An Interview With: Rich Jeanneret
Editor's Note: We here at Real Estate Weekly are experimenting with different kinds of content – and reader reaction. Sometimes we focus on personalities, sometimes on projects, agendas, trends… we thought we'd try a bit more technical a subject this time, and see what you think. Feel free to give us your feedback.
Jeanneret has been at E&Y for four years, originally from Arthur Andersen, which merged its Chesapeake region into E&Y at that time. Because his father served in the State Department, he grew up in the Middle East and even spoke fluent Arabic as a child, before coming back to this area in 1968. He attended college in New England and joined Andersen immediately following graduation. Rich has 22 years of experience providing auditing and advisory services to private equity, financial services, real estate, and hospitality industry clients.
Bisnow: You say there’s a trend toward privatization of REITS. Yes. In 2005, half a dozen REITs went private, and I think there will be that many or more going private this year again. What’s interesting is that in the past we’ve seen privatization from time to time, but generally with smaller REITs that have market cap under a billion dollars. But in 2005, the average market cap of the REITs that went private was over two billion dollars.
Why is this privatization happening?
The reasons are somewhat complex. First of all, there’s so much private capital available for real estate, given the relatively higher yields you could get over the last few years by investing in real estate versus other traditional investments because of historic lows in interest rates. Investors have been willing to pay up to a 30% premium for REIT stock prices to get a hold of those assets. For the REITs themselves, their ability to grow quickly in the public format and get access to capital has always been attractive, but then the high costs of running a public company have given them interest in being acquired. Also, you’ve got companies that don’t need constant access to debt and equity because they don’t have a business model that effectively uses that capital. Those are strong candidates for privatization since their main reason for becoming public was access to cheaper debtor equity capital, which is abundant and plentiful now in the private world. Another thing is that private companies can leverage more debt on these properties, and increase their returns because of that. As a result, the cost advantage for equity capital that the public markets once enjoyed has narrowed significantly. There are constraints in the public markets, with limitations set by investors and rating agencies, which start to get nervous if leverage grows much more above 50-60%, whereas private companies can leverage at a higher rate because they don’t have that same pressure. And you know, with the cheap cost of capital today, particularly with interest rates still being at relative lows, they can leverage off the balance sheets of these companies and generate higher returns on their equity.
Is that dangerous if they are doing something as private companies that regulators and investors would be concerned about if were they public?
I don’t think it’s dangerous. Private companies generally have more sophisticated investors, and the financing sources that place capital on real estate today are much more sophisticated than they were 15 years ago when we had a meltdown in the U.S. real estate market because of overleveraging. Financing sources are much more disciplined in how they underwrite real estate today. They’re willing to tolerate more leverage in a private setting because they underwrite better and because their borrowers are more sophisticated.
What other concerns should investors have about going private?
Obviously when you’re private you traditionally don’t have the same liquidity the public market offers. So eventually you will have to come up with an exit strategy for that capital. And you know, it’s possible that some of these companies that went private will reemerge as public companies in the future because that historically has been the cheapest cost of capital and very often a good exit strategy for the investors that took these companies private. Now that’s narrowed considerably over the last year with the amount of capital that’s flown into real estate because people couldn’t get yield anywhere else. I suspect with rates rising you will see some of that capital start to look at alternative forms of investment. And so eventually I think the cheaper cost advantage of equity capital in the public markets will reemerge again.
Is it really a significant fact that only five of three hundred or more REITs went private last year or might go private this year?
I think it is. We’ve seen over the last several years REITs going public rather than private. So I think it is clearly a trend that represents a reversal of what has been a more common trend in that marketplace, which was the private company going public. I still think you will see some of that because there will be investor interest in niche type real estate, such as student housing or senior housing. I think you’ll still find investors interested in this type of real estate because there has not been as much public investment in it, and it is poised for growth. Those areas seem to be poised to grow, for example, as universities look for additional sources of capital as a result of state government funding pressures. They’ve felt they need to raise capital, so they’re willing to privatize some of that real estate. There’s been some interest in military housing as well and niche-based office ownership. Strong local developers and owners who have a good story to tell with traditional forms of real estate in strong markets like Washington, DC can still go public today. There are some REITs that have gone public focusing on, say, telecommunication or digital tenants, medical offices, and so on. They’ll come public as smaller companies initially, and investors are interested in their tenant base because of the related growth they’re seeing in those tenants’ industries.
