Matt Werner, CFA
June 13, 2016
Matt Werner, CFA, Chilton Capital Management
Portfolio Manager / Analyst at Chilton Capital Management

The Value of Great REIT Management Teams: Capital Recycling

The most successful long term REITs practice sound capital allocation decisions.

One attribute that is very difficult to achieve successfully is capital recycling.

Capital recycling is the funding of acquisitions with proceeds from dispositions.

Ideally, a REIT can upgrade the quality of the portfolio over time without diluting cash flow per share or stressing the balance sheet.

Herein, we highlight two examples where the management team is not getting the appreciation it deserves.

management talent to execute successfully and
patience for the activity to bear fruit. In these
cases, we do not believe they are receiving full
credit by the public market for the execution
of a dramatic portfolio transformation in an
accretive manner.
Where are We Now?
We are now in the seventh year of this real
estate cycle, and the typical real estate cycle
lasts between 7 and 10 years. Historically, the
seventh year of a cycle would be associated
with decelerating rent growth, accelerating
new construction, and increasing risk to meet
return targets. As we have said in numerous
publications, this cycle is different and could be
one for the record books. While occupancy is
increasing, construction lending for speculative
projects has been muted, keeping new supply
mostly in check. As shown in
Figure 1
, the
amount of commercial real estate under
Since the modern REIT era began in the
early 1990’s, REITs have learned to enhance the
quality of the assets held. The best axiom for
real estate quality is “location, location, location”.
Across all sectors, the best locations tend to be
high barrier markets where it is difficult to build
and demand is more steady. But, more specifi
-
cally, improving a portfolio can mean different
things based upon the property sector.
With apartments, age of the portfolio and high
job growth markets are key attributes. Recently,
properties that cater to the millennial generation
with communities located near transit stops have
also boosted portfolio quality with AvalonBay
Communities (NYSE: AVB) and Equity Residen
-
tial (NYSE: EQR) leading the way.
In the office sector, Boston Properties (NYSE:
BXP) and other office REITs have also focused
on high barrier locations with solid job growth
along with a focus on tenant credit quality.
With shopping centers and malls, population
and income profile have been the major differ
-
entiators over the past 20 years. More recently,
redevelopment of existing assets including den
-
sification into multi-use projects has improved
asset quality and strengthened brick-and-mortar
importance in the face of e-commerce. The
most common upgrade attempts to enhance the
“experience” with signature dining options and
better social interaction with customers. Simon
Property Group (NYSE: SPG) is the leader with
33 properties undergoing major refurbishment/
expansion.
For these four REITs (AVB, EQR, BXP, SPG), the
15 year performance for the period ended March
31, 2016 proves our point, considering the share
-
holder total return averaged 15.5% annually ver
-
sus the MSCI US REIT Index (Bloomberg: RMS
G) at 11.5%. We highlight two case studies for
upgrading asset quality in this publication where
returns of Hersha (NYSE: HT) lagged the index
and Camden (NYSE: CPT) barely beat the index.
Under such circumstances, it takes incredible
The Value of Great Management: Capital Recycling
|
June
2016
1177 West Loop South, Suite 1310
Houston, Texas 77027
telephone:
713 650 1995
facsimile:
713 650 1739
toll free:
800 919 1995
Source: CBRE and Citi Research, as of 5/20/2016
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
Mar-8
4
Mar-8
5
Mar-8
6
Mar-8
7
Mar-8
8
Mar-8
9
Mar-9
0
Mar-9
1
Mar-9
2
Mar-9
3
Mar-9
4
Mar-9
5
Mar-9
6
Mar-9
7
Mar-9
8
Mar-9
9
Mar-0
0
Mar-0
1
Mar-0
2
Mar-0
3
Mar-0
4
Mar-0
5
Mar-0
6
Mar-0
7
Mar-0
8
Mar-0
9
Mar-1
0
Mar-1
1
Mar-1
2
Mar-1
3
Mar-1
4
Mar-1
5
Mar-1
6
% of Tota l CRE Under Construction
Historical Average
Figure 1: Historic Low Construction
Obsolescence Rate (est.)
Figure 2: REIT Occupancy
Source: Company Reports and Citi Research, as of 3/31/2016
90.0%
91.0%
92.0%
93.0%
94.0%
95.0%
96.0%
1Q01
3Q01
1Q02
3Q02
1Q03
3Q03
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
3Q10
1Q11
3Q11
1Q12
3Q12
1Q13
3Q13
1Q14
3Q14
1Q15
3Q15
1Q16
Historical Average = 93.2%
construction is barely above the obsolescence
rate of 1%, following approximately four years
where the supply of commercial real estate
actually
contracted
after factoring in obsoles
-
cence.
Figure 2
shows that occupancy has been
