Jon Fosheim was selling investments to big institutional investors at the New York brokerage of Bear, Stearns & Co. in 1985 when he met Michael Kirby, an intern with an MBA from the University of Chicago.
Kirby didn't want to live in New York, and Fosheim didn't want to sell investments. So they formed a company to buy bad real estate loans from banks.
But where to locate? The two got out a map and looked for a warm place with an airport. They found Newport Beach.
"It helped that it was snowing and 20 degrees below zero the day we decided," said Kirby, 28.
The new business didn't work out. But the two discovered another niche along the way: Few people seemed to know much about a type of real estate company the two kept encountering. It was called a Real Estate Investment Trust.
"People who knew would tell us about one that had troubles, but we'd read a research report and it would say how great the company was," said Fosheim, 38.
REITs--"Reets," as they're called--have to pay out 95% of net earnings to stockholders. In return, the REIT doesn't have to pay taxes on that income. That means a nice yield for investors if, of course, the company is well run. It also makes for a much easier and cheaper real estate investment than, say, buying an office building.
But it also means that such companies are constantly offering new stock to the public to replenish their coffers. And the brokerage houses that underwrite such lucrative offerings employ the analysts who write the investor reports on the company.
And therein lies an inherent conflict of interest, say Kirby and Fosheim. Sometimes that conflict results in puffy, worthless analysts' reports that make it hard to distinguish between the dog companies and the gems.
How do you find the gems?
Meet Green Street Advisors Inc., the new incarnation of the company Kirby and Fosheim formed in 1985. In the investment adviser business for about 2 years now, the two work--usually sans suits and ties--out of a small office in a low-rise building at Newport Center. They advise only big institutions and a few wealthy individuals--small investors need not apply.
In fact, Green Street numbers some of the biggest institutional players in the industry as clients: Citicorp Trust, Fidelity Investments, First Pacific Advisors.
The two men say the reason the firm has done well so far is that it doesn't sell stock in the 30 companies it covers, and it doesn't underwrite for those companies or for the nation's other 70 publicly traded REITs.
Kirby and Fosheim recently discussed their strategies with Times staff writer Michael Flagg.
Q. Because your company's not selling stock in any of the concerns you cover, your reports are sometimes surprisingly candid. Do you ever get nasty feedback from some of those companies?
FOSHEIM: A good example of where we got some positive feedback would be Burnham Pacific Properties (a San Diego REIT). In a recent report, we were critical of their above-average overhead. Lou Garday, the chief executive officer, is the type of executive that is not offended by that at all. In fact, when we saw him at a (trade association) meeting, he came up to us and said: "Guys, we really took your criticism to heart, and we're doing our damnedest to get those figures down to an acceptable level." The ones that are doing a good job--none of them are doing a perfect job, we don't do a perfect job--but the top-notch ones take our criticism to heart.
Q. Surely not all of them take criticism that well.
FOSHEIM: If we're questioning their integrity, probably they don't take it to heart. But we now have enough clout--if the chief executive, for example, turns around and tries to get back at us or to be vindictive--that he's not attacking just us. He's attacking a group of institutional shareholders that he covets, that he knows we're the eyes and ears for. So he has to tread carefully. The institutions will sometimes tell him, "Hey, we're shareholders of this company, and by locking the door on them you're locking the door on us."
Q. How do you go about researching one of these companies, about which most people know very little?
KIRBY: First of all, we look at the market capitalization (the total of a company's shares times its price, often used by institutional investors as a criterion for investing). It would be great to come up with a small company that had fantastic prospects, that was undervalued and all the other reasons you'd buy a stock. But if it isn't a big enough company that our customers can buy a big block of shares, it does nobody any good. As a rule, the companies we cover have to be at least $50 million, and most are considerably larger than that.
Q. Any other criteria?
KIRBY: We also try to exclude those that are predominantly mortgage REITs. Picking mortgage REITs is more a function of where interest rates are going, and we don't think we can predict interest rates. In fact, we don't think anybody can. (A mortgage REIT uses investors' funds to lend to builders and property owners, with investors sharing in the interest payments. Equity REITs use investors' funds to buy property. The investors share in rents and profits from selling appreciated buildings.)
Q. What do you look for in evaluating one of these companies?
FOSHEIM: There's a pretty simple five-part test. First, are they self-administered? Some are advised by outsiders, some are run just like an operating company, where they have employees who are the managers of the company. The others don't have any employees. They pay an outside firm to do that. We prefer self-administered management.