Are REITs losing attractiveness because real estate values are peaking?
I think people feel like real estate is peaking in price, although I like to use the term “fully valued” because I don’t think it’s overvalued at this point. But I think you’ve seen cap rates push to historic lows, not seen since the ‘80s when you had the Japanese buying premier properties at historically low cap rates.
How is this fully valued situation going to affect REITs?
REITs have found it a little harder to grow because of these low cap rates and because they can’t leverage quite to the same level as private companies can. So it’s a challenge. I suspect that REITs will probably have a little bit easier time in 2006 and 2007 buying properties because I think cap rates will recede as interest rates rise, and some of the capital that has been chasing real estate recedes a bit back into more traditional forms of interest yielding assets. Not a lot, a little bit. Rates move back up and there are competing products where investors can get yield.
You mentioned Section 404 as a cause of interest in privatization. How much has that really driven the privatization trend?
I think it’s had a significant impact on some of the smaller and medium-sized companies that have privatized. Being public today has two basic cost elements. There’s always the cost element of being public which can be a multimillion dollar operating cost figure depending on the size of the company. Recent regulations have also added a layer of expense, not to mention that the risk of being public now to management and boards is more significant. Your responsibilities and fiduciary obligations to investors are at an all-time high, even if there are innocent mistakes made. So I think there are some people out there who find being public to be very difficult.
Have the tax advantages of REITs changed recently?
I don’t think it’s changed much. There’s a clear tax advantage to being public as a REIT because if you comply with the REIT legislation as a public company, there is not taxation at the entity level. Earnings are passed on directly to investors so you avoid the double tax, which has always been an advantage for the public ownership of REITs. It’s also been a mechanism where mom and pop and private investors that don’t have substantial net worth can invest into liquid real estate. Investing in a liquid security with a decent dividend yield that historically has been stable and growing is what attracts investors to this industry. You can do that with a private REIT as well. There’s not been dramatic change in the legislation over the years other than perhaps some loosening of the REIT roles so that REITs can be more competitive players in public markets. The loosening that has occurred has given the REITS a bit more flexibility to operate their business model without running afoul of dated legislation.
How are public REITs doing in the market?
They’ve done extremely well over the last few years because when you had the tech meltdown in the late ‘90s and early 2000, they were perceived as safer assets, and billions upon billions of dollars flowed into the public real estate markets. And I think it’s here to stay. I think it’s a permanent source of equity. It’s also a place where at the same time interest rates dropped to historic lows and REITS kept on raising dividends. So its been a place people could still get yield. You could still get five, six, seven, eight percent yield by owning public real estate and I think that’s had a huge permanent impact on not only the amount of capital that’s flown into public REIT s but the liquidity for those investors investments. Big institutions and other real estate investors can invest in large blocks in REITs today and still get their money out a lot faster than they could in the 90’s. It used to be four, five, or six years ago you could buy a large block in a REIT, but it would be difficult to get out quickly because you had such a large position, and there wasn’t as much float in the marketplace. The float in the marketplace today is dramatically larger than it’s ever been.
Any issues or dangers you see with REITs today?
I personally don’t have any major concerns. I think the challenge for REITs has been the ability to buy properties because of such competitive pressure from private capital at rates of return that could pressure growth in FFO per share. “Funds from operations” is the principal measure by which REITs are valued in the marketplace. FFO is simply net income plus depreciation. REITs historically have assets that grow in value. And there’s an accounting convention that requires them to depreciate those assets. So generally REITS will take net income and add depreciation back to come up with their true measure of operating performance. And I think the key metric for REITs today in the marketplace is their ability to grow their FFO on a per share basis. Though I don’t have any major concerns about the REIT market in general, it’s been difficult for some of them to grow as quickly as they have in the past because of the competitive nature of private capital, making it more difficult for them to acquire assets. And there will be some pressure on their operating income because of energy costs, which is a major operating cost for real estate today as well as rising interest rates. So I think that will boost landlord expenses and there is a risk it could affect consumer appetites as higher energy costs and rising interest rates on home mortgages reduce disposable income making it more difficult for people to afford to travel, which could affect hotels. Reductions in disposable income could also adversely affect consumer spending, which could affect retail real estate. They may not travel as much to hotels, they may not spend as much in retail, shopping malls, etc. So I think it may be a little more difficult for certain REITs to grow over perhaps the next year or two because of things like that. On the other hand, certain types of real estate such as apartments tend to fare better in a rising interest rate environment. As the cost of home ownership rises, people tend to rent longer which drives increases in rental and occupancy rates with multifamily properties. And don’t forget that rising interest rates usually signal increases in CPI, and when CPI rises real estate owners raise rents. So at the end of the day, nobody knows for sure, but we have done a much better job in this country in the last 15 years in underwriting and developing real estate for success that at any time in the modern history of REITS.
