Gazing Into the Future By pursuing a "best in class" approach to REIT investing, BancBoston Robertson Stephens' Jay Leupp says investors can earn significantly higher returns than the 12% to 14% they should expect from REITs, generally. by Barry Vinocur

Leupp's background is somewhat unusual for a REIT analyst. First, he worked for two years as a CPA auditing failed thrifts for a national accounting firm. Next, Leupp spent two years working as a development manager for Trammell Crow Residential. While at Trammell Crow, he oversaw the development of apartment projects in north Florida and northern California. Leupp then spent three years at The Staubach Company, where he specialized in the leasing, acquisition, and financing of commercial real estate, primarily office and industrial properties. In 1994 he joined the firm that today is BancBoston Robertson Stephens.

During a recent telephone interview, Leupp covered a wide range of topics, everything from his firm's "best in class" approach to REIT investing and his views on industry consolidation to the risk he sees in companies abandoning the unsecured debt market.

At your firm's 5 a.m. morning meeting on September 16, you made the "call" that REITs had turned the corner. What led up to that call?

In meetings with nondedicated REIT investors during the six or seven weeks prior to making that call, we reconfirmed that those investors who had used REITs as a defensive and yield play in late 1997 had pretty much worked their way out of their positions over the first seven or eight months of this year. We came away from those conversations with the sense that they were again looking at REITs. We then factored into our thinking the relative and absolute valuation measures that everyone uses, such as yield spreads to Treasurys, discounts to net asset value, and multiples. Based on that analysis, we concluded that REITs were trading at their most attractive valuations in nearly 10 years. Next, we looked at real estate fundamentals for the major sectors that we follow—malls, office, industrial, apartments—and in the specialty sectors—self-storage, manufactured homes, and golf. With a few exceptions, we concluded that the fundamentals, though not as strong as a few years ago, still look very solid.

As we reviewed everything, we concluded that taken together, it constituted a "buy signal." Let me qualify that. We didn't predict the sort of major move that we saw in late September. We didn't say there would be an immediate run-up in the stocks over the next week. Rather, we said it was time to start buying the stocks. In other words, that "the slow crawl forward was about to begin."

You didn't just say "back up the truck" and buy everything?

That's right. We suggested what we call our "best in class" approach. That is, begin with the highest quality names in each of the subsectors we like. There were two reasons for suggesting that approach. First, there's the liquidity argument. These stocks have the broadest appeal to the largest population of institutional investors because they're large enough to own. Second, as a result of multiple compression, the higher quality, more liquid names were trading within, say, 50 basis points of both the higher quality and the lower quality midcap and small-cap names. That came about because when the selling got really intense, and overdone in our view, in the latter half of August and the first half of September, there really wasn't any distinction being made. The higher quality, more liquid names got battered right along with the smaller, less high-quality companies.

What's your definition of midcap, etc.?

Small cap is an equity market cap of $600 million or below. We define midcap as a company with an equity market cap between $600 million and, say, $1 to $1.2 billion. Large cap, of course, is anything over that.

Any other themes?

We also suggested focusing, within the parameters I noted, on the companies with low leverage levels. In our view, those will be the companies best positioned to take advantage of the most accretive acquisition opportunities between now and the end of the year.

Define low leverage.

We look at all of the standard leverage measures, but we focus primarily on EBITDA interest coverage ratios. We calculate that using the most recent quarter's information and adding in preferred dividend charges underneath EBITDA. The average coverage ratio for our universe today is just over 3x. I have heard some companies say the maximum they'll push that to is in the low 2s. I don't think that's a sustainable level, however. It looks too much like what we saw in the late 1980s. The "right" number is probably in the range of 2.5x to 2.75x. That, of course, depends on the sector. A portfolio of high-quality buildings that are triple-net leased to class A credit tenants can support more leverage than, say, hotels. On the other hand, malls can probably support higher leverage than most other sectors because of the predictability of their cash flows.

What about leverage's impact on growth rates and, in turn, multiples?

Companies that choose to operate at higher levels of leverage are going to pay a price in terms of their multiples. On one hand, leverage increases FFOs and FFO growth rates, but if companies adopt higher leverage as a long-term strategy, it's going to have a negative effect on their multiples. Higher leverage increases risk, so it's a balancing act.

What's your take on the relative merits of unsecured vs. secured debt?

I would hate to see REITs abandon a disciplining force in the credit-rating agencies for what I think are short-term reasons. REITs have already made tremendous headway with the rating agencies, and by using investment-grade-rated debt they look a lot more like the higher quality operating companies elsewhere in corporate America. Giving that up to take advantage of a pricing advantage in the secured market doesn't seem to make long-term sense.