FOSHEIM: Because there are no potentials for conflicts of interest. If they're advised by outsiders, there's always the potential for a conflict: the outsiders may be taking too much money, or maybe they're taking money for doing things that they typically would not be paid for.
Q. What's the rest of the test?
FOSHEIM: Two and three would be the company's focus; we like to see companies that are property-specific and geography-specific. The theory behind that is that real estate is a very localized business. In this area, there are people like Koll (Donald M. Koll, chairman of the Koll Co.) who know the market inside and out. If there's a good deal to be found, Don Koll is going to be the one to see it. We think that's true in every real estate market in the country. Then there are some companies out there trying to be everything to everybody; they buy all kinds of real estate in every part of the country. To our mind you just can't add value that way. You can't be a local sharpshooter in every market; you're going to see the deals after everybody else has seen them, and you're going to not see the best deals for that reason.
KIRBY: Four is insider ownership. We like to see the guy running the thing own some stock. In some of these companies, the management team takes big salaries out of these things and choose not to buy stock. That tells you something. It's not much of a vote of confidence in the company, and I prefer to see somebody motivated by self-interest. I think people are motivated by greed and self-interest.
FOSHEIM: Five is a franchise for adding value. REIT of California (based in Brentwood) is a good example of one that does not have a franchise for adding value. Don't get me wrong; we think they're a capable management team. But their strategy is to go out and buy fully leased properties basically sold to them at retail prices. Well, there's nothing wrong with that, but you're just not creating value. Now take a company like Federal Realty on the East Coast. Their strategy is buying 20-year-old shopping centers that need refurbishing. They end up with something worth two times what they paid for it and their rate of return on their invested dollar is much higher than these other companies, because they're creating value on Day One by turning a property around.
KIRBY: They add value in a lot of ways. For example, they know how to put better tenants into their shopping centers too.
FOSHEIM: It's a rare thing to find in a real estate company. There are less than two handfuls of real estate companies that can claim to have a franchise for value.
Q. Why is that?
FOSHEIM: Most REITs were formed with the idea of being a passive vehicle for an investor to own real estate. Therefore, they haven't been aggressive as far as going out and running it like a business. It's run more like a trust. There are only a few companies that have made the decision to become REITs that truly are operating real estate companies. Plus the tax laws make it a thin line you have to walk. Most developers cannot be REITs.
Q. Because they need to retain so much of their earnings in order to build?
FOSHEIM: That's the big reason. But there are also rules on how many properties you can sell a year. The code regarding REITs is pretty lengthy and complicated.
Q. REITs as a whole had a lousy year as an investment in 1987; the industry lost money and total returns averaged minus 10.7%. What happened there?
KIRBY: You have to remember that it outperformed the Standard & Poor 500 in 1987. This is not a glamorous industry in terms of volatility, where you can find a lot of really undervalued companies. It's less volatile versus the broad indexes like the S&P; 500. If the S&P; doubles in 3 years, for example, chances are the REIT index will lag it, maybe up only 15%. By the same token, take the October market crash, when the market goes down 30%, the REITs go down by only 10% because of their types of assets: The grocery store isn't moving out of the shopping center simply because the market went down. These companies are very quiet versus the market; they don't move up or down much.
FOSHEIM: There's another way you can look at the REIT performance in 1987, too. The class of 1985 and 1986, as we call them, were a number of new companies that came out back when the market was receptive to it. Most of them were small, ill-conceived deals that were overpriced. The ones we follow, the bigger ones, did much better.
Q. Given that they aren't the most exciting investments in the world, why would somebody want to buy REIT stock?
FOSHEIM: You'd buy them for the same reason you'd buy utility stocks--they aren't speculative-type investments, and they have to pay out almost all their income, so they're second only to utilities in terms of yield. You aren't going to hit home runs as you might with a computer stock; at the same time, you're not going to get thrown out either. You're going to get on base every time.
KIRBY: And maybe the most important reason is diversification. Any financial planner will tell you it makes sense for an individual to own real estate. Many people achieve that through owning their houses, but professionally managed commercial real estate is not a bad idea either. REITs in our opinion are the best and lowest-cost way to achieve that; you're not being gouged by going into a partnership with what Jon calls "20 percenters," where, in other words, they take 20% off the top in fees out of your investment right at the beginning.
