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RETAIL REITS FOR HIRE

Real estate investment trusts are finding a profitable side business in hiring out their services to institutional funds seeking retail expertise

By Steve McLinden

Call it a match made in fiscal heaven. Large pension and life insurance funds have plenty of cheap capital to park in shopping properties, though they lack retail expertise. Retail REITs, on the other hand, face perennially high capital costs, but they are flush with operating and management talent.

So little wonder that the two are teaming up with increased fervor on joint ventures. One such union, often called a “programmatic” joint venture, is on the upswing because it gives retail REITs a sizable fee base to operate properties without having to raise capital in the public markets to purchase them.

In such a deal, a REIT typically acquires a shopping center or a set of them on behalf of an institutional fund and then becomes the fund’s managing and operating partner, co-investing 10 to 25 percent of its own equity in what can be treated as an off-balance-sheet joint venture. The REIT receives a battery of fees for its efforts, including acquisition, management and property fees and leasing commissions. The fund, in turn, gets better-positioned shopping centers, saves on advisers and other intermediaries, and, more important, reaps most of the operating profits.

“It’s an increasingly popular model,” said David Henry, chief investment officer of Kimco Realty Corp., a New Hyde Park, N.Y.-based retail REIT. “And it is accelerating, quite frankly, because property expenses are at an all-time high.” Such ventures “really boost your percentage return on equity while you’re investing smaller amounts. The only bad side is, you have to do more deals when you don’t own all your centers 100 percent.”

Kimco, which operates several retail properties with GE Capital, typically buys a 10 to 20 percent stake in the properties it acquires for the funds; Regency Centers, a Florida-based REIT, generally acquires 20 to 25 percent.

Regency’s first programmatic joint venture was executed in 1998. The firm now participates in some $4.5 billion of such deals with the California State Retirement System, Oregon’s Public Employees Retirement System, Australia-based Macquarie CountryWide Trust and an open-ended fund, says Regency Chairman and CEO Martin (Hap) Stein. “It’s an efficient way for REITs to grow their platforms,” said Stein.

The fees add up quickly for a REIT and can be “enormous compared to what the market for operating partners was ten years ago,” according to Stein. “The biggest challenge we face is to structure the fees where we [can] get returns on investment capital that make sense for our shareholders,” he said.

Stein estimates that Regency’s profits from such third-party asset services will double from the current 10 percent of revenue to 20 percent of revenue over the next three to five years. Kimco is moving toward a business mix “where 50 percent is in our core portfolio and 50 percent everything else,” including fund joint venture fees, says Henry.

In a retail panel discussion at the Deutsche Bank Real Estate Outlook Conference, in January, Daniel Hurwitz, chief investment officer of Beachwood, Ohio-based Developers Diversified Realty Corp., said the volume of his firm’s joint ventures and third-party business would keep growing over the coming years. “But on the flip side of that, we hold the development pipeline near and dear to our heart, and we aren’t looking to put that into a JV,” Hurwitz said.

Hurwitz also cautioned that retail REITs should retain the core principles of what made their businesses successful. “Or quite frankly,” he said, “some of those funds won’t want to invest in you in the future. We must make sure our business strategy doesn’t conflict with our ultimate goal, and that is being an outstanding operating company.”

Institutional funds like the flexibility that fee-based REIT joint ventures offer. That’s “because [the funds] all have different objectives they want to achieve,” said Dennis Gershenson, president and CEO of Ramco Gershenson Properties Trust, a Farmington Hills, Mich.-based REIT, at the same conference. “Our class-A institutional partners, for example, want a safe-quality asset and [an] experienced team to run that asset,” said Gershenson. (The firm teams up with ING Clarion Partners on several joint ventures.) Other funds are willing to take greater risks with B-center portfolios, he said.

Henry says fee-based joint ventures with institutional funds keep Kimco in the game in more and more deals, allowing the firm to develop stronger ties with national retailers, their brokers and other real estate intermediaries, and to expand its foothold in more markets.

“If you have 50 Home Depots, you obviously have better relations than if you had just two,” Henry said. “It increases our scale.”

Steve Gruber, the former real estate portfolio manager of the $60 billion Oregon Public Employees Retirement System, says fund managers have come to realize that retail real estate, much more so than office and industrial property, is a relationship-driven business. “And these institutional managers have learned the importance of these relationships,” Gruber said.

Gruber, now a partner at Org Real Property, an institutional real estate portfolio advisory firm, worked with Stein on one of Regency’s first joint ventures. REIT fund arrangements differ from each other, says Gruber. Some are structured to give the REIT a percentage of operating profits once the fund achieves a set return on investment. Others call for the use of an institutional manager to reinforce the fiduciary concerns of the fund.

Most funds are finding that they get what they pay for in such arrangements, he says. “The pension fund has to pay market rate fees, but it’s getting A-level service in return,” Gruber said. “Fund management really doesn’t know how to redevelop or re-tenant a center to raise its profile, but a REIT does. The REITs, after all, are the ones with the close relationships with the likes of Saks, Tiffany’s, Neiman Marcus and Nordstrom.”

REITs are also finding these ventures an efficient way to diversify their capital sources, says Gruber. “We know from experience that the public markets won’t always be open for capital, nor will the debt markets, or even the pension funds,” he said. “So you try to branch out into as many areas as you can.” But REITs have found that they must limit the number of fund partners they bring on. “Those big funds aren’t going to want every fifth great deal,” Gruber said. “They are going to want every great deal. [There’s been] a big gold rush over the last five years to get these partnerships in place.”

Though mall REITs don’t generally enter such fee-based partnerships, they may use a more traditional model with institutional partners to help defray development and operating costs. Two of General Growth Properties’ largest deals, for instance, include the $1.85 billion, 1995 acquisition, with the New York State Common Retirement Fund, of Homart Development and its mall portfolio from Sears, Roebuck and Co.; and a 50-50 venture with the Teachers’ Retirement System of the State of Illinois in 2002 to acquire four regional malls.

The pace of these REIT joint ventures is unlikely to slow anytime soon. “On the institutional capital side, there’s certainly a lot more money entering in joint ventures these days for shopping centers,” said Andrew Johnson, a San Francisco partner in the real estate practice of Orrick, Herrington & Sutcliffe, a New York City-based law firm. “The development and investment processes inherently take a lot of operating expertise that REITs can readily offer.”

Said Henry: “We’ve all seen that it can be super profitable for [retail REITs] to be in this part of the business, and we are simply recognizing that our cost of capital is so much higher than it is for these pension funds or life companies we are dealing with.” Most institutional funds have increased their real estate allocations, Henry says. “That has led to quite a pent-up demand and therefore a high demand for operating partners like us.”