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San Diego County's REIT investment cycle is hot, but for how long?

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While San Diego has experienced several investment and economic cycles in the past two decades, the current real estate investment trust (REIT) investment cycle will certainly go down in history as one of the most influential.

For example, the substantial volume of REIT acquisition activity in certain submarkets, such as downtown, the University Towne Center area and Sorrento Mesa, and in certain property classes -- particularly Class A office space -- has drastically driven up sales prices over the past two years.

For this reason, other buyers, such as pension fund advisers and value-enhanced funds, have remained on the sidelines. This increased level of activity has been driven by low interest rates, an improving stock market and the nature of the REIT structure, which requires owners to invest their funds rather than hold them.

Like all cycles, however, this one will evolve over time and REITs' current appetite for Class A property will diminish. This will be true especially as interest rates begin to rise and property values plateau or dip, which will create downward pressure on REIT stock prices. But until that time, the REIT investment cycle is making a significant impact.

The impact of REIT ownership on management

REITs typically, but not universally, manage their properties in-house. Due to their national position, they pride themselves on national or regional contracting ability with vendors for such services as janitorial, security and parking.

This advantage can be a double-edged sword. While it provides operating expense savings, it does not necessarily correlate directly to the best customer service since a single national vendor may not be able to provide best of class service in every regional market.

Consolidation is also impacting property management. Some REITs are now managing property, even quality Class A properties, from an off-site location. This can be a dramatic change for high-profile tenants who pay a higher rental rate to avail themselves of the services and location of a Class A building, such as personalized customer service and quick response to their needs.

The reason for this difference in operational standards between REIT management of an asset versus a third-party property management firm is due to the REIT corporate structure. REIT management of an asset is primarily driven by stock price. This can be in conflict with what is in the best interest of the property or a building tenant. To encourage a better stock performance, REIT management may need to reduce operating expenses, approve minimal tenant improvements and increase rental rates, all of which compromise customer service and risk a tenant's decision to renew.

In comparison, third-party management firms focus on the goals of the client. They are typically hired to ensure the client's tenants are receiving the best customer service possible. Owners also gain from the firm's expertise in engineering, construction and leasing. Overall, it can be assumed that a tenant can expect a higher degree of personalized customer service with a third-party management firm.

What does it all mean to the tenant?

Tenants in today's market must be very savvy about the impact of investment sales on an existing or potential new office lease.

The most significant impact on tenants when ownership of a building changes is the pass-through of increased property taxes based on the most recent sale of the property. Even if a REIT is able to reduce operating expenses through regional contracts, the tenant is unlikely to benefit due to the overwhelming effect of the property tax increase on the new owner's operating expenses, which are almost universally passed through to the tenant.

Tenants in today's market must also be very savvy about the impact of investment sales when considering office space. They should ask prospective landlords some of the following questions:

¥ What is the ownership structure of the property?

¥ Is the property managed on or off site?

¥ What is the employment duration of the current property manager associated with the project?

¥ What is the property's sales history, especially noting the time frame of the last sale?

¥ What is the current landlord's future plan for the property, especially if it includes a sale?

Given the high investment basis most of today's owners currently have in their projects, owners should be paying particular attention to tenant retention and attraction. Consider this fact. When tenants are surveyed, they routinely note that the primary reasons they remain in a project are: rental rate, location and customer service. If new owners have banked upon future increased rental rates to justify an investment, they will have no choice but to prove to the tenant that the location and customer service they can provide makes the higher rental rate a good value.

Looking ahead

Once REIT stock prices are impacted by increasing interest rates and plateauing property values, they will have some interesting choices. Improve the profitability of their existing properties by even further reducing operating expenses, increasing rental rates or both. Suffer through a lowered stock price, which will reduce their investment ability in the market. Sell off properties before interest rates get too high to take advantage of the current market. These actions are bound to influence this cycle and the next.

For the third-party management industry, the best strategy is to develop a strong track record for attracting and retaining tenants. They must also demonstrate the ability to improve the value of their properties through properly planned and executed capital improvements and energy conservation measures. As buildings continue to trade hands, this capability will be of paramount interest to owners who choose to maximize their overall investment yields for the long-term.

Thompson is regional vice president of San Diego for PM Realty Group, a full-service commercial real estate firm with nearly 3 million square feet in San Diego.

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