One indication of the value of a REIT in the eyes of the investing public is at what ratio to dividend is the company traded. The higher the ratio, the more valued is the company in the eyes of investors. We on the board were presented with the reality that office REITs, in general, traded at approximately a 50% premium to flex/industrial REITs.
Our senior management had grown up in Washington, as had most of the trustees. Some senior managers had hands on experience in the leasing and management of office properties in the area. Prices for office space in the downtown area were then less per square foot than in many of the other top 10 office markets in the United States. What could go wrong as we transitioned from being focused on flex/industrial properties to becoming primarily an office property REIT?
Let me count the ways!
1.
JOBLESS RECOVERY FROM RECESSION. Unless jobs increase, investors correctly believe that demand for office will not increase…and it didn’t.
2.
SOVEREIGN
FUNDS. Offshore capital found its way to Washington, DC, as the area was perceived as a safe haven versus the disruption in their respective nations. Office prices went up, resulting in lower yields than anticipated on what we purchased (versus what we had projected in our forecast).
3.
SEQUESTRATION. Investors moved away from all REITs focused on Washington, during a time with the federal government could not complete a budget and automatic spending cuts were triggered.
4.
INDUSTRY EXPECTATION. Most investment real estate is acquired with maximum debt to enhance yield (when the cost of debt is lower than the yield of the property unleveraged). REITs had generally been leveraged around 50% prior to the “Great Recession”. Analysts’ post-recession recession gave a premium to those REITs with leverage much lower (ideally at 30%). With less cheap debt to apply to leverage cash flow, the current net return percentage on properties dropped.
5.
TEAM TALENT. The founders of FPO were ready, willing and able for the transition to office properties. A few of the newer senior managers, and some of existing lower level staff, struggled to adjust to their new duties in office leasing, management, accounting and capital improvements. With no longer being the dominant owner in the region (as FPO was in flex/industrial), our ability to demand price concessions from vendors and to negotiate with tenants was hindered (as we became an owner of downtown office buildings).
BOTTOM LINE. Good ideas are not always the best ideas. Sometimes a great strategy, even with good tactics, can fail due to unexpected changes in the economy, community, financial markets and team members. FPO had a good idea – increase value for investors by moving from flex/industrial into office assets. The investment bankers encouraged the move. Initial results were positive. But a series of unfortunate changes in the world in which we operated had a huge negative impact on the opportunity for success.
