A few modest proposals

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About Block Party Expert Ralph Block tackles topics and themes in the REIT industry.

NAREIT will be holding its annual convention in Phoenix in less than two weeks. I suppose some golf will be played in the Arizona sunshine, but the main events will be general discussions of industry conditions, specific REIT strategies for damage control during this Great Economic Tsunami and positioning for offense over the next 12 to 36 months.

Even though I will make an appearance there, no REIT executive is going to ask me what his or her management team ought to be doing over the next year — but I will nevertheless offer a few modest proposals here. While less audacious or shocking than those of Jonathan Swift, perhaps they may stimulate some discussion.

Priority One is taking advantage of the recent opening in the credit markets by extending debt maturities, including credit lines and secured debt. Also, issuing new unsecured debt, of five years and longer, is now an option for some REITs. It's too soon to tell if the more favorable interest rates and rate spreads (indeed, even lender willingness to provide credit) will segue into an extended period of credit availability — or is just a temporary opening of what has been a very sticky window. But, right now, there are few REITs with the strength to look gift horses in the mouth. REITs must position themselves to enjoy an eventual space market recovery, and extending debt maturities beyond the dénouement of the troubled CMBS market should be a high priority for every REIT.

Second, most REITs have already cut their dividends (some are paying them largely in stock), in recognition of very weak space markets, to help pay down debt and, in some cases, to build firepower for an eventual acquisition pie-eating contest. However, it seems to me that a significant number of REITs have not yet "right-sized" their dividends to reflect what are likely to be further declines in operating cash flows extending through next year. There's no Golden Rule on dividend policy but, in these troubled times, it would seem appropriate to pay out no more than 85% to 90% of expected trough AFFO (after recurring capital expenditures); the cash flow saved can be used for further deleveraging or, hopefully, to play offense, and investors are learning to live with modest dividends until cash flows improve.

Also, because most REIT shares now trade at prices in excess of estimated NAVs, REITs should be planning additional equity sales, even at the cost of further FFO/AFFO dilution. Investors aren't placing all that much emphasis on current earnings anyway, and secondary stock offerings are likely to be, in most cases, accretive to NAV. Furthermore, the reduced leverage ratios resulting from additional equity offerings are likely to be quickly reflected in higher stock prices, e.g., Macerich Co. announced a secondary offering a week ago and the stock immediately traded higher until the all-inclusive bloodbath Oct. 28.

A corollary of the foregoing point is that, when deciding how to delever, selling equity should be favored over selling assets. There is little reason to sell assets today at cap rates that, in some cases, are flirting with double digits when stock can be sold, in many cases, at implied cap rates less than 8%. While some REITs may not have a choice, those that do should quickly visit their friendly investment bankers rather than their commercial real estate brokers.

Today's investor preference for lower-levered REITs is not one that's going to go away soon. In addition to raising more equity, when possible, most REITs should sit down, perhaps off-site on a Saturday, and re-think how they calculate their leverage ratios. I am still hearing, in conference calls this earnings season, that "our leverage is only x% of total market cap." That type of formula is going the way of no-doc home mortgage loans. Rather, REIT executives and their boards need to begin thinking about an appropriate leverage ratio in terms of debt/EBITDA, fixed-charge coverage ratios or some other formula that is not asset- or stock-value centric. AMB Property Corp. and Ventas Inc., for example, seem to be moving in this direction.

Finally, those REITs that have strong liquidity positions and very modest leverage ratios should be thinking about how to create value via property acquisitions. But it's not as simple as it sounds, and there are lots of moving parts here — effective and intelligent capital allocation is never easy. Fortunately, the acquisition window hasn't yet opened, so there is time. It seems to me that a REIT's first priority is to ascertain its cost of equity capital (the cost of debt should perhaps not even play a role, given today's conviction that low leverage is the best leverage).

It's never easy to determine the cost of equity for any company, and doing so is at least as much art as science — but it's an essential exercise. If value is to be created (rather than simply goosing FFO or AFFO) via an acquisition strategy, then the long-term returns from an acquired asset will have to exceed that cost. Today it's very difficult to ascertain a reliable expected internal rate of return for any acquisition, but it's essential to go through this exercise with diligence and conservatism. When quality assets do appear on the market, via foreclosures, distressed sellers or otherwise, value creation will depend upon deploying precious capital at a return that exceeds its real cost.

I don't know about you, but incremental additions to my REIT portfolio will be made, in large part, on the basis of how each particular REIT will be approaching these issues.

Disclosure: I and members of my family have investment positions in the REITs mentioned in this blog post.