Game Changes as Some Sit One Out

Real estate investors ranging from billion-dollar pension funds to small entrepreneurial groups are taking advantage of their best chance in years to buy properties without competing against cash-rich real estate investment trusts.

Investors of all stripes have remained in the real estate market throughout the ascendance of REITs, which started in 1992, but the slowdown this year of REIT acquisitions is allowing institutional buyers and other more traditional types of investors to resume their roles as more active players in buying real estate assets.

The fund executives, as well as brokers and others who track commercial property sales, say the so-called REIT retrenchment is a double-edged sword that works against sellers but in favor of buyers. With REITs backing off, sellers may find now they have only two or three bidders on properties that would have drawn a dozen bids a few months ago. But that also means buyers face less competition and therefore have a better chance of getting properties at lower prices.

“If you’re a net buyer of real estate assets, the REIT retrenchment means there is less capital in the markets, and that’s a big plus because that kind of market favors buyers. But if you’re a seller, you have exactly the opposite point of view,” said Mike Croft, chief executive of Los Angeles-based CommonWealth Partners, which manages a $550-million real estate acquisition and development pool funded by the California Public Employees’ Retirement System.

The CalPERS and CommonWealth Partners venture on Monday announced its first acquisition since the two organizations formed their partnership, the $87-million purchase of the 801 Figueroa Tower in downtown Los Angeles. In addition to the Figueroa project, CommonWealth and CalPERS are co-investors in a number of other properties, including the 635,000-square-foot Trillium Tower in Warner Center, in which CalPERS had already invested before the two formed their joint venture.

Croft said the CalPERS fund is precisely the kind of investment vehicle that can take advantage of the REIT retrenchment. The fund is designated solely for office properties in Southern California and other parts of the Southwest. A substantial portion of the $550 million already has been invested, but “a very significant amount” remains to be invested for fiscal year 1998-99, which ends Sept. 30.

Toward the other end of the size spectrum, operators of Century City-based Summit Fund see opportunities to buy properties priced between $5 million and $25 million, said Larry Bond, a managing director of the privately financed fund.

“Most of the CEOs of REITs have said publicly that their acquisition plans for 1999 are almost nonexistent,” Bond said.

Bond said Summit “wants to remain under the radar screens” of the big institutional investors, but he said the fund is “trending up” in terms of the sizes and types of properties it pursues because the reduced competition from REITs means Summit can now afford to bid on properties it wouldn’t have bid on six months ago.

“We’re buying an eight-story, 100,000-square-foot office building in Chicago right now that we would have had significantly more competition on just a few months ago, and we’re a finalist in the bidding for a shopping center in San Francisco that we probably wouldn’t have been a contender for when the REITs were bidding,” Bond said.

How much the decline in REIT purchases has affected the number of bidders or the price paid for a specific property is difficult to measure, said Rod Wycoff, a senior managing director with Landauer Real Estate Counselors in Los Angeles.

“We know there’s been a shift, but it’s very difficult to quantify. Everywhere you look, you see properties that haven’t sold, properties that have fallen out of escrow and lots of evidence of a re-pricing, but it’s difficult to determine how much of a repricing,” Wycoff said.

Nonetheless, brokers and investors are certain that the decline in REIT buying has changed the landscape for non-REITs.

Paul Stockwell, a corporate managing director with the Julien J. Studley Inc. real estate brokerage in Los Angeles, said non-REIT investors today see a chance to buy at more palatable prices than they could when REITs were bidding up the cost of everything from skyscrapers to apartment complexes.

“There are opportunities today for smaller partnerships that are maybe looking at acquisitions from $5 million to $20 million from one to three capital sources. Back when the REITs were buying everything in sight, these companies were getting priced out of the market,” Stockwell said.

REIT Deal Fell Out of Escrow Twice

As an example of how the REIT retrenchment has opened doors for other investors, Stockwell cited San Francisco-based Sagamore Equities, which bought an 83,000-square-foot office building in the Burbank Media District for $10 million in July after the property had twice fallen out of escrow with prospective REIT buyers.

“This was a deal that Sagamore probably got because the REITs were slowing down,” Stockwell said. “This is a good example of how an entrepreneurial capital group can take advantage of an opportunity today.”

Bigger institutional funds have had the money to compete with REITs, but in general the institutions have been reluctant to bid as high because they are traditionally more cautious, conservative investors, said Paul Trevino, senior vice president of multifamily investments at Sares-Regis Group, which acquires apartment properties in partnership with institutional investors.

Sares-Regis closed escrow within the last six weeks on a $24-million, 301-unit project in Boulder, Colo., and a $6-million, 158-unit complex in Stockton. The company is in escrow on $56 million worth of apartment buildings totaling 867 units in Phoenix, Denver and Norwalk.

Before Wall Street shut the spigot on REIT financing, Trevino said, “the REITs were operating with a buy-or-die mentality.” In order to continue to show increased earnings every quarter, they were acquiring properties rapidly because acquisitions produce earnings growth faster than simply holding on to an existing group of properties and waiting for rents to slowly rise.

Initially, Trevino said, the acquisitions produced fast growth for the REITs because they bought the properties at below-market prices that earned hefty returns. But as the REIT phenomenon proceeded and the real estate markets recovered, the REITs bid prices higher and higher until acquisitions no longer produced such high returns.

By contrast, Trevino said, “Institutional capital is much different from REIT capital. It isn’t driven by the need to show earnings growth every quarter.” He said institutional investors also were less comfortable in the frenzied bidding environment that sometimes developed during the height of the REITs’ buying spree.

“If you get into the fervor of the bidding process, with 10 or 12 bidders competing, you can overreach. I think there were situations where people felt they simply had to have a certain asset, and they overpaid,” Trevino said.

Trevino said the industry was surprised by how quickly the REITs bowed out of the action.

“There was no sign or signal that the market prices of those REITs would diminish the way they have. It happened so fast that there were acquisitions where, during contract negotiations, the REITs reduced the prices they were offering,” he said.

More Cautious REITs to Rejoin the Bidding

Now that the REITs clearly have left the playing field, according to Landauer’s Wycoff, the industry is asking, “What next?” Sares-Regis’ Trevino said his Irvine-based company’s management is thinking hard about what’s the best strategy to pursue in light of the REIT retrenchment.

Wycoff believes life companies and pension funds will pick up the pace of their acquisitions, but he said there probably will be a lot more assets for sale than there will be buyers because the life companies and pension funds typically move at a more deliberate pace than the REITs.

Bond of Summit Fund believes owners who were thinking of selling will either reduce asking prices or choose not to sell. “Economic fundamentals are pretty good right now, so owners aren’t in a position where they have to sell,” he said.

Eventually, the REITs are expected to return to the bidding table, but probably more circumspectly.

“I think they will be more cautious in the prices they pay,” said Croft of CommonWealth Partners. “Initially, REITs thought their cost of capital was lower than it really was, and therefore they paid high prices for assets.”

Croft said REITs, once considered to be buyers only, will probably become buyers and sellers. He expects CommonWealth will talk to some of the REITs about buying some of their assets, although his institutional fund will not be under the kind of pressure to buy that drove the REITs to spend so freely.

“We’re not in any hurry. We just have the capital available when we need it,” Croft said.