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by Barry Vinocur
Photographs by Dan Bryant
When word leaked in late 1993 that famed Fort Worth, Texas, investor Richard Rainwater planned to launch a real estate investment trust there were plenty of naysayers. Their concerns ranged from how much time Rainwater would "really" spend focusing on the REIT to whether it was "too rich a deal" for Rainwater to whether the REIT would be the "sole vehicle" for all of his real estate-related activities to the view that the man who had helped the oil-rich Bass family amass a fortune, by investing in companies such as Disney, was an interloper who had no real experience in, and no real commitment to, real estate.
By the time the company founded by Rainwater and John Goff, the company’s vice chairman, and Gerald eran REIT investors, as well as a number of highly regarded analysts panned the offering. Crescent Real Estate Equities Co. wasn’t given much of a chance to succeed.
Haddock, the company’s former president and CEO, went public on April 28, 1994, the battle lines had been drawn. A long list of veteran REIT investors, as well as a number of highly regarded analysts, panned the offering. Crescent Real Estate Equities Co. wasn’t given much of a chance to succeed.
Undeterred by the criticism and buoyed by a real estate market that was in the midst of a strong recovery, Rainwater and Goff rolled up their sleeves and got to work. For a while - nearly four years, actually - Rainwater, Goff, and Haddock could seemingly do no wrong. It was a heady time for REITs generally, but for a handful of companies such as Crescent, it was more than that. A lot more. Crescent’s stock price soared. The company on a split-adjusted basis had come public at $12.50 per share. (The stock split 2-for-1 in late March 1997.) In late 1997, it was changing hands (again, on a split-adjusted basis) at just north of $40 per share. The Crescent team it seemed had the "Midas touch." One-time naysayers became fans. It was the best of times.
What happened next is the subject of debate. Critics charge that Crescent fell victim to hubris and that it confused a bull market with brains and paid dearly for it. Others suggest it isn’t nearly that simple. Did Crescent make mistakes? It did. Rainwater concedes it did. But those who met with Rainwater before Crescent’s 1994 initial public offering, and following it, were told to expect missteps. As Rainwater told Business Week in a November 1998 interview, there are always missteps. "People are correct in that we have made mistakes. But that happens all the time. There are some things we did at every company I’ve ever been associated with - Disney, Honeywell, company after company - that we wish we’d never done."
Understanding where Crescent went wrong is interesting, perhaps even instructive, but it’s where Crescent is headed that’s far more important. Nevertheless, even those who have stuck with Crescent through the tough times - the stock traded as low as 151¼8 in early November (at press time it was changing hands at 183¼16) - point not to a specific deal or deals that threw Crescent off track but rather to a mindset that led Crescent astray.
Crescent, said one institutional investor, made some bad decisions. Chief among those, he stressed, were its so-called forward equity deals. (In a forward equity deal, a company borrows money using its stock as collateral. If its stock price rises - what it expects to happen - it pays back the loan with fewer shares than it used to collateralize the loan. If its stock price falls, watch out. Crescent and a handful of other REITs got hammered when REIT prices plummeted in 1998.) "The forward equity deals weren’t Crescent’s only mistake, but those deals were a warning - one that not all of us picked up on at the time - that Superman thinking had taken hold. When others tell you that you can leap tall buildings that’s one thing. When you start believing that you can, you’re in trouble," the institutional investor added.
Less forgiving observers agree the forward equity deals were a bad idea, and that they were symptomatic of a mindset that spelled trouble, but they argue that what got Crescent into hot water was Haddock. "Gerald was a bright enough fellow, but he wasn’t the guy who should have been running Crescent day-to-day. For one thing, he couldn’t communicate with investors," says a veteran analyst with a buy-side firm that invests on behalf of institutions. Others agree. By the time Haddock realized that he had lost credibility with investors and analysts and tried to right the ship - among other things, Haddock organized a meeting for analysts and investors this past spring - the damage had been done. The meeting was a qualified success, but it also convinced investors that there had to be a change.
Opinions differ on what happened next. Crescent said Haddock decided to step down well before his resignation was announced. Others say Rainwater and Goff were persuaded that Gerald couldn’t continue to run the company. If Crescent was to get a second chance, there would have to be a change. Whichever account is correct - if either is - the end result was that on June 11, 1999, Crescent announced Haddock was stepping down, and Goff would replace him as president and chief executive officer.
