COVER STORY, JUNE 2007

FOCUS ON REITS
Old staples and new niches are going strong.
Karen Stone, CCIM

Since REITs were first set up by congress back in the ‘60s, they have grown into a trillion dollar industry. Originally intended to allow individuals to own interests in large real estate portfolios, REITs have moved into the portfolio percentages of institutional investors. After the last 7 years when REITs outperformed other indices, people are no longer asking, “Why should I buy an interest in a REIT?” Instead, they are asking, “Which REIT should I buy?” As they have proved themselves to be strong performers, REITs are no longer thought of as investments that are only reasonable dividend producers. They are now also sought after for their better than expected growth potential.

Today, REITs hold large portfolios in all property sectors, including some newer niche markets that are proving to be strong performers.

Retail 

Kimco Realty Corporation, headquartered in New Hyde Park, New York, owns and operates the nation’s largest portfolio of neighborhood and community shopping centers. As of April 23, 2007, the company owned interests in approximately 1,365 properties comprising 175 million square feet in 45 states, Puerto Rico, Canada, Mexico and Chile. One hundred of those assets, which total approximately 14 million square feet, are located in Northeast markets running from central New Jersey to Maine. Joshua Weinkranz, vice president of the Northeast region, oversees the leasing, property management and asset management of this portfolio.

According to Weinkranz, “Occupancy levels for properties in our Northeast region are at the highest levels we have seen in quite some time — in  the 97 percent range overall. In addition, we are seeing rents increase because of continuing upward pressure. Pricing is still aggressive for better quality assets with cap rates in dense in-fill markets remaining strong in the 6 to 7 percent range.”

Kimco’s properties are primarily leased to strong destination anchors and service-oriented retail tenants such as the Linens n’ Things located at the Manhasset Center in Manhasset, New York.

Kimco’s properties are primarily leased to strong destination anchors and service-oriented retail tenants. Because of this, the performance of their portfolio has been more stable through the ups and downs of economic cycles. “We like to focus on acquiring Class A and B+ assets, but we will consider buying value add opportunities that have redevelopment or repositioning potential,” Weinkranz notes.

He adds that new ground-up development continues to be difficult in the Northeast because of scarcity of land. “Because of this, we have been focusing on adding value to our portfolio by redeveloping and repositioning our existing assets throughout the Northeast.”

Many markets along the East Coast are hot right now. “We are currently focusing on opportunities on Long Island, in the New York metro area, in northern New Jersey, in the suburbs of Boston and in certain parts of Connecticut,” he notes. “We are actively looking to buy assets in the better markets in the Northeast.”

Kimco’s focus and formula has proven to be successful in the marketplace. “We have had average compounded growth of 10.5 percent annually since our IPO in 1990,” says Weinkranz, “and we expect to continue those average double digit annual earnings over the next 5 years.”

Industrial

According to Mark McConnell, regional director for the Baltimore/Washington region of Chicago-based First Industrial Realty Trust, “We invest in all things industrial — from small flex space to bulk distribution facilities.” Since becoming a public REIT in 1994, First Industrial has acquired a portfolio of more than 1,000 properties totaling more than 100 million square feet. Forty of those properties, representing approximately 3.5 million square feet, are located in the Northeast region that is centered in the Baltimore/Washington, D.C. area. “This has been a very strong market for us,” notes McConnell, “because job growth and population growth have been brisk, catalyzed by growth in government.” 

McConnell notes that cap rates for stabilized, quality industrial properties range from a strong 5.95 percent to 7.5 percent. In a competitive marketplace, First Industrial has taken the initiative to create investment opportunities. “If we can’t buy our way in,” says McConnell, “we will build our way in. We currently have 1 million square feet under construction — with more to come,” he adds.

Compared to other asset class REITs, industrial REITs have several strong pluses. “Industrial properties are easier to operate, involve fewer tenants and less capital is required when space needs to be re-leased,” says McConnell. “In addition, the industrial market has been very strong nationally. The industrial sector has become a primary tier asset class.”

McConnell notes that difficulty acquiring stabilized core assets continues to be a trend in the REIT market. “Because of very aggressive capital competing in the marketplace, we see more and more REITs taking on value-add redevelopment and repositioning plays. In addition, it seems that REITs are becoming more specialized.” 

McConnell says First Industrial would like to spend $150 million to $200 million in equity this year in the Baltimore/Washington market. “We believe the growth projections for this market will continue to fuel demand for additional industrial product and we expect to see continued cap rate compression.”