increasing steadily, and has already surpassed
the peak of the prior cycle. Therefore, there
is not enough vacancy or new construction to
slow rent growth in many property types.
What Does the Capital Allocation Tree Say?
Referring back to our trusty capital allocation
tree from February 2015, the other important
factor in determining the proper course of
action is the premium or discount of a REIT to
its Net Asset Value, or NAV. For the past year,
most REITs have traded at a discount to NAV –
some discounts were, and still are, very signifi
-
cant. Simply, the capital allocation tree says the
appropriate decision to create value is to sell
assets and buy back stock or pay down debt (or
both) with the proceeds. Some of the nation’s
largest equity REITs heeding the red light to
grow are Camden Property Trust, Vornado
Realty Trust (NYSE: VNO), Equity Residential,
and Equity Commonwealth (NYSE: EQC), all
of which have sold assets and are either sitting
on cash, retiring debt, repurchasing stock, or
paying special dividends. It should come as
no surprise that the leaders of these REITs are
Ric Campo, Steve Roth and Sam Zell, respec
-
tively—all three are titans in commercial real
estate that have been intimately involved in real
estate for 30-40 years.
Capital Recycling, the REIT Way
First, the REIT must decide
what
to sell. Logic
would say to sell the ‘worst’ properties. Howev
-
er, the ‘worst’ properties may have the most po
-
tential for dilution given the cap rates are likely
the highest, making the yield very difficult
to replace. Selling the ‘best’ properties also
would be short-sighted as the best assets usually
have the most long term growth potential and
least risk. An additional factor to consider is
the tax basis, as many REITs own properties
with significant embedded gains that can create
onerous tax burdens for the REIT if gains are
not distributed to shareholders. Herein lies
the difficulty of capital recycling.
Though it is nearly impossible to judge a
capital recycling decision within a year or even
longer of the transaction, it is easy to recognize
astute management team decisions in hind
-
sight, especially over a full cycle. Ideally, we
would prefer that each decision be made with
the ultimate goal of upgrading quality and en
-
hancing long term growth while being mindful
of cost of capital and leverage. Again, this is
easier said than done, with only a handful of
REIT management teams that can claim a track
record that follows such guidelines.
Hersha Hospitality Trust
Hersha Hospitality Trust, a gateway city limited
service lodging REIT, has not had the luxury of
issuing large amounts of equity at a premium
to NAV in the past five years to make accretive
acquisitions. But, the HT management team
did not let itself become a victim. In fact,
HT was one of the most active companies in
the transaction market over the same peri
-
od. From 2011 to May 1, 2016 (
Figure 3
), HT
acquired 3,233 rooms for $1.2 billion, and sold
5,437 rooms for $900 million (pro rata owner
-
ship), which equates to 8,670 rooms and $2.1
billion combined. In comparison, as of March
31, 2016, HT owned interests in 8,892 rooms
and had a total enterprise value of $2.5 billion.
HT’s transformation began in earnest in Au
-
gust 2011 when the company announced that it
would be selling 18 hotels to Starwood Capital
Group for $155 million. Proceeds from the
transaction were used to enter the new markets
of San Diego, Los Angeles, and Miami, and also
for the acquisitions of Hyatt Union Square in
New York City and the Rittenhouse in Philadel
-
phia, which dramatically increased portfolio
quality.
When its share price was again trading well
below its private market value during late 2013,
HT announced the sale of 16 hotels to Black
-
stone (NYSE: BX) for $217 million. The port
-
folio consisted of hotels in Connecticut, Long
Island, suburban Philadelphia, and Rhode
Island. Proceeds from this sale were recycled
into purchases in Santa Barbara, Northern Cal
-
ifornia, Miami, Key West, and Washington DC.
The company also followed the capital allo
-
cation decision tree properly for share repur
-
chases, completing one of the largest REIT
share buyback programs as a percent of market
capitalization in 2015. During the year, HT
repurchased 5.2 million shares for $124.5
million, which represented over 10% of shares
outstanding!
2
Source: Chilton Capital, Company Reports, as of 3/31/2016
Figure 3: Hersha Capital Recycling Activity
$1
10
$1
20
$1
30
$1
40
$1
50
$1
60
$1
70
$1
80
($300,
00
0, 000)
($200,
00
0, 000)
($100,
00
0, 000)
$0
$1
00,
000
,000
$2
00,
000
,000
$3
00,
000
,000
20
11
20
12
20
13
20
14
20
15
20
16
Net Ac
quis i
ti
o
