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COVER STORY, NOVEMBER 2005
WORD ON THE REIT
REITS lead way in race for space in active West.
Interviews by Brian A. Lee
REIT BEAT
an analyst's view
WREB: What has been the biggest REIT headline in the West in the past few months?
Sarajian: REITs have actually been quite active in the West this year. Maybe the biggest headline grabber has been Public Storage's “bear hug” offer for Shurgard Storage Centers, which has so far been rebuffed. But there have also been many other noteworthy events including September's ProLogis Corp./Catellus Development merger, which should enable ProLogis to solidify its West Coast holdings while gaining entry into some attractive metro New York markets. The recently announced Brandywine /Prentiss combo was also to some degree motivated by Brandywine's desire to acquire a foothold in some healthier West Coast office markets. We've also seen a number of REITs trading in and out of property market positions, taking advantage of deep demand, such as Equity Office Properties' sale of several underperforming assets in Northern California to reposition its West Coast portfolio. And certainly Macquire's aggressive bid for the fairly sizeable Commonwealth portfolio earlier this year put that relatively young public REIT on the map.
WREB: What kinds of properties are hot for REIT acquisitions? Is there a property type or two that is/are getting the most attention in the West?
Sarajian: Bulletproof multifamily and retail are perhaps the most sought after asset types (and clearly not just by REITs). But since these are pretty expensive, players in those sectors are seeking out value-adding opportunities like tired, under-managed assets in good locations that can be redeveloped or maybe a large mixed bag of assets where they will take on some dogs to get at some diamonds. Buying vacancy is also a strategy some office REITs have employed — like Arden Realty and CarrAmerica Realty, for example — as a way to ride the improvement taking hold in some tightening submarkets. And robust global trade continues to drive demand for industrial space in Los Angeles, making it among the best performing markets in the United State for both AMB Properties and ProLogis.
WREB: Has the competitive nature of the market caused many REITs to shift strategies?
Sarajian: This has absolutely been the case. Many REITs threw in the towel 2 years ago and have been selectively selling into the frothy market. But this has enabled them to generate inexpensive internal capital, while profitably culling away weaker or slower-growing assets. Essex Properties Trust for example traded out of some Southern California assets (in a very attractively priced sale to United Dominion Realty Trust) and reinvested proceeds in recovering markets in Northern California. We've also seen REITs begin to expand their investment horizons a bit by pursuing crossover development (e.g., a retail REIT considering development of attached multifamily units as part of a mixed-use project) or mezzanine debt investing (as a way to bolster returns or perhaps create a potential shadow pipeline of acquisitions should the borrower default down the road).
WREB: Where do you think the opportunities lie in 2006 for REITs? Are there real estate conditions unique to the West that will spur this activity?
Sarajian: I think infill development activity of all stripes will continue to take hold in many of the West Coast's larger, more expensive markets. A few factors are driving this trend. First of all, traditional bread-and-butter acquisitions will remain out of reach for spread-conscious public REITs — they are simply too expensive today. Secondly, municipalities of all stripes, hungry for ways to bolster their coffers, are becoming increasingly more progressive and accommodating to mixed-use developments for their ability to generate desirable sales and property taxes. (Look at how successful Long Beach, California, has been, and, after many false starts, downtown Los Angeles's revitalization efforts may finally be taking hold.) And both weary commuters and intrepid empty nesters are becoming much more receptive to in-town living. There are noteworthy perils here, too, though. We are concerned that in some western markets (such as San Diego, for example), investment buyers are artificially fueling the demand for condos, which could make for a very ugly resale market in the event a sharp correction occurs.
WREB: What will be the biggest challenges for REITs in 2006?
Sarajian: Probably managing expenses and growing development pipelines. With top-line organic core portfolio growth still somewhat tepid for all but the retail REITs, effectively managing higher fuel and utility costs as well as increased property taxes could be an increasing challenge. And development pipelines are ramping back up, since accretive acquisitions are extremely hard to come by. The risk here is that the recent resumption of meaningful construction could prove premature should the economy slow materially, as some are suggesting may happen.
REIT BEAT
a company view
WREB: What's your assessment of the REIT industry in general?
Stern: REITs have performed very well and should continue to as the market fundamental continue to increase, which we have seen in all of our four regions — LA North area, which is our valley, tri-cities market; the LA West market, which is West L.A. and South Bay; Orange County; and San Diego. All of those regions are seeing positive fundamentals and strong absorption.
WREB: Where do you see the most competition right now in the market?
Stern: Acquisitions continue to be fiercely competitive right now. There's obviously an overwhelming abundance of capital right now. Therefore, the demand is greatly outweighing supply at this time. What does that mean? It obviously means that you continue to see cap rate compression for those trophy buildings and across the board through Class A and B product in the Southern California region. There's really not a huge disparity between Class A and B pricing in today's market because there's so much capital chasing so few product. I think that's widespread throughout every REIT here. We obviously see the same competitors time and time again and I think that sentiment is widespread.
WREB: What commercial property type offers the most opportunity in your view?
Stern: We have seen that the office sector has gained the most momentum as the year progresses as I mentioned with the increased fundamentals. We're not looking to get into any other product type so office will continue to be our main business. I think to be an owner of real estate in any product type today is obviously a great position to be in and that should continue in Southern California.
On a risk-adjusted basis, I still think that office gives you a fairly good spread versus some other product types, possibly retail and industrial.
WREB: What are the biggest challenges for those in the office market?
Stern: It behooves one to be a landlord in today's office market. Construction costs have gone up exponentially and it has made it much more difficult to build new product in Southern California. There is new construction activity in the region, however most of this is in a non-office sector. Therefore, it has only reconfirmed strong values for existing properties in Southern California. Replacement costs continue to rise which certainly enhances the values of existing inventory today.
WREB: What is Arden's strategic focus currently?
Stern: We continue to aggressively seek new acquisitions in the aforementioned four regions as well as really start to accelerate our development component, most notably at Howard Hughes Center [in West Los Angeles] where there are four parcels still available for development. In fact, we have announced that we are going to begin, hopefully by the end of the year, to break ground on a 155,000-square-foot spec office building down at Howard Hughes Center.
WREB: Does Arden have a disposition strategy as well?
Stern: We have implemented a capital recycling initiative where in the last few years we have disposed of those non-strategic assets in the portfolio based on asset quality, market quality, return analysis and strategic position in the portfolio. We have disposed of those properties and redeployed those proceeds into better quality assets in those core markets where we continue to strive for more critical mass. Year-to-date, we have acquired approximately $300 million in office properties and we have sold about $150 million year-to-date.
WREB: What were your non-core versus core markets?
Stern: We have divested in secondary and tertiary markets such as Bakersfield, California; the Inland Empire; Whittier, California; and other submarkets where we do not feel the potential for rental growth is necessarily the strongest. We would rather have critical mass in the core markets, those areas like Beverly Hills, West Los Angeles, West San Fernando Valley, almost all of San Diego, tri-cities area and down in Howard Hughes Center.
WREB: How does Arden distinguish itself?
Stern: We are a company that is extremely well regarded internally and externally with regard to our management of our properties and our responsiveness. What differentiates us on the leasing side is our responsiveness and our ability to do deals in a timely fashion. On the management end, we are very tenant oriented and we strive to have the best retention in the industry.
©2005 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
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Sherer at (630) 554-6054.
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