Office

Another REIT with a strong presence in the East Coast real estate market, Corporate Office Properties Trust (COPT), specializes in suburban office buildings. As of the end of first quarter 2007, COPT owns 244 properties totaling approximately 18.2 million square feet with a portfolio value of approximately $4.5 billion. Seventy percent of its properties are located in the Washington, D.C. area. 

Headquartered in Columbia, Maryland, COPT has been a REIT traded on the New York Stock Exchange since 1998 and has been involved in commercial real estate through a predecessor company since 1988. COPT is the No. 1 office REIT in the country, as well as the No. 1 equity REIT for a 10-year time frame in terms of total shareholder return.  

According to Rand Griffith, president and CEO, COPT is differentiated from other office REITs because of its focused strategy. “We work very hard to own large office parks that are generally located around government demand drivers,” says Griffith. “Half of our revenues come from government and defense contractors who service the government,” he explains. In fact, COPT is the largest owner of secured buildings outside of the government. Because of the stability of its major tenant, COPT’s investments tend to be non-commodity in nature.

Because of its specialized focus, COPT has been very successful in developing strong tenant relationships. “We were voted No. 1 in the country in the largest owner category for customer service in the last 3 years in a CEL & Associates ranking which results from votes received from tenants,” notes Griffith. “We have been very successful in keeping tenants over the long term and we enjoy a good bit of repeat business.”

During 2006, COPT added $1.2 billion in market value to its portfolio through both the acquisition of existing assets and its own development efforts. So far this year, COPT has almost $500 million in assets in various stages of development. COPT has carved a niche inside the office REIT market that has proven to be somewhat recession proof. “A driving force in the office sector is job growth,” explains Griffith.

Griffith notes that the office market throughout the U.S. is fairly well stabilized at this time.  “We are seeing positive rent growth throughout the country. Rental rates are starting to increase, approaching the level where they justify new construction,” he continues. “The general forecast is that the office market will be in pretty good shape for the next couple of years.”

Griffith says that 2006 was a very exceptional year for office REITs and office pricing. A number of portfolio transactions were spurred, the largest of which was the sale of Equity Office for $39 billion. “The general feeling is that this trend will continue, although most of the privatizations have shifted to hotels and, to a lesser extent, retail,” says Griffith. “This shows that at this time the private market can lever up and extract more value than the public market.”

Regionally, the northeast office REIT market is strong. “Of the three best markets in the country, two of them — Washington, D.C. and Midtown New York City — are in the northeast,” says Griffith. In other northeast markets, including Boston, downtowns and CBDs are coming back. In Boston, demand remains strong. “There is also an enormous acceleration of rents in New York,” Griffith notes.

In addition to producing strong returns for its shareholders, COPT is committed to being an environmentally conscious company. In 2003, COPT made a commitment to building all future projects according to LEED certification requirements. In 2005, COPT was awarded the first NAIOP green award. “We are committed to constructing buildings that are healthier and that enhance performance,” says Griffith. “Our experience is that we are seeing a 35 percent reduction in electricity and a 40 percent to 50 percent reduction in water consumption. Over time, this adds up to be very significant.”

Focus on Single, High Credit Tenants

This 368,000-square-foot Class A office and warehouse facility in Parsippany, New Jersey was part of a $75 million sale lease-back transaction Caplease negotiated with Tiffany & Co. The building is Tiffany’s principal operating facility supporting worldwide operations.

Capital Lease Funding (CapLease) has had a meteoric rise in assets and returns since it became a public REIT in 2004. “In 3 years, we have grown to $2 billion in assets,” says CEO Paul McDowell. “The compounded annual growth rate of our portfolio over the last 2 years has been about 75 percent per year. Our earnings are growing just as rapidly, with double digit growth during each year since 2004.”

CapLease’s business model has created a strong portfolio that is diversified geographically and by asset class, with one common theme: all assets are leased to a single tenant with investment grade credit on a long-term basis. “Because of the type of assets we buy,” says McDowell, “we have a defined cash flow, so there is a low probability that there will be an interruption in our income stream.” 

The result is long-term stable earnings with long-term stable dividends. “We currently have the strongest dividend in the REIT industry,” continues McDowell. “Because we are diversified across property types and markets, we can survive downturns in the economy and produce reasonable performances over the long term.”

Because of its focus on single tenant assets, costs for running the portfolio and the company are lower, and are more easily controlled and overseen. “Because our properties are leased to single-credit tenants on a net-lease basis,” explains McDowell, “management of these assets is not labor intensive. Once the assets are in our portfolio, they are relatively easy to run,” he continues. “Also, because of this, we can grow our portfolio more quickly than other asset types.” CapLease also has a strong, seasoned management team headquartered in New York. “We are much more than just portfolio stewards,” notes McDowell. “We have the talent to grow the company very rapidly.”