What’s the implication of all these trends to real estate executives in this region who are developers, brokers, contractors?
This is probably the best real estate market in the United States, maybe even the whole world. We have such a healthy marketplace here. We’ve had the strongest job growth in the country here for the last several years. And if you look at the economic data, job growth is expected to outstrip housing starts for the next ten years. And we’ve had a healthy resurgence of our office markets. Particularly out on the Dulles Corridor, which had been economically hit pretty hard four or five years ago with the tech and telecom meltdown. I think in this region, these trends are probably not that consequential to our overall economic health. We’ve had a few more companies come public here because we’ve got a number of good niche investment bankers who understand Washington real estate very well, and can sell Washington real estate very well because of the strength of our local economy and our connection to the federal government. I don’t think some of the going private trends or other concerns should hurt this market as much as perhaps it could hurt other markets. Some of the most valuable real estate in the country is here. It doesn’t mean that the REITs here or the other real estate companies here won’t face the same challenges over buying expensive real estate and rising energy and interest costs and things of that nature. But I don’t worry about this marketplace because of its strong core fundamentals.
Are investors interested in struggling retailers for their real estate value?
Yeah, it’s interesting. There have been some acquisitions of some underperforming major merchandise retailers for multiple reasons, but one of the underlying reasons is that they have valuable real estate locations. Consider some of the major retailers that have been around for a long time. They own real estate in very valuable areas and the play was for the real estate itself since there was an expectation that some of those stores will be closed and there would be an alternative use for the real estate. I think it will be interesting to see if that trend continues. Retail has been through quite a transformation over the years and many old line retailers that have been adversely impacted by changes in merchandising so we could see more of this.
On a personal note, how did you develop your own real estate practice?
Arthur Andersen and E&Y were the two dominant real estate accounting and advisory firms in this marketplace. Andersen’s practice grew primarily through doing many of the major real estate workouts in the late ‘80s and early ‘90s when the real estate market around the country and in this area took a deep dive. We did a tremendous amount of restructurings for the banks and creditors or for the developers themselves. And then when those companies were restructured in the early ‘90s, we helped them go public and became their auditors. E&Y was a major player in real estate going back to ’94 through its merger with the specialty real estate firm Kenneth Leventhal. And Andersen and E&Y were one and two in the city, and we put our practices together back in 2002 and developed a dominant market share.
What does the E&Y’s Mid-Atlantic real estate practice consist of? How many people and what kinds of activities?
In our four principal offices — Washington, Richmond, Philadelphia, and Baltimore — we probably have over 100 people who focus a majority of their time in real estate. We provide audit, tax and advisory services to most of the major real estate companies in the region.
Clients such as?
Our market share is about 40% of the region, at least as we measure it with publicly available data, and I think it’s a function of our strong reputation and great service. We have some of the large REITs in this area as audit and tax clients and provide advisory services for a majority of the REITS in this area that are not our audit clients. We do work for some of the large mortgage REITs in the area as well, and you know, we have a growing practice around some of the newer companies that have gone public in this region. We have also have a very strong practice around private real estate equity funds and serve most of the large funds in the region.
And your bottom line on real estate?
Real estate’s had an incredible run here over the last few years. Clearly the amount of capital available and low interest rates have benefited this industry enormously. And while I think real estate will continue to do well, it will not enjoy the same low cost of capital it’s had over the past few years. And it’s facing some other challenges with rising energy costs and what happens because of rising rates and the impact of inflation. But off and on still very bullish on the industry as a whole. :)