Goff hit the ground running. He called investors and analysts. He acknowledged that mistakes had been made. He committed himself to turning things around. He pledged that by the time Crescent held its third quarter earnings conference call in November, he would present the company’s strategic plan. Waiting months to hear the plan didn’t sit well with some investors, but most understood it would take a while for Goff to get his bearings and craft a plan. "They put in a lot of late nights and weekends working on the plan," the veteran analyst with the buy-side firm said.
Make no mistake, Goff had plenty on his plate. The list of issues he had to deal with was long, and the clock was ticking. At the top of the list was Charter Behavioral Health Systems. The largest operator of psychiatric care hospitals in the country, it had been spun out of Magellan Health Services in a high profile June 1997 transaction. (The hospitals were leased to CBHS by Crescent. CBHS was a joint venture, 50 percent owned by Magellan and 50 percent by Crescent Operating Co., which had been spun out of Crescent also in June 1997.) Beset by a series of problems, including a sharp falloff in EBITDA (earnings before interest, taxes, depreciation, and amortization) and negative publicity related to problems at some of its facilities, CBHS was made a top priority. Goff also had to tackle a series of balance-sheet related issues, including resolving the company’s forward equity deals.
Goff stuck to his timetable and in early November, as promised, he outlined Crescent’s strategic plan for the period from 2000 through 2002. In keeping with the plan it had pursued from its inception, Crescent said it would focus on three primary investment themes. First, it recommitted itself to being a value investor. Second, the company would continue to look for opportunities where it believed that after applying its management skills, renovation and expansion capital, and strategic vision, it could significantly increase operating cash flow. Third, and finally, he said, Crescent would look for opportunities, as it had previously, where it could acquire properties from operating companies.
Step-by-Step
Goff’s plate, as noted, was piled high. Not only did he have to confront balance sheet issues, including the equity forwards, and rebuilding the company’s tarnished image with investors and analysts, he also had to craft a strategic plan that provided a credible solution for Crescent’s biggest headache - Charter Behavioral Health Systems. Goff and the Crescent team also had to convince investors and analysts that they could get a handle on the numerous businesses that Crescent was involved in, from its core business as an owner of office properties to such seemingly far-flung enterprises as refrigerated storage and land development.
During the November conference call, Goff said Crescent had invested approximately $3 billion in office properties (including IPO assets and capital improvements). "Currently, these assets yield an unleveraged NOI return of approximately 12 percent. At a cap rate of 9 percent, they would have a private market valuation of approximately $4 billion, and at a cap rate of 8 percent, a private market valuation of approximately $4.5 billion. If one assumes 50 percent leverage at 8 percent on current market values, a leveraged yield on equity would approximate 16 percent."
Office properties, he added, would be the primary source of the company’s funds from operations. "The principal driver of growth in our office portfolio over the next three years will be the internal growth realized through our efforts to improve occupancies and increase current in-place rental rates to market rates. Embedded growth in this portfolio approximates $120 million ($0.89 per share) in incremental FFO, a 33 percent increase assuming 95 percent occupancy and rents adjusted to current quoted market rates. If rents were further increased to estimated replacement cost levels, FFO would increase by another $140 million ($1.05 per share) or an additional 39 percent."
Goff pointed out there are significant opportunities to enhance Crescent’s income by providing an array of services to the company’s tenants. Most notably, he said, "telecommunication services will become an increasingly significant source of revenue and critical to maintaining our competitive edge within the industry." He highlighted Crescent’s then recently announced ownership in Broadband Office, which Goff said not only should be an important source of additional income via royalties, but also would provide the company with the potential to profit from its equity ownership in the technology company. (Among Broadband Office’s high-profile investors is Kleiner Perkins Caufield & Byers, one of Silicon Valley’s best known and most successful venture capital firms.)
"Another avenue for increasing value lies in exchanging office space for equity in start-up technology firms," Goff said. By partnering with venture capital and certain technology firms, he stressed, Crescent could provide space in its properties that would otherwise be inefficient to lease due to location, size, or configuration. "If one assumes stabilized occupancy of 95 percent, our remaining 5 percent vacant space is equivalent to over $30 million in annual ‘equity’ available for investment."
