COVER STORY, JUNE 2007

REIT MARKET DOES IT AGAIN
REITs try to outpace other markets for an eighth year.
Daniel Beaird

When an industry outperforms all other major U.S. equity markets for a seventh consecutive year, that’s something to report; and it’s just what the U.S. REIT (real estate investment trust) Index accomplished at the end of last year. Reporting a 34.35 percent return for 2006, the Index outshined the Russell 2000 (18.37 percent), the Dow Jones Industrials (16.29 percent), the S&P 500 (15.79 percent) and the NASDAQ Composite (9.52 percent). So, what drives the success for REITs and as the industry hits lucky number seven, can it extend its streak to 8 consecutive years of outpacing the other equity markets?

Strong commercial real estate fundamentals, increasing portfolio allocations to commercial real estate, a high number of mergers and acquisitions, and steady economic growth due to market leading performances have all been marked as reasons for the success of REITs during the past 7 years as well as the growing number of aging baby boomers seeking another source of income for their retirement years.

“Institutional investors have been putting more money into real estate and plan to continue that trend because that’s the easiest way to put private equity money under good management very quickly,” says Brad Case, vice president of research and industry information with NAREIT (National Association of real estate investment trusts). “The average portfolio allocation to real estate has increased during past 6 years, and institutional investors haven’t reached their target allocation yet and intend to invest even more money into real estate in the future.”

With the industry outpacing other markets for 7 consecutive years, there is a nagging concern about REITs being overvalued in the marketplace. But, according to Case, that concern isn’t validated. “If that was the case, then much less acquisition activity would be taking place, but certainly there is a lot of smart money that doesn’t think REITs are overvalued at all,” Case says.

Rand Griffin, president and chief executive officer with Corporate Office Properties Trust, agrees. He’s heard questions about REITs being able to outperform other markets again for many years. “Everyone bets against REITs versus the stock market,” Griffin says. “But at the end of the year, for 7 consecutive years, that question has had the same answer.”

According to Griffin, major factors in the success of REITs include mergers and acquisitions, in which he points to the Blackstone Real Estate Partners’ acquisition of Equity Office Properties Trust earlier this year; the allocation of funds into commercial real estate; and the aging baby boomer population.

“Ten point nine seconds,” Griffin says. “That’s the rate at which another baby boomer turns 60 years old.” And these baby boomers are changing the face of retirement and seeking alternative ways to fund their active lifestyles; and REITs provide another source of income for those retirees’ net worth.

According to NAREIT statistics, approximately two-thirds of the REIT Index’s 12.72 percent average annual total return during the past 20 years was delivered in the form of dividends, a characteristic that makes REITs important components of institutional and individual retirement portfolios. Pension funds have boosted their allocations to commercial real estate each year for the past 5 years, and the funds are increasingly including REITs in their real estate allocations. The occurrence of real estate investment funds in 401(k) programs has also tripled in the past 5 years. “NAREIT works hard to make REITs a selection for 401(k) programs,” Griffin says. “REITs constitute up to 20 percent of some 401(k) programs today, and we would like to see REITs constitute up to 50 percent of some 401(k) programs by the year 2010.”

Mergers and acquisitions (M&As) grabbed the headlines for REITs in 2006, especially public companies that were taken private. Blackstone’s acquisition of Equity Office Properties is a great example of privatization as Equity Office Properties was the largest publicly held office building owner and manager in the country with interests across 16 states. With such focus on privatization patterns, the market slightly ignored other M&As last year.

“Its important to know that last year, when attention was being paid to acquisitions that took companies from public to private, there were also many IPOs, providing activity in both directions,” Case says. “In fact, most of the activity during 2006 was not public to private, but public to public.”

Whether the M&A trend continues depends on the direction interest rates are heading and whether or not alternative investment opportunities present themselves to private investors. However, with so much capital available and low rates, the idea of investors continuing to pump money into commercial real estate and REITs is very viable.      

With all of these positives, is there any cause for concern? “There’s always cautions to all sorts of public companies, in which REITs are some, in the public sector,” Case says. “The company has to evaluate not only how well its part of the industry is going to do, but also how well its going to do relative to other parts of the industry.” 

At year’s end 2006, the office segment of the REIT industry had rebounded and was the top performing sector with returns at 45.22 percent. While the office and industrial segments remain relatively strong, the retail and lodging segments are off to a hot start in 2007 with regional malls performing the strongest.

“Much of the strength in the retail sector is due to the strong fundamentals as well as the increases in efficiency in bricks and mortar retailing,” Case says. “That translates into greater success for the tenants, and therefore, greater for the services that REITs are providing.”

But, with retail, lodging, office and industrial sectors leading the way for REITs, it doesn’t necessarily mean it will stay that way. “Sectors move up and down relative to each other, but there is no reason to expect pieces of the equity REIT sector to be lagging behind any other piece of it,” Case says.