Q. Isn't there some risk out there too? In overbuilt markets, for instance? After all, real estate is an extremely cyclical industry.
KIRBY: The people that run the companies we don't like so much, who buy properties all over the country, one of their arguments is that real estate is a cyclical business. And they're right. But it's not cyclical everywhere at the same time. When the bust in Texas was taking place, New England was booming. There's rarely been a time in history when all the real estate markets in the country are going up or down at the same time. There are always pockets of good and bad news. So they would argue: 'Hey, buy our company. We got some offices in the Northwest, we got shopping centers in the Southeast, we got apartments in California. We're all over. Sure, some of the markets have got problems, but overall you're going to have stability.'
Q. But you don't buy that?
KIRBY: We think that sounds great-- except that it doesn't work. In each one of those markets, they're going to get outperformed by the local guys. Sure, diversification is going to get you out of that whipsaw of being a boom-and-bust business. But we say construct a portfolio of various companies that are all local sharpshooters where, when you get done, you have a diversified portfolio. At the end, you've got an owner of shopping centers in the Southeast, you don't just have a company that owns one shopping center there. At any one time, even one or two of your sharpshooters are going to be in a tough market, but overall the others are going to do better and take a lot of that volatility out of the market.
Q. Who invests in REITs now? Is it mostly individuals?
FOSHEIM: The typical large equity REIT might be held by 35% institutions and 65% individuals. Smaller REITs would be weighted a lot more toward the individual investor, with maybe only 5% ownership by institutions. With the smaller ones, it's not worth it to the institutions to pick up the phone and say: "Buy me 100 shares." They like to deal in lots of 20,000 or 30,000 shares.
Q. Hasn't there been a lot of consolidation in the industry lately?
KIRBY: That's a real trend in the industry among the smaller REITs and will probably continue to be big for a while. There were a large number of transactions last year. By far and away the biggest reason was efficiency, the economies of scale in owning and operating a small REIT. It just does not make sense to have a REIT smaller than a $50-million market capitalization. There are several savvy individuals out there buying REITs, and also some larger REITS looking to acquire or merge with smaller ones.
Q. There are a couple REITs that specialize in Southern California real estate, where many markets are still booming, are there not?
KIRBY: There are two that specialize solely in Southern California real estate: Burnham Pacific Properties and Real Estate Investment Trust of California. There are a couple that come close, Mortgage Investments Plus (Woodland Hills) and Santa Anita Cos. (Los Angeles).
Q. Which companies do you like these days?
FOSHEIM: I like Burnham and Santa Anita. Burnham is the local sharpshooter in San Diego County, a small partnership that converted to REIT status about 3 years ago. They've grown quite a bit since then and are now just reaching the $100-million range in market capitalization. They meet most of our five criteria. They're not self-advised, and that's a big bone of contention we have with them. (But) I think they'll become self-advised some day soon, so that's not that big an issue. And the price is right. Our current valuation of their properties is close to $21 a share, and the shares today trade at about $18.50 or so.
KIRBY: Santa Anita is really two companies: a horse-racing business and a real estate business. They're the Rolls-Royce of horse racing. At the same time they've got some damned good real estate. In Arcadia they've got this shopping mall, and the thing is just primo. They've got people begging to get in there. Those two things are the crown jewels, even though Santa Anita isn't the local sharpshooter that Burnham is. But from a pricing standpoint, they're even more attractive than Burnham. At $30 a share, they're trading at 20% below what we think they're worth, which is $38 a share.
Q. Given the federal government's search for "revenue enhancements" these days--which sounds suspiciously like the polite name for "tax increases"--what are the prospects for a change in the way income from REITs is taxed?
FOSHEIM: If an aide to a congressman is overheard saying something about it in an elevator, the trade association--the National Assn. of Real Estate Investment Trusts--marshals the troops immediately. They'd like you to think there are a lot of people trying to attack the favored tax status of REITs.
KIRBY: The answer to the question is no, there is not any serious talk. If anything, the rules have gone the other way recently. In the last couple of years it's been loosened up quite a bit. REITs, for instance, didn't used to be able to manage their own property. But REITs have never been able to pass losses through to investors for tax purposes like partnerships could. So they don't induce the kind of strange things, the type of overbuilding, that partnerships did.
FOSHEIM: At the point in 1986 when congressmen were madder than hell at losing all these tax revenues through private partnerships, the REITs didn't get picked on because they've never been a big tax shelter.