Commercial Real Estate: Trends
The beat on REITs
Many are adding to Virginia portfolios, but Mills Corp. hits a bump

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by Rob Walker
for Virginia Business
March 2006

The REIT rally of the past five years may be slowing as interest rates rise and other market sectors improve. But in Virginia, where real estate investment trusts have bought, built and managed hundreds of properties, REITs are strong players both as development engines in growing markets and as components of balanced investment portfolios. “Virginia is going to continue to be a big player on the REIT map because of the critical mass of employment and growth in the D.C. to Richmond to Hampton Roads ‘crescent,’” says David H. Downs, who holds the Alfred L. Blake chair in real estate at Virginia Commonwealth University.

While more traditional real estate firms continue to dominate, REITs have muscled their way into Virginia markets. Liberty Property Trust, based in Malvern, Pa., manages 6.8 million square feet of office and industrial properties in Hampton Roads and Richmond. Highwoods Properties Inc. of Raleigh, N.C., manages 3.4 million square feet of space at Innsbrook, Stony Point and other office centers in Richmond. Meanwhile, Chicago-based Equity Office Properties Trust manages 4 million square feet of office space in Northern Virginia.

The REITs anticipate continued growth in regions where they now do business. Proximity to the nation’s capital “gives us components that should be recession resistant,” says Joseph Stettinius Jr., senior vice president, Washington region, for Equity Office, whose flagship Virginia property is Reston Town Center. “We don’t subscribe to the idea that there is a bubble here in the office sector.”

In the last three years, the Hampton Roads portfolio of Liberty Property Trust has doubled, says Craig Cope, vice president and manager of Liberty’s Hampton Roads office. Much of the growth has been in warehouses and distribution centers, offshoots of the rapid expansion of the Port of Virginia. “Demand here is increasing,” says Cope. “We are looking for land” for new buildings.

After the Sept. 11, 2001 terrorist attacks, commercial real estate expansion declined, and Virginia is still in the ear

ly to middle stages of a recovery, according to Robert F. Norfleet III, who follows REITs for Davenport & Co. in Richmond. “You’re going to see a fair amount of building for awhile in attractive markets like Northern Virginia, Richmond and Hampton Roads.” And REITs should continue to prosper in a state where above average population and economic growth bode well for occupancy and rents, says Norfleet.

Still, the REIT sector was shaken by recent reports about financial problems at the fast-growing Mills Corp. in Arlington. One of the nation’s largest shopping center developers, Mills owns 42 malls in the U.S., including Potomac Mills outlet mall in Prince William County, one of the state’s largest tourist attractions. Early this year, investors reacted after Mills abandoned 10 projects, put some loans into default, dismissed 14 officers and brought in outside management to examine its books after concluding it would need to restate its earnings for the last five years. The company said accounting errors were related primarily to investments by a subsidiary and the accounting for long-term incentive compensation.

After the news broke on Jan. 6, Mills’ stock (MLS on the NYSE) took a hit. Since last summer when it traded at a high of $66 a share, the value has dropped by about a third, and dipped to $37.64 in late January after a major equity partner announced more bad news. KanAm International GmbH in Munich froze the assets of two of its real estate funds for three months because investors had been withdrawing money in response to press accounts about Mills’ plans to restate earnings. When Virginia Business went to press, the stock was trading at nearly $40 a share. Meanwhile, several law firms have filed securities class-action suits against the company, alleging that Mills violated federal securities law by overstating its income.

Mills has outlined steps to correct its accounting errors, including the establishment of a best practices office and the retention of Deloitte Consulting LLP to help implement improvements in accounting and information technology. “We have a strong portfolio of retail properties and development opportunities and the underlying fundamentals of our business remain solid,” CEO Larry C. Siegel says in a statement.

Despite Mills’ current problems, “The tangible assets have value,” says VCU’s Downs. “Potomac Mills is not going away. And the stock shows the Street expects a turnaround, or at least another player to come happily to take that portfolio.”

Highwoods also is restating financial results for 2002, 2003 and the first three quarters of 2004. Company President Ed Fritsch said in a statement that “these adjustments will not have a material impact on net income of FFO [funds from operations] going forward and did not impact our cash position other than increased audit and related expenses. The adjustments related primarily to transactions or practices that occurred or were established a number of years ago.”

Recently some REITs, faced with declining valuations on Wall Street, have decided to go private, says John B. Levy, president of John B. Levy & Co., a real estate investment banking firm in Richmond. They are doing so because in some cases, private investors are seeing greater value in REIT portfolios than is Wall Street. In addition, REIT managers “are being overwhelmed by the burdens on publicly-held firms from legislation like the Sarbanes-Oxley Act” of 2002, says Levy.

Sarbanes-Oxley, passed in the wake of scandals at Enron and other companies, requires greater oversight and transparency in accounting than had been required previously.

Still, REITs are generally seen as a good way to diversify portfolios. Created by Congress in 1960 as a way for average people to invest in large, income-producing commercial buildings, REITs have evolved through the years. Initially used to finance real estate, today’s REITs are run much like large corporations, providing dividends to shareholders.

In a recent Davenport report, Norfleet writes that while REITs may not outperform broader market sectors, as they have in recent years, investors will continue to turn to them for “solace in reliable returns through dividends and relatively lower volatility.”

Nationally, the total return on REITs in 2005 was 14 percent. Early this year, the sector was up about 4.5 percent, consistent with the electric utilities index and the Russell 2000. “They’ve been in line with other comparable benchmarks,” says Lou Taylor, a REIT analyst with Deutsche Bank in New York City. “Barring something unforeseen, we expect they will continue to perform around the current healthy level.”

While a substantial rise in interest rates could constrain business and hurt occupancy, REITs might benefit from another modest tick or two upward in interest rates. The cheap money available under the low rates of recent years enabled smaller, opportunistic investors to compete for properties, notes Cope of Liberty Property Trust. “With interest rates going up, we can be more aggressive and competitive,” he says. Stettinius agrees, “Smaller buyers would be affected more than we would by an uptick, if it’s not too large. That would help us.”