ns (le
ft
axis
)
Re
vPAR (righ
t axis
)
average age of 12 years and average rent per
unit of $922/month. Additionally, Camden
had only one wholly-owned project still under
construction (with one other within a joint
venture). As the economy continued to slowly
recover, management saw signs of the historic
opportunity. In the 4Q 2010 earnings call CEO
Richard Campo even ventured out to say the
next few years “will be one of the best operat
-
ing environments for our business that we’ve
seen in a very long time.”
He was right. The time between 2010 and 2016
was unprecedented especially for management
teams looking to improve portfolio quality in
an accretive manner. On the 4Q 2012 earnings
call, Dennis Steen, the CFO at the time, men
-
tioned Camden was able to dispose of 20+ year
old properties near a 6.3% cap rate and recycle
the proceeds into relatively new properties with
higher expected growth profiles near a 6.0%
cap rate.
Aside from acquisitions, proceeds from dis
-
positions were also being used to fund de
-
velopment. In 2011, the jobs to apartment
completions ratio was 10:1 across CPT’s 17
markets, far above the “normal” ratio of 5:1.
This led to initial yields ranging from 6.5% to
8.0% for Camden’s development pipeline, 300
basis points above the market cap rate in some
instances. Anecdotes from CPT and other
apartment REITs indicate that all apartment
REITs achieved yields far above their pro forma
underwriting during this historic period.
As of March 31, 2016, CPT’s capital recycling
efforts had produced terrific results. Due to
the transformational activity since 2010, the
portfolio’s average age remained flat at 12 years
while the average rent per unit increased 44%
(from 4Q 2009 to 1Q 2016) to $1,327 per unit
per month. Additionally, despite shrinking the
portfolio to 60,172 units, Camden’s recurring
FFO and dividend per share increased 69%
and 67%, respectively, over the same period.
Importantly, Camden was also able to enhance
the company’s balance sheet to one of the
strongest in the sector by lowering its net debt
to EBITDA ratio to 5.2x as of March 31, 2016,
down two full turns from the beginning of
2010. Furthermore, the company expects the
ratio to be near 4.5x by year end 2016.
Today, management believes that “apart
-
ments are fully valued in the private market”
as private companies enjoy a cost of capital
advantage versus public companies due to their
higher leverage targets. As a result, Camden
plans to continue to enhance its portfolio
qual
-
ity through capital recycling by being a net
Despite these efforts, HT traded at one of the
biggest discounts to NAV as of February 2016.
Once again, HT did not shy from dramatic
moves, deciding to sell a 70% share of 7 of the
company’s Manhattan hotels for $575 million,
equivalent to a 5.4% trailing cap rate. Remark
-
ably, the weighted average cap rate of HT’s
$900 million in dispositions from 2011-2016
was 6.7%, while the weighted average cap rate
on the $1.2 billion of acquisitions was 7.2%*.
Therefore, the capital recycling program was
accretive
to earnings, a feat that is very rare.
The increase in quality and geographic diversi
-
fication has been a huge benefit for sharehold
-
ers. Management projects that 2016 portfolio
RevPAR (Revenue Per Available Room) will
be $171, which would be 50% higher than the
company’s RevPAR in 2011. The company’s
West Coast and South Florida portfolios were
the top two performing markets in 2015, and
will comprise approximately 33% of HT’s
EBITDA, pro forma for the New York joint
venture transaction. The midpoint of HT’s
2016 Adjusted FFO per share guidance implies
a 52% increase over 2011’s Adjusted FFO per
share, and Adjusted EBITDA is projected to
be 38% higher than 2011. HT’s pro forma net
debt plus preferred equity to EBITDA ratio is
6.0x, a far cry from the 7.6x ratio employed at
the end of 2011.
In summary, Hersha was able to increase asset
quality, diversify geographic exposure, lower
balance sheet risk, and lock in value creation
through accretive acquisitions and share
repurchases. We would be willing to bet that
management takes full advantage of the cash
from the New York joint venture to create more
value for shareholders, and will continue to dis
-
play top-notch capital allocation decision-mak
-
ing for shareholders in the years to come.
*Excludes Ritz Carlton Georgetown and Rittenhouse
Camden Property Trust
Camden Property Trust has demonstrated a
long track record of success as an apartment
owner and developer. However, the Great
Recession provided the ultimate test for CPT
on development discipline and balance sheet
strength, as it did for many other REITs. The
result of the test produced a “right-sized” devel
