Bigger Really Is Better Building a national apartment REIT wasn't easy, but you wouldn't know that by talking to Equity Residential's Doug Crocker. In a one-on-one interview, EQR's Crocker discusses "the model" that serves as the basis for his company's investment strategy; what investors "really" should expect from real estate; and why bigger really is better. by Barry Vinocur

Though Equity Residential has completed more public-to-public company mergers than any of its peers, its operations have yet to skip a beat. For the quarter ended September 30, the company's funds from operations (FFO) per share rose nearly 10% over the year-ago period, in part as a result of $1.5 billion in acquisitions along with strong same-store net operating income (NOI) growth of 6.1%.

Equity Residential's day-to-day management team—headed by Douglas Crocker II, its president and CEO—is routinely ranked among the best in the industry. Last year, and again in 1998, Crocker was named one of the industry's outstanding CEOs by Realty Stock Review (Property's sister publication) based upon a poll of analysts and investors. Crocker is frequently singled out not only for his operating strengths, but also for his grasp of matters often left to a company's chief financial officer.

During a recent interview, Crocker explained that he wants to keep a very sizable portion of Equity Residential's assets unencumbered by debt. "Unencumbered assets are like cash in the bank," he told us. He terms those assets a company's ultimate safety net. "A lot of CEOs think their credit lines are their ultimate safety net. I don't agree. I have seen periods of time during which banks didn't—or couldn't—honor their commitments."

Crocker also finds himself at odds with those advising REITs to ramp up their leverage. But he doesn't believe increasing a company's leverage raises the company's total value. "One plus one has always equaled two, not three. The underlying asset is only worth what the underlying asset is worth," he states. Furthermore, Crocker underscores that by increasing leverage, particularly at this point in the real estate cycle, managements run the risk of putting their clients at risk.

Crocker and his team also are given high marks for the development joint venture they put together last year with Lincoln Property Co. Rather than a conventional development joint venture, Equity Residential's senior management team crafted a deal that incentivizes its joint venture partner to deliver on each and every project. As of the end of this year's third quarter, there were nearly 9,000 apartment units under development. (Under the agreement's terms, Equity Residential isn't required to accept every development project.) Crocker says Equity Residential will fund a portion of its development pipeline by selling properties as it rebalances its portfolio. As of the end of the third quarter, the company had sold roughly $140 million of assets at cap rates below 8.5%. It expects to sell $175 to $200 million in properties this year and $200 to $250 million in 1999.

Looking past this year, Crocker advises that investors should expect companies such as his to deliver 10% to 13% levered annual returns over a 10-year period. "They're not going to do 20% FFO growth; they're not going to do 15% growth. It just doesn't happen in the real estate world!"

No one flinches when someone mentions a national REIT today. But back in the summer of 1993, when Equity Residential came public, that wasn't the case. Why did you go against conventional wisdom?

We wanted stability, predictability of earnings. We thought—and we still believe—the national REIT is the best way to achieve that goal.

How was the model built?

First, I asked our research department to give me the historic population growth rates and the expected growth rates for the next decade for the top 25 cities in the United States. Next, I said to our guys—because we know this better than the researchers—we need to list the "apartment friendly cities." That enabled us to know the cities where job growth was most likely to translate into demand for apartment units.

The next step?

We weighted everything on a regional basis. I didn't want to have more than 20% of the company's income coming from any one region of the country. Why? Because I'm a frustrated economist and I have studied recessions, and they always start in different regions. Different sections of the country trigger, or start, a recession. Recessions work themselves across, or sideways, or up or down, depending on which recession you look at. The last recession started in the southwest. By the time the recession in the southwest is over, the rest of the country, or sections of it, may still be in a recession or getting ready to go into one. So you don't want to have all of your eggs in one basket. That protects you against a downturn. When we finished our analysis, it turned out that we had to add more cities to the basket. That's how we ended up with the country's top 35 cities.

Sounds straightforward.

The next step was to weight each of those cities based on two primary factors, growth and relative growth, and ease of entry. So Houston, which historically has had good growth but has no barriers to entry, carries a lower weighting, same as Las Vegas. Whereas Phoenix, which has terrific growth and great population demographics working in its favor, carries a higher weighting than Houston or Las Vegas. Then, there's Seattle, which earns a higher weighting for a number of reasons, but doesn't get as high a weighting as it would otherwise have gotten because the economy is so dependent on two major industries. On the other hand, a city such as San Francisco, which has very high barriers to entry and a relatively broad base economically, and which even in the last California "depression" did relatively well, carries a higher weighting.

How much higher, and what's the range of weightings?

The range is between 1% and 8%. Those "positives" I mentioned relative to San Francisco add 3% to 5% to the NOI weighting. So, San Francisco would carry a 5% to 6% weighting.

How does that work in practice?

A city that carries an 8% weighting probably has a 6% weighting as its downside. If the weighting drops below the 6% level, it gets major attention from our acquisitions group until the weighting is brought back up to the 6% level. It's a dynamic process. So there will be instances when we decide not to act. For instance, Las Vegas is below 1% and I'm not going to protect that 1%. We'll probably let it get down to 1¼2% before we start protecting it on the downside.

How dynamic is the process? Is the data updated daily, weekly, monthly, quarterly?

Monthly.

How has the model performed?

