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NEW CHALLENGES FACING REITS AS NEXT DECADE BEGINS

By Debra Hazel

It’s been 10 years since the creation of REITs provided the shopping center industry its big bang, sparking rampant consolidation and completely changing the way it was run. But with the prospect of an economic downturn and the number of new malls reduced to a trickle, the industry is at a crossroads, with some seeing public ownership as a hindrance to further growth.

Prior to 1991, about the last words outside observers would use to describe the U.S. shopping center industry would be “open,” “liquid,” “consolidated” or “disciplined.” The business was populated by visionary mavericks who saw a piece of dirt and built on it, using other people’s money and not worrying too much about center operations.

Then the major institutions that had financed shopping center development simply stopped doing so. To continue to grow, Kimco Co. co-founder Milton Cooper sold shares of his neighborhood center company to the public in November 1991. Until then, only a handful of shopping center firms, including The Rouse Co., Federal Realty Investment Trust and Weingarten Realty, were publicly held.

Developers large and small followed suit over the next few years. Today the equity capitalization of the retail REIT sector has grown to $25.7 billion, from $13.8 billion in 1994, the first year the statistic was compiled, according to the National Association of Real Estate Investment Trusts, Washington, D.C.

The transparency imposed on the business by quarterly reporting required of REITs has transformed it, creating a more open, more consolidated, more professionally run industry, while introducing new avenues of financing.

“It absolutely was a complete revolution,” said Lee Schalop, research analyst for Bank of America, New York City.

At the time, though, most developers simply were searching for capital to expand.

“I thought at the time that the concept of a REIT was so powerful,” said Cooper, chairman and CEO of his New Hyde Park, N.Y.-based firm. “I really thought [other IPOs] would be sooner than actually happened.”

But the next shopping center developer to issue stock, The Taubman Co., didn’t do so until the next year, and many of the other largest REITs were not formed until 1993 and 1994.

When they did so, though, a notoriously secretive industry suddenly became much less so.

“The transparency of information, the knowledge of the capital markets, is far superior to what there ever was,” said Robert S. Taubman, president and CEO. “It’s helped other companies achieve a mass of critical size.”

That openness also attracted new financing types. Prior to the credit crunch of 1990-91, most developers invested little or none of their own funds in their centers, relying primarily on banks and large institutions such as TIAA. For some companies, the equity raised from stock issuances helped to fund growth. And vehicles such as commercial-mortgage-backed securities, nonexistent in 1991, have since become an important element, while large banks are less of a factor than before.

“The CMBS market has become a major provider of debt to REIT owners, and we have to compete with that,” said James Easler, managing group leader of Teachers Insurance and Annuity, New York City, a pension fund and leading investor in shopping center properties both before and after the REIT revolution.

As a result, debt is more affordable — for the largest companies. Over the last 10 years, already substantial portfolios have become even larger through consolidation. Indianapolis-based Simon Property Group has grown from owning and/or managing 114 centers in 1993 to a 250-center portfolio today, largely through five significant corporate acquisitions: DeBartolo Realty Trust, Corporate Property Investors, Retail Property Trust and much of the portfolios of New England Development and the IBM pension fund. Even more significant, said Simon CFO Stephen E. Sterrett, is the company’s growth from $3 billion to $18 billion in assets.

“If you buy into the vision Sam Zell articulated, in each sector you’ll see a dominant $30 billion REIT,” Sterrett said. “A mature industry consolidates into oligopolistic structures.”

General Growth Properties (GGP) went public in 1993, although then-chairman Martin Bucksbaum had first proposed the idea in mid-1990, according to nephew John L. Bucksbaum, now Chicago-based GGP’s CEO.

“Given the country was built out and so many properties were in the hands of institutions, there would be new opportunities for acquisitions, and these acquisitions would be large,” the younger Bucksbaum said.

GGP’s subsequent acquisitions included CenterMark Properties in 1994 (in a partnership with Westfield that was later sold to Westfield), Homart Development in 1995, most of the MEPC portfolio and U.S. Prime Property in 1998.

“We really could not have done any of them as a private company,” Bucksbaum said.

Acquisitions were not limited to the mall REITs. Kimco, which began as a strip center owner primarily in the Northeast, now owns and/or manages nearly 500 properties in 41 states. Expansion has come through development, the 1997 purchase of Price REIT and acquisition of retail properties such as Gold Circle and Hechinger (see Requiem for the REITs).

