Western real estate advisors case study: REIT roll-up

Real Estate Issues, Dec 1997 by McMahan, John

This case is based on a series of roll-up proposals offered to institutional investors over the last year. The pressure for "action" inherent in the roll-up situation creates a crucible in which assets, careers, and fortunes may be made or lost in a relatively short period of time.

Camilla Concilatore raced into the management meeting 25 minutes late, her heart pounding, and largely out of breath. Just before the meeting, she had placed a call to Tom Razier to ascertain his receptivity to a "roll-up" of Western's clients' assets into a Real Estate Investment Trust (REIT). Tom was the head of real estate investments for the Bloomfield Urban Retirement Plan (BURP), one of Western's largest clients.

Cami had started at Western in 1991 as a real estate acquisition officer and now served as the firm's director of portfolio management. The management meeting was called to finalize strategy for the proposed roll-up, tentatively scheduled for closing on October 15,1997, just three months away. Unfortunately, the news she brought would not be well received.

BACKGROUND

Firm's Beginnings: Western was founded in Los Angeles in 1987 as an investment advisor for pension investor clients. The firm was registered under the Advisor's Act of 1940 and was a fiduciary under ERISA. Western specialized in suburban office and industrial properties located primarily in the western United States. Western's founders, Jim Aires and Serge Leosky, were 1981 classmates from a well-known western business school. They later worked together as mortgage brokers specializing in loans for office and industrial properties. As a result of their mortgage activities, they became acquainted with several major pension funds and believed that they could develop an investment niche that would provide attractive equity returns to pension investors. To raise the initial $200,000 in equity capital for their new firm, they invested their life savings as well as proceeds from second mortgages on their homes.

Clients: Raising pension capital turned out to be harder than they had anticipated. It took over two years to secure their first pension client, who invested $25 million in a separate account.

Although from time-to-time they considered sponsoring pooled funds, they continued to focus on separate accounts and by mid-1997, had attracted 14 pension clients allocating $835 million to the firm for investment purposes. Six of the clients were public pension plans; five were corporate; two were Taft-Hartley; and one was a college endowment fund.

Investment Strategy: Western's investment strategy was to concentrate on the rapidly growing suburbs of metropolitan areas in the western United States where they believed they could secure superior investment returns. They focused on new, modern, suburban office buildings leased to local (27.3 percent); regional (39.2 percent); and national business firms (33.5 percent).

Assets: As of December 31, 1996, the firm had approximately $725 million in assets under management comprising 43 properties located in California (48.3 percent); Washington (27.1 percent); Arizona (17.6 percent); Oregon (5.2 percent); and Colorado (1.8 percent). Ninety-three percent (93.0 percent) of the portfolio's value was in office and R&D buildings, with the remainder in industrial warehouse facilities. The average length of leases in the portfolio was 4.2 years. Approximately 20 percent of the investments had been developed by Western's staff.

Investment Performance: Despite the recession of 1991-1993, and the problems besetting the office sector, the properties had performed relatively well over the past seven years, with a 10.3 percent total annual return-of which 8.2 percent represented net operating income (NOI).

And things were getting much better. As a result of asset value write-downs in the early 1990s and rapidly improving property markets in the West, Western's NOI return for 1996 was 10.3 percent, and was expected to be 11.3 percent for 1997. Management believed that NOI returns would reach 12 percent by 1998. Tenant improvements and leasing commissions typically reduced NOI returns by approximately 15 percent annually.

Organization: Western was organized as a corporation, with a functional/matrix organizational structure. Jim was President and CEO with Serge serving as the chief operating officer. Besides Cami, other officers included Mary Ishade, chief financial officer; Bill Closdeale, director of acquisitions; and John Leascom, director of asset management. Property management was performed by independent contractors. Non-founding officers owned 37 percent of the company.

Profitability: During its early years, Western had lost money, but began to enter the black in 1990. Profitability then turned down in 1993, as new capital dried up and clients demanded higher levels of reporting and other services. With new capital flows in late 1995, however, profitability had returned. EBITDA for 1996 was $2.2 million and was expected to increase to $2.6 million in 1997 and $3.1 million in 1998 (Exhibit 1).