Pretty well, so far. But until we live through a recession, we won't know for sure whether it really works as planned.

The patient has to be at death's door before you know whether the prescription works?

We know the model works in overbuilding because we've had overbuilding in Atlanta; we've had overbuilding in Houston; we've had overbuilding in San Antonio and, to a lesser degree, in Austin; and we've had overbuilding in some markets in the southeast. In the face of that overbuilding, our growth in same-store NOI continues to chug along, and we beat everybody except the guys in the northeast and the west. So it's proving that it works. Now you have to hit the side of a cliff with a recession to know whether in that situation we can still beat the competition.

What happens when the economy hits the side of that cliff?

Hopefully, the model takes our NOI to break-even. That is, no growth in a recessionary period.

What happens in an economic expansion?

We built 3% inflation into the model. So when you factor inflation into the mix, you should get 4% to 41¼2% NOI growth. That should give us the 6% to 7% FFO growth in normal times.

What about years like 1996 when your company and others were delivering much higher growth and stratospheric total returns? Was that just a moment in time?

Sure it was. It happened because of two major factors. The first was that we were in a period I call one of the great all-time turkey shoots from a value appreciation standpoint. Property values in 1993 and 1994—they sort of slowed in 1995—were rising at the rate of 0.75% to 1% per month. It was during that period that everybody on Wall Street was saying, "Crocker, you're crazy. You're overpaying for properties." My answer was "spread the word." We were the biggest buyer around because by the time we bought the property that we had put under contract 90 days earlier, it was already worth more than we paid for it.

Then you had the slowdown in 1995. The next year, property values rose at a rate of about 0.75%. In 1997, property values rose at a rate of about 50 basis points per month, or about 5% to 6% for the year.

What happened was that we were coming off of a period when markets were out of equilibrium. As markets approached equilibrium, rental growth slowed. So, you had an extraordinarily strong period of rent growth, which wasn't sustainable, because rents will ultimately rise at the rate of inflation.

The second factor?

There was this tremendous capital vacuum. For want of a better word, a dislocation. Companies could issue stock or raise money via debt offerings and invest the proceeds at a substantial premium to the cost of that debt or equity. Everyone took tremendous advantage of that arbitrage opportunity. During that period we were able to create tremendous wealth for our shareholders.

But those two factors weren't sustainable. They represented a point in time. And that's what we told the buyers of our stock during that period. We emphasized that we were in a very unique period of time, and that it wouldn't continue. I don't know if they all believed us or understood what we were telling them. But periods such as those usually result from a period of overbuilding followed by a recession. I don't believe we're going to see that sort of opportunity again in this country.

Never again?

Never is a very long time, and I make it a policy to never say never. But I think the events of recent months suggest that the public market is going to discipline real estate. That's never happened before.

This has been a rough stretch. But I recall that when we spoke a few months back you told me when you and Sam Zell sat down in the fall of 1997 for an annual lunch, you and he decided that it looked as if the REIT market might hit an air pocket.

That's right. Last fall, Sam and I sat down to do what we refer to as our global business plan. Obviously, I along with the other senior executives do a very specific business plan, but he and I do this global business plan. We ask ourselves: Where is the world heading? Where are interest rates headed? Which way do we see the stock market heading? And, finally, what do we think is in-store for REITs?

At that lunch we agreed that the REIT world was getting a little overheated. Real estate prices were getting a bit ahead of themselves because there was so much money flowing into the sector. We decided that if we were right, the capital markets would correct the situation. Again, if we were right, we thought the REIT industry would experience a good-sized slowdown in the second half of this year. If that slowdown happened, we thought it would take anywhere from six months to a year before things sorted themselves out.

What did you decide to do?

We concluded that the best way to prepare for what we thought was most likely to happen was to raise equity from all sources and any sources. And, that's what we did. We did a couple of underwritten deals. We turned on the spigot on our dividend reinvestment program, which brought in about $20 million per month. And, we raised capital via unit investment trusts (UITs). Altogether, we raised roughly $550 million. I was hoping to raise between $800 million and $1 billion, but the market started to shut itself off in April. So we lost April, May, and June because Sam and I didn't think "it" would happen until June. Nevertheless, we got the company into pretty damn good shape for what's happened.

I don't want to leave you with the wrong impression, however. I mean, we never expected this thing to be as bad as it has been. But the planning that we did put us in pretty good shape from a liquidity standpoint.

You have completed more mergers than any other REIT that I can think of. I know you and Sam are major proponents of the "bigger is better" theory. Recently, however, some REIT CEOs, as well as some academics, have questioned whether bigger really is better. What are they missing, if anything?

For one thing, they assume that as you grow you won't be able to reduce operating expenses much more when you reach a "certain" size. But no one knows what that size is. In theory, at some point, operating expenses can't be compressed anymore. As a theoretician myself, I'll say, "OK, I buy that." Now, let's take the guy who has 50,000 apartment units vs. my 500,000 units. Let's assume that my operating expenses are $200 less per unit than his are and the cost of capital is 150 basis points less than his is. Since that accounts for roughly 80% of the numbers anyway, when he and I look at the same property, he sees an 8% cap rate and I see an 11%. So don't tell me I don't have an advantage over him. What I'm doing, then, is I'm generating a higher return on every marginal dollar than my competitor is. And, in the final analysis, that's what it's all about.