Industrial Insight • Know What Drives the Owner – Real Estate Investment Trusts (REITs) • 3/9/11

When representing a tenant in a lease transaction, understanding what the owner considers important can help drive a better deal and serve the customer. Local investors, who need to make a mortgage payment, care mostly about monthly cash flow. This is also true for REITs in the aggregate, but it may not be the case for each individual transaction.

REIT performance is measured by a metric called Funds from Operations (FFO), which is a GAAP, not cash concept. Under GAAP, REITs report straight-line rent that takes into account all escalations and free rent, while completely ignoring the concept of time-value of money. Thus, while a local investor might not be able to afford a longer free rent period or a very low first-year rent with larger escalations, a REIT smoothes this cash flow and reports a constant income throughout the lease term. Structuring a lease payment that arrives at the same total rent obligation, but a more favorable present value of the rent stream can help clients and leave the owner indifferent.

REITs’ performance is also measured by few key operational statistics that shift some of the balance of power to tenants. The primary operational metric is occupancy. Offering higher occupancy can help secure better terms for the tenant than dealing with a private investor. ProLogis is a great example of occupancy focus.

At the beginning of the current downturn, ProLogis was very aggressive in dropping their rents below the prevailing market rents to keep their overall occupancy up. The second useful metric is tenant retention. This concept relates to renewals and REITs are very interested in showing high retention numbers. Capitalizing on this driver can help in renewal renegotiations as higher renewal rates can translate into higher stock multiples for REITs, leaving the tenant with more room to negotiate.

Of course, REITs are sophisticated, institutional owners that ultimately focus on earnings. The final metric, same store NOI growth, compares the rent on the expiring lease to the new rent for the same space. So, ultimately, rent matters. However, having a clearer understanding of all the decision variables of the market participant sitting across the table can help in structuring a better deal than flying blind.

Source: SEC Filings, Grubb & Ellis