This year will be remembered as the one in which real estate investment trusts took on the strut and swagger of legitimacy.
Questions about REITs' viability as a real estate investment are now answered with a cocksure smirk, like the one Michael Jordan uses to dismiss opposing basketball players who try to check him.
The sector has grown steadily in size since late 1993, but in true American fashion that places a premium on bigness, it wasn't until office buildings became a major presence in REITs that the party really got started.
"In the 1993-1994 REIT (initial public offering) boom, you saw small assets typically," said Christopher Lucas, director of REIT research in the Washington office of Coopers & Lybrand. "In 1995 and 1996, it was self-storage facilities and limited-service hotels.
"Now we have made this quantum leap to offices, which in the past were owned by institutions," he said. "That sets the new standard.
"To me," said Mr. Lucas, "the seminal point is the REIT market now encompasses the entire spectrum of traditional real estate, and there is plenty of depth.
"When the market cap was $50 billion to $60 billion, people said the liquidity wasn't there," he said. "The companies are large enough now. The opportunity set is complete: central business district, suburban office, industrial and warehouse, apartments and the whole retail spectrum.
"And there is more than one choice."
Private realty still bigger
Publicly held real estate is still dwarfed by privately-owned real estate: $104 billion at the end of August vs. an estimated $3 trillion. But like a young lion ready to take over a pride from the old king, REITs are emboldened by the back-up of the capital markets, and as a result, realize their time is now.
Case in point: Indianapolis-based Simon DeBartolo Property Group's hostile tender offer for Retail Property Trust, a private pension fund REIT managed by The O'Connor Group, New York.
O'Connor, together with two other private regional mall operators, was trying to convince RPT's pension fund investors to allow them to combine the three portfolios and take them public.
Simon, however, outbid the other group, raising its offer repeatedly and agreeing to pay almost $4 a share above net asset value for RPT.
And in what would be a brazen show of hubris, Craig Faggen, a managing director with Los Angeles-based Triton Pacific L.L.C., envisions that REITs might approach pension funds that own property directly and offer to take asset and property management assignments away from the real estate managers - for a lower fee.
"The transformation (from private to public) down the road is large because most real estate is still not owned by the public," said Steven A. Wechsler, president of the National Association of Real Estate Investment Trusts, Washington, the industry trade association.
"There is room to grow," Mr. Wechsler said. "Part of that growth is going to be led by increased level of pension fund investment in real estate."
Proponents of investing in private operating companies and REITs claim it is superior to single property investment and private fund investing because a REIT:
Eliminates the inherent conflicts between an adviser with multiple clients;
Aligns investor and operator interests; and
Is more efficient in the operation of the real estate.
The 'corporate model'
REITs and operating companies provide "a corporate model for real estate," said Jeff Ennis, real estate consultant with Wilshire Associates, Santa Monica, Calif.
"REITs and operating companies have a business strategy that goes along with the assets and seeks to create economies of scale on the business side through savings on asset and portfolio management fees and leasing fees," said Mr. Ennis.
"They have a specialty by geography or property type or both," he said.
"With an operating company it is easier to plan, operate, report and borrow than with a series of discreet assets," said Arthur Solomon, chairman of Lazard Freres Real Estate Investors L.L.C., New York.
"Operating company formation has fundamental advantages that won't disappear," said Mr. Solomon, whose firm has acquired major stakes in six real estate operating companies and operates a $1 billion partnership in search of these deals.
"This works better for the pension funds."
Several pension funds concur. Pension funds at the vanguard of using REITs and operating companies as the vehicle to invest in property include Ameritech, IBM, Pennsylvania Public School Employes' Retirement System, Commonwealth of Pennsylvania State Employes' System, State of Michigan, Oregon Public Employes' Retirement Fund and New York State Common Retirement Fund. On the endowment side, Yale University is a leader.
"We believe that successful real estate companies which have a long track record in the market have proven and will continue to prove to be better real estate performers than bringing in third parties to manage those products," said Philip Van Syckle, head of mortgage and real estate for the Michigan retirement system, Lansing.
Michigan has completed two operating company deals: In 1995 it contributed cash and apartment buildings to Simpson Housing and recently it invested $140 million for a stake in Edens & Avant.
The affinity for REITs and operating companies doesn't mean pension funds will shun direct property investments. The likely outcome is privately held real estate will become a smaller part of the overall portfolio with higher return expectations, said Michael Humphrey, a consultant with Cleveland-based Courtland Partners Ltd.
According to a report from Courtland Partners, institutions invested $110 billion in real estate in 1989. Direct property accounted for 60% of the total and private pooled funds making up 40%. REITs' share was insignificant.