-
opment team, along with one of the strongest
balance sheets among all REITs. Along the
way, CPT was able to tactically execute acquisi
-
tions, dispositions, and developments to take
advantage of the favorable environment, while
simultaneously de-risking the company.
At the end of 2009, CPT had 63,286 units
across 183 operating communities with an
3
seller in 2016. In fact, on April 26, 2016, Cam
-
den announced it had sold its entire Las Vegas
portfolio for $630 million, equating to a ~5.4%
cap rate. Concurrently, the company also
increased its 2016 disposition guidance to $1.1
billion at the midpoint, which would equate to
a ~9% reduction in assets.
The disposition of the Las Vegas portfolio not
only enhances Camden’s overall portfolio qual
-
ity, but it also improves the company’s return
on invested capital growth. CPT’s Las Vegas
portfolio was almost two times the average age
of the overall portfolio at 23 years and had
average rent per unit of $874/month. Despite
the properties having higher NOI growth, a lot
of capital had to be reinvested to maintain the
growth due to the portfolio’s age. Capital ex
-
penditures (capex) for Las Vegas were almost
$1,500/unit, or 25% above the portfolio aver
-
age. Some of the proceeds will be distributed
to shareholders as a special dividend, while
the remainder will be used to fund CPT’s $1.4
billion development pipeline that is projected
to produce initial yields of 7%.
Camden’s portfolio recycling efforts since 2010
have undoubtedly enhanced its portfolio qual
-
ity and growth profile. Management has been
opportunistic and bold, acting on what the
market has been signaling even when it took
the company out of its bread and butter busi
-
ness (development) in 2009/2010 or when it
signaled to drastically shrink the portfolio size.
Though Camden’s geographic exposure may
not have been ideal for the past six years, the
management team made astute decisions on
acquisitions, dispositions, development, and
the balance sheet. Thus, we believe the compa
-
ny’s share price at a 9% discount to NAV as of
May 24, 2016 does not reflect any future value
creation that will result from skillful capital
allocation.
Chilton Buys Come in Different Shapes and
Sizes
Camden, Hersha, and all of the aforemen
-
tioned REITs exemplify the importance that
capital allocation and management team
strength factors into the Chilton investment
process. While these companies may not have
been the best performers in the portfolio over
any given period, we can use such confidence
to increase position size when the market is not
ascribing the proper value to such a company.
Conversely, to our own detriment, we have
avoided some companies that have outper
-
formed our own portfolio due to a lack of
confidence in capital allocation. Ultimately, we
believe our long term outlook will prevail and
the market will correctly recognize the
intrinsic value of each of our portfolio
companies through some series of catalysts.
Matthew R. Werner, CFA
mwerner@chiltoncapital.com
(713) 243-3234
Blane T. Cheatham
bcheatham@chiltoncapital.com
(713) 243-3266
Bruce G. Garrison, CFA
bgarrison@chiltoncapital.com
(713) 243-3233
RMS: 1862 (5.31.2016) vs.
1753 (12.31.2015)
vs. 346 (3.6.2009) and 1330 (2.7.2007)
Please feel free to forward this publication to interest
-
ed parties and make introductions where appropriate.
Previous editions of the Chilton Capital REIT
Outlook are available at
www.chiltoncapital.com/
reit-outlook.html.
An investment cannot be made directly in an index.
The funds consist of securities which vary significant
-
ly from those in the benchmark indexes listed above
and performance calculation methods may not be
entirely comparable. Accordingly, comparing results
shown to those of such indexes may be of limited use.
The information contained herein should be
considered to be current only as of the date indicated,
and we do not undertake any obligation to update
the information contained herein in light of later
circumstances or events. This publication may
contain forward looking statements and projections
that are based on the current beliefs and assumptions
of Chilton Capital Management and on information
currently available that we believe to be reasonable,
however, such statements necessarily involve risks,
uncertainties and assumptions, and prospective
investors may not put undue reliance on any of these
statements.
This communication is provided for
informational purposes only and does not constitute
an offer or a solicitation to buy, hold, or sell an
interest in any Chilton investment or any other
security.
4
Next
get_app  Login to Download this PDF
More from Matt Werner, CFA
Nov 03, 2015
Oct 21, 2015