by Elaine E. Derso

By year end, the major capital markets issues that concerned the REIT industry in 1999 resulted in a growing number of stock repurchase program announcements. Almost half of all equity REITs had announced share repurchase programs.

Preliminary evidence suggests that investors are paying more attention to companies that are able to expand their businesses despite the difficulties of operating within a capital-constrained environment at a time when the real estate cycle is quite mature, rather than responding positively to stock repurchases.

Following classic finance theory...

Even though REITs have shown generally strong operating fundamentals, their stock prices have just come off the second year of an industrywide slump. So it’s not surprising that a growing number of REITs are deciding to follow Wall Street’s advice and implementing stock repurchase programs. Between January 1998 and yearend 1999, 87 of the 183 equity REITs announced such programs.

By doing so, they’re simply following classic finance theory. Namely, when the return on investment on share repurchases exceeds that on alternative investments in the company’s business, companies should buy back shares. And, reducing the number of shares outstanding while maintaining earnings levels should result in a higher share price.

...But not benefiting from buyback programs...

On the whole, the buyback REITs perform about the same as the non-buyback REITs. On the basis of an admittedly rough measurement, they produced similar median total return performances in 1999.

This is not surprising, since REITs with share buyback programs appear, as a group, to be broadly representative of the entire equity REIT industry. They include all property subsectors and span a wide range of market capitalizations. The buyback and non-buyback REITs do not seem to differ significantly from each other, except for the corporate decision to establish such a

program. Moreover, a preliminary study indicates that net issuers of stock have outperformed net buyers.

...Because investors prefer companies that can grow

Investors seem to be rewarding REITs that are investing available capital in the ongoing business, in the expectation that the stock market will eventually reward the companies’ success in building their basic businesses. This makes sense, since the initial investment decision is generally based on investor confidence in a company’s business strategy and management’s ability to implement it.

From this point of view, share buyback programs may not look like a wise use of corporate resources in a capital-constrained environment, at least to the extent that the funds used to buy back shares could be used to build and manage the business. There may also be concern about the extent to which share repurchase programs represent an ad hoc response to stock market conditions that may not translate into enhanced shareholder value in the long run.

Limits to the buyback strategy...

Reduced liquidity in stocks that are already relatively illiquid can result from buybacks. What’s good for the Fortune 500, in terms of theory, may not be good for REITs and other smaller public companies. After all, the industry spent much of the 1990s pursuing the “critical mass” that would, among other things, ease access to the capital markets.

Funding stock buybacks in a capital-constrained environment raises issues of costs and limits. Lender covenants, ratings agency scrutiny, and rising interest rates limit the amount of debt that can prudently be added to the balance sheet.

Property sales reduce earnings and raise a question about how many properties or regions are genuinely extraneous to a company’s business strategy. Some smaller companies may find that the best way to maximize shareholder value is, like MGI Properties, to adopt and execute a formal plan of liquidation.

...May lead to another sorting out of the industry

As long as real business opportunities exist, investors are likely to reward REITs that find and exploit them. Stock buybacks seem most appropriate when there are few or no business opportunities suitable for investment. Whether they can be integrated into corporate strategy probably depends on issues like whether the scarcity of desirable investments is of shorter or longer duration, the structure of the balance sheet, and the size and strength of the property portfolio.

The bottom line for the industry could be that another sorting out of survivor companies lies ahead. It is not clear how many companies, as a result of the recent upward trend in stock prices, will continue to be net issuers of stock or for low long. Nor is it clear how many stock repurchase programs will be the first step to going private or simply a way to invest excess cash flow in the short term while continuing investment in growth projects for the long term.

Elaine E. Derso is a senior securities analyst and consultant as a principal of Realty Resources.