Goff stressed that Crescent didn’t expect the level of growth in market rental rates that was experienced during the mid-1990s. Nevertheless, he added, "the company’s portfolio growth is still expected to exceed market growth rates as occupancies increase and in-place rental rates move to market rates."
Looking ahead, Goff said, Crescent would aim to increase revenue from ancillary services from its current level of approximately $2.1 million to approximately $7.5 to $10 million by the end of 2002. Further, he said, Crescent expects to complete the sale of approximately $365 million of non-core, non-strategic office assets sometime early in 2000.
Goff also stated Crescent would try to capture the value of its extensive commercial land inventory, consisting of approximately 100 acres, through expansion by existing tenants. Proposed near-term office development opportunities, he added, approximate 5.8 million square feet. These developments would typically generate minimum unleveraged returns of 12 percent. Goff stressed that because Crescent didn’t view new development returns as satisfactory relative to its current cost of capital, the company would likely look to joint venture partners to provide capital for the projects. Crescent would serve as the developer and property manager and in turn would receive fee income as well as ownership through a promoted interest or modest equity investment.
Next, Goff focused on Crescent’s hotel and resort properties. Since the company’s IPO, he reported, Crescent had invested approximately $420 million in the acquisition of hotels and resorts with an additional $84 million in capital improvements, of which approximately $51 million had been funded and approximately $33 million was committed but not yet funded.
"Our hotels and resorts can be classified in three categories: upscale business class ($204 million invested), destination resorts ($190 million invested), and Canyon Ranch ($110 million invested)."
The upscale business class hotels, Goff explained, currently yield unleveraged returns of approximately 15 percent. They were purchased in conjunction with adjacent office properties to provide a competitive advantage on price for both the hotel and office assets and were thus acquired at significant discounts to replacement cost. The business hotels currently operate in an increasingly competitive environment with only average growth prospects relative to the overall industry. Goff said Crescent would look for opportunities to sell those assets at attractive pricing over the next two years. Crescent would redeploy the sale proceeds into higher return on equity businesses.
Canyon Ranch and Crescent’s other destination resorts (Sonoma, Ventana, Hyatt Beaver Creek), Goff explained, are unique assets in terms of management, concept, and/or location. Those properties, he added, currently generate unleveraged returns in excess of 15 percent. "We believe these assets, along with their respective management teams, are capable of significant but selective expansion as a result of their franchise or brand power."
Looking ahead, Goff said that to further capitalize on the niche destination spa business, Crescent had facilitated the formation of a new management company headed by one of its existing senior executives. "This new company will operate the destination spa resorts at Sonoma and Ventana and lead a joint venture with us to acquire additional complementary resorts that are or can be converted to luxury spa destinations and operated under our Sonoma Spa brand. We believe the opportunities for this strategy exceed $300 million over the next three years. Over a five-year period, we expect to generate unleveraged returns in excess of 20 percent on new capital deployed by Crescent."
Crescent’s October 1997 co-investment with Vornado Realty Trust, another REIT, in the refrigerated storage business was the next business Goff addressed during the November conference call. Crescent, he said, had invested approximately $320 million of equity in that business since
its initial investment. "This represents our approximate 40 percent equity share of a total gross investment with our joint venture partner, Vornado, of approximately $1.4 billion." AmeriCold Logistics, he stressed, is well-positioned as the dominant company in the refrigerated storage business in the United States, controlling approximately 30 percent of the country’s refrigerated storage space with facilities located nationwide. "The company’s annual same-store growth rate of 3 to 5 percent provides acceptable growth in today’s real estate environment. In addition, the company provides stable cash flow returns of approximately 11 percent on our original investment and approximately 14 percent after moderate leverage."
Reinvestment opportunities ($85 million in 1999 by the joint venture partners), Goff explained, offer stabilized unleveraged returns of 20 percent or greater and consist primarily in the construction of new facilities rather than acquisitions.
"In conjunction with Vornado, we will seek to reduce our equity investment in the business and minimize future equity investments by: obtaining additional financing through securitized debt, senior secured notes, or a combination of the two, attracting equity partner(s) for expansion capital, and/or pursuing public market alternatives."
