SAVVY REITS USE SCREENING TECHNIQUES
TO ACQUIRE QUALITY PROPERTIES

Special to Real Estate Weekly (1/26/00 issue)

Georgia Malone, president of Georgia Malone & Co., Inc., is an attorney, broker, and real estate advisor, who is actively involved in the sale and purchase of multifamily portfolios for acquisition by REITs and other buyers.

In the early nineties, the REIT game was quantity. Hungry REITs eager to show growth and satisfy anxious investors appeared to be on a non-stop acquisition binge of residential and commercial properties. The thinking was that the more REITs would buy, the more assets they could show, and hence higher and higher earnings. Acquiring more and more properties, it was believed, was the sure route to REIT success.

However, Wall Street took a dim view of this acquisition philosophy even though the real estate market boom was fueled in part by the REIT frenzy. Many properties that appeared on the surface to be decent purchases turned out to be poor investments. Suddenly to some analysts the balance sheets of successful REITs began to look suspect.

As the stock market turned tough on REITs, executives had to focus in on something they could control—how to run their businesses more efficiently and profitably, as well as ensuring a strong revenue stream for their stockholders. A big answer to the problem could be found in how REITs acquired properties.

To insure a better return on investment for stockholders, REITs needed to develop a better screening technique to identify potential properties, even before they did due diligence to evaluate the property’s quality and long-term asset value.

In screening properties on behalf of our REIT client, we have developed five key criteria that must be satisfied. They are: Cap rate, location, age of units, resale value and financeability of the project.

Cap Rate
Cap rate is the most important criterion in evaluating property acquisition. For instance, an ideal cap rate for a class C site should be about 13 percent as opposed to a 10-to-12 percent cap rate for a class A property. The reasoning behind this is that a class C site is in a less desirable location, requires more work and doesn’t have good resale value. On the other hand, the cap rate on a class A property, which is in a prime location, should be less because it will go up in value in about five years.


Location
The second most important criterion is location. An acquisition director should strive to buy a mix of A, B and C type residential properties in different areas of the country as a diversification tool. The idea is not to concentrate in just one area of the country or with one particular type of property.


Here’s why: if there is a downturn in the economy in the Northeast but a boom in the Southeast, one serves to balance out the other so the REIT does not get burned.

Age of Units
While location plays an important role in finding quality properties, REITs should also investigate the complex’s infrastructure. REITs should not overlook the relationship between the age of a complex and its maintenance requirements as older complexes are usually more expensive to maintain.

What hurt many REITs when acquiring residential properties is that they did not pay attention to the renovation cost of older complexes. Whether it costs $500 or $20,000 to fix up a unit, it is important to know the property’s age and how the renovations will affect the bottom line, which could impinge on a REIT’s net operating income.

Resale Value and Financeability
When evaluating renovation and maintenance costs, REITs should also seek avenues for generating additional revenues from their properties. In this way, they not only create a healthy climate for new sources of capital, but also will enhance the properties’ resale value. For instance, many apartment complexes in upstate New York don’t charge for storage facilities. A landlord can charge $10 or $15 a month extra in a 1,500 to 3,000-unit apartment complex and increase a REIT’s earning potential.


The days of simply acquiring and selling properties to achieve higher earnings for a REIT are now long gone. With stockholders demanding better returns on their investments, REITs must follow a specific set of guidelines in screening and identifying "quality" properties in order to survive and expand their businesses. If not, REITs will face a very difficult future in attracting capital for new investments.