At the end of last year, the $170 billion of institutional investment in real estate was divided 45%, 30% and 25%, respectively, between direct property, private pooled funds and REITs. By 2001, the proportion on the estimated $250 billion of institutional investment in real estate is forecasted to be 40% direct property, 12% private pooled funds and 48% REITs.
The ways pension funds and their real estate advisers are using REITs and operating companies include active management of a portfolio of REITs, trading property for stock, joint ventures and rolling up old-style private pension fund partnerships into REITs.
Acceleration, diversity in '97
Pension funds were involved from the beginning of the current REIT era, which got under way in 1993-1994. But 1997 was notable for an acceleration and a diversity of deals that involved pension funds.
The big story between REITs and pension funds has been the roll-ups. A roll-up occurs when properties from a private partnership or those owned separately are contributed to a new entity that will manage the properties in an operating company. The technique was used in 1994 by the private developers who couldn't refinance their properties and had to sell equity stakes to repay lenders.
Pension funds have been surprisingly disciplined and judicious in analyzing roll-up proposals.
Equity Office Properties Trust, a Chicago REIT that resulted from the roll-up of four Zell/Merrill Lynch Real Estate Opportunities Partners fund this year, was the first successful roll-up of a largely pension fund partnership of office buildings. The fund was marketed to pension funds in 1994 with the roll-up strategy a way for pension funds to exit the partnership.
AMB Institutional Realty Advisors Inc., San Francisco, was the first traditional pension fund real estate manager to gain shareholder approval of its roll-up, which occurred last month. The company is expected to go public later this fall with a REIT of industrial properties and shopping centers.
Not all roll-ups OK'ed
But pension funds are not rolling over for the roll-up.
They twice nixed Chicago-based Heitman Capital Management's attempt to roll-up; said no to an effort by The RREEF Funds, Chicago; and are likely to give a thumbs down to MIG Realty Advisors, several consultants said.
Zell/Merrill was successful because much of the senior executives' money was also in the deal. In that case and AMB's, the property focus was narrow and the resulting public company was large vs. its peers, said Mr. Ennis.
Those that failed did so because they were complex, the strategies weren't defined and investors wanted to end their relationships with those advisers, said Bruce Eidelson, principal with Institutional Property Consultants, a San Diego real estate consultant.
Goodwill between the investors and their managers can't be emphasized enough, but the pension funds and their consultants are making decisions on the merits of the proposals, which is why MIG's proposal is likely to fail, said several industry sources.
"One of the issues is, does the market need another apartment REIT," said Kevin Howley, managing director with SSR Realty Investors Inc., San Francisco.
"No one is arguing for more apartments," said Mr. Ennis.
Too many apartment REITs?
According to a research report from Prudential Real Estate Investors, Parsippany, N.J., there were 33 apartment REITs as of March 1997, which is more than investors need or want.
MIG is proceeding, in spite of these sentiments. A shareholder vote is scheduled for October, said James Cote, president of the West Palm Beach, Fla., adviser. The REIT, which would go public in three to six months after gaining shareholder approval, would have a market capitalization between $800 million and $1.2 billion.
Cabot Partners L.P., Boston, also plans to roll up its commingled funds and separate accounts into an industrial properties REIT, and so far has received a favorable reception from investors and their consultants. Cabot's outcome should close the door on the private pension fund partnership roll-ups for the awhile.
"It will be more of a mergers and acquisition game," said Mr. Ennis. "I can't think of too many others," said Mr. Eidelson. "The logical candidates have formulated their proposals and are fairly along in the process.
"My guess is you will see more deals like Meridian," he said.
Meridian is a deal executed by Prudential Real Estate Investors, in which the firm traded property for stock. The technique isn't new, but with the roll-up phenomenon drying up, and REITs hungry for properties to achieve growth, that activity is expected to increase.
Other practitioners playing the game are AEW Capital Management, DRA Realty Advisors, LaSalle Advisors and Jones Lang Wootton.
In addition to Meridian, PREI also did property-for-stock swaps with Starwood Lodging Trust, a hotel REIT, and Equity Residential Properties Trust, an apartment company.
Capturing the premium
Perhaps the strongest motivation fueling pension fund and investment manager interest in working with REITs is an attempt to capture the premium that public REITs are paying for private property. But there is no guarantee that the premium will be there. Whether it is via a roll-up and IPO or a merger and acquisition, the stock pension funds get is restricted for up to one year. Often, there are trading volume restrictions once the holding period expires.
It's unknown if the roll-ups will trade at a premium one year after their IPO.
Bernard Winograd, chief executive officer of Prudential Real Estate Investors, believes the premium will be there for Prudential clients that approved the property-for-stock exchanges. If he is right, REITs will become the "win-win" investment that its proponents claim it is. Time will tell.