Crescent’s investment in land developments was next up. The company’s investment in that business is approximately $310 million. "Historically, the internal rate of return range for our land investments has been approximately 20 to 35 percent." Since its IPO, Goff added, Crescent’s land investments had declined from representing 21 percent of the company’s funds from operations in 1994 to 13 percent of its FFO in 1999. "Yet, FFO from these investments has increased from $8 million to $60 million during that same period."
Goff explained that Crescent’s land investments are often misunderstood partly because of their complex structure but also because the developments are depleting assets that many mistakenly believe will be difficult to replace with new investments. "We mitigate the risk often associated with land development by investing in projects with significant infrastructure already in place (The Woodlands, Desert Mountain) and by preselling lots before substantial development costs are incurred thus allowing us to use the pre-sale proceeds for underwriting construction (Crescent Development Management Corporation)."
The Big Issue
The company, Goff said, had invested approximately $399 million in behavioral healthcare facilities leased to Charter Behavioral Healthcare Systems. To date, he added, the company had received an average unleveraged cash return on its investment between 10 and 11 percent.
"Our entry into this business," Goff acknowledged, "was ill-timed, the structure of the transaction was overly complex, and we did not have appropriate ownership incentives for CBHS management. Consequently, CBHS is unable to meet rent obligations or provide an acceptable return on our investment. The company will require a complete restructuring to regain its financial and operational footing." Crescent, Goff added, had made its investment at what it thought was the bottom of a decade-long decline in the industry. "Our timing was off by two to three years. The industry continued to deteriorate and only now shows signs of stabilization."
In the third quarter, Goff added, Crescent commissioned a "Big 5" accounting firm to assess its options related to CBHS. As part of this process, the accounting firm appraised CBHS’ 87 facilities at their highest and best use. Based on that appraisal, Crescent estimated the net value of its behavioral healthcare real estate assets at approximately $280 million. "Through a third-party appraisal, we have independent confirmation that the facilities have substantial value and a variety of alternative uses." In addition, Goff said, Crescent had determined that it could sell 53 of the facilities and still generate approximately 95 percent of CBHS’ current EBITDAR (earnings before income tax, depreciation, and rent) from the remaining facilities.
"A restructured CBHS consisting of the 34 core Crescent facilities and nine CBHS joint venture facilities is estimated to generate stabilized EBITDAR of approximately $45 million by fiscal year 2001 (October 1, 2000 - September 30, 2001). This would represent 1.8x rent coverage, assuming $25 million rent on these remaining facilities, and would represent a 15 percent return on their value."
Goff stressed Crescent believes that CBHS, with fewer facilities and a new business model, can emerge as a stronger company both financially and operationally and be uniquely positioned as the behavioral healthcare leader in the communities that it serves.
Other Plans
Crescent’s strategic plan also included - depending on the company’s stock price - the repurchase of up to $500 million in Crescent stock over the next two years. (Industry sources report Crescent has already begun an aggressive buyback program. Goff declined to comment on the buyback.) During the conference call, Goff said that Crescent plans to fund the buyback program through a combination of joint venture equity proceeds, asset sales, and financing arrangements.
"By the close of the first quarter of 2000, we expect to refinance our revolving credit agreement ($660 million with a current balance of $585 million as of September 30, 1999) and a $320 million term loan and have immediate buying power of $200 to $300 million. Our floating-rate debt exposure would then be less than 20 percent of total debt," Goff said. As of the close of the third quarter of 1999, Goff added, the company’s debt level as a percentage of net asset value was estimated at approximately 40 to 45 percent.
Bottom Line Assessment
In a recent note, Realty Stock Review (one of Property’s sister publications) underscored a position that it has taken since the company’s 1994 IPO. "We have always maintained that Crescent was not an investment for the faint-of-heart. Further, we continue to counsel yield-conscious investors against jumping on the Crescent bandwagon solely based on its ‘juicy’ yield. Though management recently said it plans to maintain its current dividend, we believe that decision will be subject to periodic reassessment." The question facing investors is if the company cut its dividend, "Would you still want to own the stock?" the newsletter wrote. "Though Crescent has been a rough ride, we believe that a refocused Crescent offers significant upside. The stock is trading at a significant discount to our consensus net asset value (see page 84), and though earnings growth will be flat in the near term because of the fallout from the CBHS restructuring, we believe Goff and his team have their eye squarely focused on the future, and that future looks a good deal brighter to us than Crescent’s recent past."