By Art Gering

An understanding of what Capital Automotive REIT does can be gained from considering its NASDAQ ticker symbol, CARS. The firm’s business is acquiring the real property and buildings used by the operators of multi-site, multi- franchised automotive dealerships in major domestic markets, and leasing the properties back to the dealers on a triple-net basis.

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AGE: 57 EDUCATION: University of Michigan FAMILY: Wife, Beth; daughters, Kathryn (14) and Lindsay (12); son, Ryan (10) FAVORITE BOOK: "The Sweet Season" by Austin Murphy FAVORITE SPORTING ACTIVITIES: Golf and skiing FAVORITE SPORTS TEAM: Montreal Canadiens FAVORITE VACATION SPOT: Colorado COMMUNITY ACTIVITIES: Eckert is active coaching youth sports OTHER PROFESSIONAL ACTIVITIES: Director with CARS, NAREIT, Munder Funds and Fieldstone Investment Corporation

The end of 2004 brought some important developments for the seven-year-old McLean, Va.-based REIT, including a secondary common share offering and receiving an investment-grade rating on its unsecured debt. Capital Automotive President and Chief Executive Officer Thomas Eckert recently sat down with Portfolio to discuss the driving forces behind his company’s operation.

Portfolio: Why did you decide to focus your business on automotive real estate?
Eckert: When we looked at the credit of the auto retail business, we felt there was tremendous inefficiency in the credit markets. Generally speaking, if you think about any city in the U.S., some of the largest privately owned companies in those markets are multi-generational auto retail families. They did not become multi-generational and very wealthy because the auto retail business is either cyclical or highly volatile. In fact, they are very stable, strong cash flow businesses.

Back in 1998 (when CARS went public) we realized that there would be an opportunity to provide capital for automotive retail real estate. Also, the consolidation of the auto retail business was just beginning. The consolidators needed capital to buy franchises, not to invest in real estate. The average auto retailer in the U.S. earns about a 30 percent return on equity so, clearly, by buying more franchises, they could maximize their profitability and we would own the real estate, which is pretty inefficient equity by comparison.

Portfolio: Is the company insulated from downturns in the overall auto industry?
Eckert: Auto manufacturing and auto retailing are two very different and distinct businesses. Auto manufacturing is a very difficult business, particularly for the three domestic manufacturers. It has very high fixed costs and a high variable margin. Even in a decent economic climate, we still see significant incentives offered to buyers because the volume shipped in a high fixed-cost manufacturing environment is very important to profitability.

Domestic auto manufacturers also have significant legacy costs to deal with in terms of pension and health care. They operate in a very strong union environment, which gives them tremendous inflexibility. It is a business in North America and around the world with far too much capacity, which exacerbates the need for incentives.

The auto retail business is almost the antithesis of manufacturing. It has, principally, a variable cost structure. The largest costs are commissions, advertising and inventory. It is a high-volume, low-margin business. Retailers are not only in the business of selling new cars; the vast majority of their profits are derived from selling used vehicles and from parts and service. Thus, the auto retailer can remain profitable even if sales are soft for a year or two. The parts and service business continues to grow due to longer manufacturer warranties, certified pre-owned vehicles, and the increased complexity of vehicles.

By focusing our strategy on doing business with the largest dealers in the country, we target well-capitalized entities with long track records in the business. About three quarters of our rents come from the 100 largest dealers in the country. In seven years, only one dealer has had a rental payment default. We have yet to have a vacant facility. Our tenants, on average, have maintained a ratio of about 3.5 times operating cash flow to total rent obligations. In the net lease business, that is very high. Most net lease property owners would be happy at 1.2 times to 1.5 times.

Portfolio: Other than the obvious, how is this business different from companies in other property sectors?
Are there high barriers to entry for prospective competitors?
Eckert: This is not an asset class where you buy the property, finance it, and put it on the shelf until the leases roll over. This is an asset class where dealers are constantly renovating their properties, expanding or periodically relocating to larger facilities. We have a lot of interaction with our clients, and we have created very flexible financing products that can meet their needs. A manufacturer may ask a dealer to adopt its most recent facilities guidelines, which we typically fund.

With a $2.3 billion portfolio, we have great relationships with many of the top auto retailers in the country. Over the past six months, despite the entrance of a couple of new competitors into our market, our acquisition pace has remained robust. We are not bold enough to say that competition cannot impact us—we just work harder to maintain our lead.

Portfolio: Is there a liquid market for your assets?
Eckert: There is not the same liquidity that you would have in, for example, the apartment or the office sectors. We are the largest owner of auto retail properties in the world. For the past seven years, we have had no competition. We could monetize these assets in the 1031 market, but, generally speaking, there is not a real liquid market for auto retail properties. It goes back to the structure of our leases. Although most of our properties are located in tremendous retail locations, the dealer has that site tied up for 20 years or 30 years. If you do not give a dealer that type of longevity control, he would never enter into the transaction. If he loses his site, he loses his franchise in many markets because an alternative site is unavailable.

This is both the blessing and the curse of our business. In the near term it is going to be difficult for us to realize the significant appreciation that has occurred in our properties. However, that also means our cash flows from rents are very stable.

Portfolio: Have institutional investors grasped your story?
Eckert: We are about 75 percent institutionally owned. All of the largest dedicated REIT funds have been or currently are shareholders. Institutional investors were initially skeptical of the auto retail business. However, the steady performance of the public auto retailers and the strong performance of our portfolio have proven our business model. As of December 2004, we had a 315 percent total return over the previous five years. Our investors have been richly rewarded.

In 2004, we underperformed the Morgan Stanley REIT Index. That is due in part to two issues: we were involved in a major lawsuit with a former employee that was settled in the fourth quarter, and we initiated seven capital transactions in the past 14 months, which restructured our balance sheet from 100 percent secured financing to an unsecured structure. Those transactions paved the way for us to get an investment-grade rating.

Portfolio: Tell me about your recent capital transactions.
Eckert: Management and our board established a strategic initiative to become investment grade. We have completed two preferred share offerings, a 6.75 percent unsecured 15-year monthly income note transaction, a 6 percent convertible debt offering, and two common share offerings. We also syndicated a $150 million unsecured revolving line of credit and a five-year, $150 million term note. We were fortunate to approach the market when there were windows of significant demand.

On Dec. 20, 2004, Moody’s and Standard & Poor’s gave our 15-year monthly income notes an investment- grade rating, which should lower our cost of capital and provide flexible financing to meet our clients’ needs. Near term, the rating will lower the cost of our $250 million revolving line of credit and $150 million term loan by 50 basis points.

Portfolio: How will Capital Automotive increase value for shareholders?
Eckert: We view our mission as creating stable cash flows, which can be accomplished in a few different ways. One, we will continue to grow through acquisitions and rent escalations. Two, we believe that the investment-grade rating will provide greater investment spreads than we have previously experienced, which will equate to a more profitable business. Lastly, we have increased our dividend for 29 straight quarters, and we have announced a 6 percent increase in our 2005 dividend to $1.80.

We try to run our business in a conservative and prudent manner. With a 4 percent to 7 percent annual FFO growth and a 5 percent dividend, investors should have a low teens total return over the long term. In today’s world, if you can deliver that with a degree of stability, you are adding significant value.