When I talk to nondedicated REIT investors, they invariably comment about the sector's relative illiquidity. They also express concern that any REIT rally will trigger a wave of equity offerings.

There's no question that the selloff in the first half of the year was related, in part, to the large volume of equity issued in the latter half of last year and the first quarter of 1998. In the near term, at least, the sector is going to have a reputation for opening the floodgates whenever the stocks show some kind of strength. But I don't think we'll see the floodgates open in the same way going forward. Some companies will undoubtedly try to issue equity if a rally that's sustainable takes place. Some of those companies have a good reason to issue equity, and some of those companies have the sort of track record to support their cases. But it's going to be a very discriminating market going forward. For example, even average players probably won't be able to issue equity until there's a sustained bull market in the stocks.

What about the liquidity issue?

There's no question that this is still a relatively illiquid sector. The selloff we saw in late August and early September, as well as September's short-lived rally, highlighted the relative illiquidity of even the largest companies in the sector. I don't see that changing until the sector gets to probably at least twice the size that it is today.

What about 1999 earnings?

We reworked every one of our 42 models after second quarter earnings were in. Where we had assumed large amounts of equity raising or acquisitions, we worked them down. Before we reworked everything, we estimated 10% to 11% earnings growth next year. Now that number is just over 9%. However, we haven't factored into our numbers any potential boost in earnings from refinancing debt.

What should investors expect from REITs in terms of total returns?

From the sector overall, 12% to 14% per year is probably reasonable. We try to do better than that, of course. For the better run companies, if you buy them right, we would expect something in the 16% to 20% range. That just comes from picking some of the faster growers that may be undervalued or finding a company here and there that might have been overlooked. Or, you could buy a sector when it's out of favor. For instance, if you take the classic cyclical equity investor approach, you'd be "damning the torpedoes and loading up the boat" with hotel stocks. A lot of the companies are trading at five times cash flow, but you have to have the patience and the stomach to ride it out.

What about dividends? Every-body looks at payout ratios and says dividends are secure. But are they?

By looking at FAD payout ratios and debt service coverage ratios, you can get a pretty good idea of how safe the dividend is. In other words, all things being equal, if the EBITDA/ interest coverage ratio is a comfortable 3x, the dividend is safer than if that coverage ratio was only 2x. The lower the EBITDA/interest coverage ratio—again, all things being equal— the more risk that the dividend will be cut if revenues drop significantly. After all, dividends are going to get cut before interest payments on debt get missed. You really need to look at payout ratios and EBITDA/interest coverage ratios together.

If companies don't push their leverage too much at current payout ratios, which are in the range of 75% to 80% on this year's FAD, we're probably in pretty good shape. There's a pretty good cushion. If we would have headed into a downturn two years ago, when the average payout ratio was in the mid- to high-80% range, there would have been a lot more risk, and we could have seen some dividend cuts.

What about consolidation?

There's already been some, and there's likely to be more. We're not in the camp that believes eventually there will be only, say, a half dozen or maybe a dozen very large REITs and that will be it. We do think that the larger companies with strong balance sheets, such as a Public Storage, an Equity Residential, or an Equity Office, will grow and they will be able to take advantage of depressed market conditions. But we don't view real estate as a classic consolidating industry. In other words, it is not an industry that has no new unit or supply growth, nor an industry in which the only way to achieve growth is to consolidate.

What's your take on the bigger is better argument?

In some sectors it clearly is. In the apartment and office sectors it definitely is. It's also a plus in the mall and self-storage sectors. I'm not as convinced that carries over to the industrial sector, however. Bigger is better in the apartment and office sectors because a company can use its size advantage to do those things that allow it to maintain higher occupancies and grow rents faster. Companies also can use their size to achieve economies of scale, that is, lower their costs. Simon Property Group says it increased its NOI operating margin by 1,000 basis points over 10 years as they have grown, so Simon has definitely proven that bigger is better. Another example is Public Storage, which because of its size was able to establish a national reservation system. They couldn't maintain a call center like that if the company wasn't in 50 markets and didn't have 1,100 properties. The call center is a big reason why Public Storage, over the last three quarters, has been able to maintain occupancy above 91.5% to 92%, which is better than the sector overall. So, size has definitely helped Public Storage.

What keeps you up at night?

I worry that companies might push the envelope too much when it comes to leverage or creative financing strategies. People talk a lot about doing joint ventures, including new development joint ventures. When JVs go right, they work really well. But when a JV turns sour, it can really get ugly. People start suing one another and that can get real expensive real fast.