REIT trends tend to focus on certain property types as a whole and how they are faring across the country. When specifically examining one region of the country like the Southeast, its important to investigate why certain REITs own properties there.

For example, Malveryn, Pennsylvania-based Liberty Property Trust has opened offices throughout the Southeast through the years. Heavily involved in the office and industrial game in the Southeast, Liberty sees a bright future for those types of properties in the region through a growing workforce and the region’s access to the Eastern seaboard.

As well as acquiring properties in the Southeast, Liberty is also developing office and industrial properties. And it is developing those properties with a sense of environment in mind as most of its developments seek LEED (Leadership in Energy and Environmental Design) certification.

“The argument against this kind of construction is the higher construction costs to the company,” says Larry Gildea, senior vice president and regional director for Liberty’s Mid-Atlantic region. “But, the costs are not that much higher. The world is trending towards environmentally-friendly initiatives and companies will look at LEED-certified buildings first.”

In January, Liberty’s Gate Parkway in Jacksonville, Florida, received LEED certification, making it the first commercial building in Jacksonville and one of only 10 buildings in the state of Florida to be LEED certified. Gate Parkway was developed as a build-to-suit project for PHH Mortgage, a subsidiary of PHH Corporation. The three-story, 158,000-square-foot building features an entryway consisting of a canopy of steel and glass into a two-story atrium. The 300-foot length of the building is mitigated by dividing it into three distinct sections anchored by vertically-ribbed wall panels with floor-to-ceiling windows. The building’s features include waterless urinals, low-flow showerheads and sensor faucets, high-energy efficient HVAC equipment with special filters and carbon dioxide monitors, a highly reflective TPO roof membrane, and low emission paints, carpet and adhesives. Gate Parkway received the Office Project of the Year award from the northeast Florida chapter of the National Association of Industrial and Office Properties (NAIOP).

Meanwhile, in Greensboro, North Carolina, Liberty is seeking LEED certification for Bull Ridge Distribution Center, which was completed in May. It is expected that Bull Ridge Distribution Center will be the first speculative warehouse building to be LEED-CS (Core and Shell) certified in the United States. The 341,000-square-foot building features an ESFR sprinkler system, flexible floor plans ranging from 46,500 to 341,000 square feet, a 310-foot building depth and 50- by 50-foot interior column spacing with 60-foot depth at the rear loading dock doors. The maintenance of the building will also be supported by a green cleaning program that includes environmentally-friendly cleaning solutions. In addition, preferred parking will be provided for fuel-efficient vehicles.

“These industrial warehouses are significant in the Southeast because retailers want to be able to reach the East Coast from their industrial sites,” Gildea says. “The industrial trend in the Southeast is for big warehouses to get bigger and for small warehouses to get smaller.”

So, Liberty builds both. The 80,000- to 100,000-square-foot warehouse typically serves four to five tenants, while larger warehouses are more likely serving a single tenant.

“The rising population and easy location is going to keep the companies coming to the Southeast,” Gildea says.

Corporate Office Properties Trust's Washington Technology Park in Chantilly, Virginia.

Among office REITs, Corporate Office Properties (COPT) is one of the top performing companies in the sector. Headquartered in Columbia, Maryland, COPT focuses on office properties of at least 50,000 square feet in size in suburban markets in the Mid-Atlantic region.

In 2006, COPT’s stock market price hit a historic high at $50.47 and shareholder returns remained among the highest in the office REIT sector at 46 percent for 1 year and 426 percent for 5 years. The company continued to build its land inventory for future development as it closed on Fort Ritchie, a former U.S. Army Base located in Washington County, Maryland, providing 1.7 million square feet of office development capacity and 673 residential units.

“The 1.7 million square feet of office development capacity is the largest in Washington County,” Griffin says. “Fort Ritchie consisted of barracks and outdated housing, which will be renovated along with a community center.”

COPT’s proposed development on the former Fort Ritchie site includes 67 acres of historic area, 24 acres of lakes, 20 acres of community use, 79 acres of business development, 135 acres of residential development and 257 acres of woodland area. It is anticipated that Fort Ritchie will be developed during a 10- to 15-year time period with the intent of creating 4,500 jobs.

At the beginning of this year, COPT acquired the 2.4 million-square-foot Nottingham office portfolio in the White Marsh, Columbia, BWI, Towson and Hunt Valley submarkets, all in Maryland. The acquisition included 56 operating properties and 187 acres of land at a cost of $363.9 million. Approximately 85 percent occupied, major tenants of the operating properties include Comcast Corporation, MedStar Health Inc., Orbital Sciences Corporation and The Johns Hopkins University. The 187 acres of land can support a minimum of 2 million square feet of office development.

With the population figures of the Mid-Atlantic and the population boom in the Southeast, REITs continue to enter the market in office and industrial, retail, lodging and other sectors. Meanwhile, the REIT industry across the country continues to outperform the other markets. Can it outpace the markets for an eighth consecutive year, nobody knows for sure; but, it definitely doesn’t hurt to have a solid 7-year track record.


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