Before it became a REIT, CapLease pioneered the securitization of the high-credit single tenant asset class in the mid-1990s. “We are also the premier financer of these assets,” notes McDowell. “We are able to get efficient, low-cost debt capital to finance the fixed and determined cash flow from our long-term credit tenants.” About 20 percent ($400 million) of CapLease’s portfolio is held as debt investments, primarily mortgage loans. 

According to McDowell, as the REIT market has matured, rather than questioning the efficacy of the vehicle, the question has become, “How much longer can real estate continue to have such strong appreciation in the face of an economy that is starting to show signs of slowing down a bit?” McDowell thinks we are beginning to see the first very small hairline cracks in the commercial real estate industry as far as rent growth and absorption are concerned. “In the last quarter, several office markets across the country have seen an up-tick in vacancy. One quarter a trend doesn’t make, but perhaps this shows that we will not continue to see a meteoric rise upward in the overall real estate market.”

Focus on Life Sciences

Certain demographic trends, such as research relating to cancer and aging, are fueling the expansion of the life sciences industry, one of the largest and fastest growing segments of the U.S. economy. San Diego-based BioMed Realty Trust has taken advantage of this trend and created a REIT niche focusing on real estate assets leased to tenants in this industry. “Our goal is to provide real estate to biotechnology and pharmaceutical companies, scientific research institutions and government agencies,” says Matthew McDevitt, regional executive vice president, who oversees operations on the East Coast as well as manages the acquisitions and leasing of properties throughout the U.S. 

“BioMed has a very focused business plan,” notes McDevitt. “We have not had to divert from that business plan to meet our acquisition and growth goals.” In fact, BioMed has doubled in size every year since it has gone public. “In 2004, we acquired more than a half billion dollars in assets. In 2005 we acquired more than $715 million, followed by $1.3 billion in 2006.” Today BioMed has 57 properties in its portfolio, representing just under 8 million square feet with a value of just under $4 billion. 

“We are poised to continue our growth,” says McDevitt. “Our senior management team is made up of experienced, seasoned real estate professionals that bring more than 80 years of combined real estate experience to the table. We have based this company on a motto: ‘We promise — we deliver.’ We have the talent and the experience to do that,” he emphasizes.

BioMed has also been able to create diversification to mitigate risk while maintaining its narrow life science focus. “Within the life sciences industry, we diversify our properties in several ways:  by the “stage of life” of the tenants, by the products they produce and by location,” explains McDevitt, “We categorize companies in the industry into four life stage tiers, ranging from the fully integrated triple-A credit conglomerates to companies that emerged from a university setting several years ago and have had a few rounds of venture capital.” Product diversification includes investing in a range of companies that not only produce drugs, but that also produce “tools,” such as proteins, that are used in the manufacturing of drugs.

BioMed’s properties are geographically diversified throughout the U.S. Its portfolio is experiencing the most dynamic growth within scientific corridors that are centered in and around cities where companies can find and attract qualified workers.

Although they are enjoying a healthy expansion rate, some life science companies are facing challenges as the pressure on drug companies to bring cheaper drugs to market increases. “It costs around $1 billion to bring a drug to market today,” says McDevitt. “When congress puts a cap on what you can charge for that drug, this could potentially have a negative effect on our particular market.” BioMed also keeps a watchful eye on capital inflow to the industry by looking closely at venture funding and the public markets.

BioMed has recently increased its holdings in the Boston market by developing the Center for Life Sciences building. Located at 3 Blackfan Circle in the Longwood Medical Area of Boston, the 18-story, 703,000-square-foot building was topped off in mid-April. “It is literally the center of the life sciences industry for the country,” notes McDevitt. “It sits in the center of a wheel with strong spokes, such as Harvard Medical School, around it,” he explains. The building is already 80 percent leased to Beth Israel Deaconess Medical Center, Dana-Farber Cancer Institute, Children’s Hospital Boston and the CBR Institute for Biomedical Research. Approximately 130,000 square feet remain available for lease. Designed by Boston-based Tsoi/Kobus Associates, Inc., its architecture incorporates numerous energy efficient and environmentally advanced features. It is expected that the Center will qualify for a LEED rating for sustainable buildings. William A. Berry & Son Inc. is building the Center, which is scheduled for delivery in 2008.

It Still Comes Down to the Basics

No matter how sophisticated the vehicle, how creative the financing, or how diversified the portfolio, making good investments in real estate assets still comes down to the basics: location, quality of the tenant, the physical quality of the asset, and the strength of the marketplace and the economy. “Real estate is still a contact sport,” says McDevitt. “To make good investments, you still have to kick the bricks and mind the details.”


©2007 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.