“Initially, the generally held opinion was that shopping center REITs should be focused regionally. In time, we saw the benefits of being national,” Cooper said, citing the ability to deal with tenants that were expanding nationally.

But the most recent corporate acquisition, this year’s purchase of most of the Richard E. Jacobs portfolio by Chattanooga, Tenn.-based CBL & Associates Properties, may be the last major deal for some time, Easler said. While some B-level centers may change hands, institutions are looking to invest in top-performing centers, preferably in major metro areas, and most of those are already tied up.

The consolidation has affected private companies, as they are forced to compete with their larger brethren (see Pondering Privatization). Once a traditional private developer mainly of regional malls, Newport Beach, Calif.-based Donahue Schriber formed a private REIT in January 1997 and shifted its focus from regional malls to community and neighborhood centers. Competing with the public REITs was one factor in the change, acknowledged Pat Donahue, executive vice president.

“What the REIT format gave to Donahue Schriber was a new structure in the product life of shopping centers,” Donahue said.

Others chose growth by what many at the time saw as a more difficult route: development. Developers Diversified Realty, Cleveland, went public in 1993 with assets of around $500 million. Eight years later, its assets total more than $3 billion, with most of the growth coming from ground-up construction of large community centers.

“When we went public,” said Scott A. Wolstein, DDR’s chairman and CEO, “development was a dirty word. The lesson is: Don’t listen to what people say when they’re wrong.”

To some extent, a company’s prior culture dictated its method of growth, according to Taubman, whose firm is opening four regional malls this year.

“Some companies focused more on volume, some on types of markets they were interested in being in, and others were more selective,” Taubman said. “Our company’s franchise is to be involved in creating more productive, very dominant retail sectors. It wouldn’t surprise anyone that Simon and General Growth are the largest acquirers and we’re one of the most significant developers.”

But how much more the industry will continue to grow is a matter of debate. While Taubman says that population growth will continue to feed new developments, some chains are complaining that there isn’t enough new shopping center product to fulfill their expansion needs. Public developers under Wall Street scrutiny must be more cautious with new building.

“There is a disincentive to be entrepreneurial. There is a constraint on growing,” Easler said, observing that such megadevelopers as Simon are building only one new mall a year, and Taubman’s openings this year have been questioned by some on Wall Street. “But I argue that it’s called discipline.”

Discipline also is integral to managing assets, and REITs have become increasingly sophisticated in operating existing centers.

“When I came to Simon in 1988,” Sterrett said, “everyone was still building malls. Most of the attention was focused on finding sites and securing tenants. After the mall was open, the focus was on building the next mall, not on making that mall better.”

That changed rapidly. Firms such as Simon and Colonial Properties have used their status to implement strategies in the public era, including branding, the pursuit of national corporate sponsorships and other marketing vehicles.

“Suddenly, the recognition that enormous value could be created in operations became very relevant to how these companies could be structured,” Taubman said. “[That meant] moving from a culture of building a business to operating it, finding efficiencies, capitalizing the company differently.”

REITification has not been a cure-all for the industry’s problems: Retail consolidation continues to make leasing challenging, and the national economy has been a concern. Wall Street remains lukewarm to publicly held real estate, with all of the shopping center REITs trading at significant discounts to net asset value.

The market does not understand shopping center economics, developers maintain. One reason, Cooper said, is that the industry historically did not utilize reporting based on GAAP (generally accepted accounting principles). Another factor is that retail REITs are only 10 years old, vs. many decades for public markets in general. As the industry becomes better understood, stock prices should go up, executives said.

“Ours is a very long-term business. We build assets with life spans of 50 and 100 years,” Sterrett said.

Ironically, a more difficult economic environment actually could help. Until late last year, REITs had not gone through a downturn. If the industry succeeds during the current economic uncertainty, investors may recognize its stability and reward the stocks. But no one expects the roller coaster to end.

“I don’t think the ride is ever smooth in public markets; it’s just the life of a public company. The trick is not to let it demoralize you; in time you’ll be rewarded for it,” Wolstein said, noting that markets are inefficient over the short term, but much more efficient long term.

With transparency, consolidation and more sophisticated management, the result is an industry that at long last has grown up.

“This business, that’s basically 40 or 45 years old, has completely come of age,” Taubman said. “It’s matured into an extremely viable, well-capitalized industry.”

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