance scores among the highest financial performers, while companies that "do good" don't always "do well." Vornado and General Growth Properties Inc. (NYSE: GGP), the Chicago-based mall giant, scored near the bottom of Green Street's most comprehensive study to date, conducted in August 2003, but have been among the industry's—and Wall Street's—top performers for years. Equity Office scores near the top in Green Street's governance ranks, but has lagged its peers in total return performance. Meanwhile, there are a number of companies that rank equally high or low in both categories. AMB, for one, does well on both counts.

Green Street's Kirby says that a few companies' financial performance is simply so compelling that it renders governance matters moot.

"Their track record has been so good for so long, and their business acumen is just unquestionable so that the idea of having a benevolent dictator is fine," Kirby says.

Lowrey agrees that governance has two parts, theory and reality. "People say, 'I don't want staggered boards; I want independent directors; I want people to act as fiduciaries,' " he says. "But on the other hand, people say, ‘You know, Fascitelli and Roth make money, and I'm going to invest with these guys.' " He was referring to Vornado's well-regarded president, Michael Fascitelli, and chairman and chief executive, Steven Roth.

Despite their recent run of stellar total returns, REITs, like any industry, haven't earned a free pass, and investors scrutinize governance flaws as potential signs of deeper problems.

"The metrics for governance are very crude," Salomon says. "But these things are fundamental." On the other hand, he adds, "They're not a substitute for great leadership."