The Ground Game

3/28/2014 | By Ralph Block

Published in the March/April 2014 issue of REIT magazine.

I’ve been a REIT investor for decades (my California license plate reads REITDOG), but when reflecting upon REITs’ stock performance last year, I don’t know which of us to feel more sorry for.

In a Wall Street Journal story in early January, your colleague David Henry, Kimco Realty Corporation’s (NYSE: KIM) CEO, sounded quite frustrated, lamenting the disconnect between steadily improving property fundamentals and weakness in REIT stock prices.

REITs’ shorter-term share values are, of course, subject to the fickle preferences of stock investors. Healthy cash flow and net asset value (NAV) growth, along with reasonable valuations, often mean little to them. Nevertheless, the market’s judgment shouldn’t be ignored. Let me explain.

The real estate industry is cyclical, although, fortunately, with a long-term upward trend. And, due to this cyclicality, certain REIT business and capital deployment strategies may be wise at certain times, but not others. Furthermore, the cost of debt and equity capital will fluctuate, as will returns from the investment of that capital. It’s essential, of course, to have a long-term business plan, but it’s also smart to be opportunistic and to understand that capital costs and investment returns will change with market conditions. Value creation is still the name of the game.

Certain REIT business and capital deployment strategies may be wise at certain times, but not others.

REITs’ cost of capital – debt and equity – is higher now. As I write to you, many REIT shares are trading at prices below estimated NAVs.

This certainly affects the advisability of raising additional equity for external growth. There is also a large amount of private capital looking for quality real estate – and it’s willing to pay up for

it. Accordingly, perhaps it would be wise this year to de-emphasize growth through large volumes of property acquisitions.

You have been successful at times with new property developments. There may be additional value-creation opportunities here, but please don’t forget the leasing, construction and financing risks

in new developments. Stabilized returns on them are only educated guesses. Given the uncertain nature of the U.S. economic recovery, perhaps the redevelopment of some of your existing properties would be a better focus. Investment returns may not be as large, but will be less risky and provide better returns on invested capital.

Keep debt leverage modest and, if possible, reduce it. Debt levels have a significant impact on the value of your REIT’s shares, and, although interest rates may not increase much this year, the long-term trend is probably up. Let’s not forget our near-death experience just six years ago.

Fewer property acquisitions and caution in new property developments, along with debt reduc- tion, will affect your external growth prospectsfor the next year or two. Growth-centric investors may be discouraged. But your shares are ulti- mately valued on the basis of your credibility, debt leverage and smart capital allocation decisions, as well as your property values. Furthermore, like the Hippocratic Oath – “first, do no harm” – conser- vatism in safeguarding shareholders’ capital can never be overrated.

Meanwhile, there is still much that your organization can do. Strong internal property management and leasing – old-fashioned blocking and tackling – will create shareholder value, and will be appreciated by the long-term investors

so crucial to your REIT’s sustained success. So will cost control. Sell your properties with less potential. Focus on a few really good acquisitions that will increase your dominance in promising markets, taking advantage of existing relation- ships, where possible, to buy them off market.

That old Woody Hayes strategy – three yards and a cloud of dust – won many games for Ohio State. It may also be a pretty good REIT strategy this year.

Ralph Block is the author of “Investing in REITs” and “The Essential REIT” blog. Views expressed are solely those of the author.


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