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When Ernst & Young last convened senior-level executives for its annual REIT CFO Roundtable in May 2012, the sector was still in the midst of a four-year streak of outperforming the general market. That had changed by the time participants gathered for this year's three-day event, held last month at the Arizona Biltmore in Scottsdale, and this year the discussion focused on the challenges of making an IPO happen. What follows are excerpts from a frank discussion among REIT executives, including Green Street Advisors Inc.'s Adam Markman, Simon Property Group's Stephen Sterrett, Morgan Stanley Real Estate Investment Banking's Cameron Clough and EY's Michael E. Straneva, who served as moderator. In part two of this story, EY's Howard Roth goes one-on-one with Spirit Realty Capital's Thomas Nolan Jr., who successfully took his company public in the fall of 2012.

MICHAEL E. STRANEVA: From 2009 to 2012, REITs beat the rest of the stock indices, but in 2013 things changed. REITs underperformed the general market. What was the cause, and when will it change?

ADAM MARKMAN: REITs have underperformed so far this year relative to other equities. Rising interest rates haven't helped, and the current crisis in Washington has led to a little bit of a logjam in the capital markets. The jury is still out as to how these changing markets will affect IPOs.

CAMERON CLOUGH: In the equity market, except at certain times—for example, the dawn of the modern era, when a lot of companies were driven by the need to refinance their balance sheets—you haven't seen huge volumes of REIT IPOs. Those are intrinsically difficult to do. If you have a year in which you see five to 10 IPOs get over the finish line, it's not a bad year. I think we'll see a number like that this year. If you're not going public driven by financial distress, then you're going public because it's an opportunity for something better: better capital access, valuation, liquidity. But if you're not being driven by distress, then you will ultimately decide to end up being public because it's a better outcome.

There are some very sophisticated investors who know what they like and don't like structurally, and have a very specific view of where they like to see value. And they are pretty important to the success of the deal. So the intersection of what is acceptable to the investors, on one hand, and what is acceptable to IPO sponsors, which generally speaking are not driven by distress, is a small one.

STRANEVA: How big is this IPO discount rate?

CLOUGH: That's a good question. It probably depends on where you measure from. The simple answer is probably 10% to 15%, but it depends on your starting point for the comp fair value.

STRANEVA: Everybody looks at the highest multiple REIT in their peer group and says, “I want to trade at that multiple as opposed to mid-tier,” right?

CLOUGH: They feel good about the companies they have created.

MARKMAN: One of the things I think is interesting is that so much of the growth we've seen in the REIT industry has been from guys that are avoiding that discount. Existing public companies that are converting to the REIT structure have added something like 10% to the industry's equity market cap, and we have also seen significant growth from non-traded REITs that are listing on the major exchanges. We've been vocal with criticism about a lot of aspects of that business, but the one thing non-traded REITs get right is their capital structure. They have very little debt, which allows them to list their companies without raising equity. Both are interesting ways to avoid that IPO discount. Companies aren't actually raising new equity or relying on a new group of shareholders.

STEPHEN STERRETT: When we look at investing in our existing properties, it's much easier to underwrite. It's much easier to execute, and less risky than a ground-up, new development. With a new project, you do your best analysis, but at the end of the day you are not sure how it will perform. That's what the investor is going through when somebody comes through on an IPO pitch, versus an established company that has been around for a long time. There is higher risk associated with an IPO.

CLOUGH: Scale is a critical factor in thinking about REITs these days. There is the ability to afford a fairly healthy aggregate G&A number. As a larger company, you can hire the best people; you can offer them great careers. On the debt/equity side, the financing costs are lower for a big company than for a small company. You have the ability to invest, to be in many markets, to deploy capital into the markets and assets that makes sense. If you're smaller, you have less option value across your portfolio. You may be forced to invest where it's not necessarily the right thing to do.

MARKMAN: One other advantage is liquidity. Institutional investors have trouble taking the time to underwrite a smaller company that they can't really deploy capital into. Bigger companies have additional liquidity, which helps them attract institutional capital.

Now, the real question is: How accurate are NAV estimates? Because with the exception of multifamily, we've generally not moved cap rates despite how much interest rates have moved.

STERRETT: The two sectors that had the highest NAV premiums a year ago were malls and strip centers, and both have now suffered dramatically. But if you think about the business and you believe that the economy is recovering, albeit at a relatively tepid pace, our business positions are getting better. In fact, in our comp property, NOI growth is higher in 2013 than it was in 2012; and it was higher in 2012 than it was in 2011. So it's a bit of a conundrum, because we're very much a consumer-facing business. We see business conditions getting better, yet the public market is valuing our real estate less so today than a year ago.

CLOUGH: Stock prices historically have done a fairly good job of predicting where NAVs are going rather than the converse. I would expect cap rates to rise, and I believe that the public market is doing a pretty good job of telling us that will happen.

REITs and Debt Ratios

STRANEVA: Are REITs evaluating whether they should increase debt ratios in order to pay a higher dividend, or move in the right direction?

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CLOUGH: I think there's a cycle here, a psychological cycle as well. We saw a lot of REITs chastised for their aggressiveness in managing their balance sheets going into the fall. And a lot of executives swore off debt. So the “new right” level was very low or zero. And they behaved accordingly. They pushed out maturities, replaced debt with equity and generally added a lot of protection to the balance sheet. I don't think there is any question that, on the margin now, a lot of people feel they can add a point or two or three of leverage; you've got plenty of room. My expectation, especially with those that have a falloff in share price, is that it's going to make issuing equity a little harder. We'll continue to see people push ahead on the balance sheet on the margin, hopefully within reason, but I think there will be a tendency toward more—a little more leverage.

MARKMAN: People have placed too great an emphasis on growing their asset base, which we think is the wrong place to focus. We think value per share makes sense. Sometimes that means making the company smaller and not bigger. So when there are anomalies between your share price and the value of your real estate in the private market, the right thing to do might be to shrink your company. The easiest thing to do to create value for shareholders when REITs are trading at big discounts to asset value is to sell assets at market prices and buy back shares at a discount to NAV. It's the easiest thing a CFO can do to create shareholder value. And the opposite side of that trade works when shares are trading at a premium—it's a green light for growth. You should be issuing equity and buying assets at market value, locking in shareholder gains. The math is really easy for any CFO to do, but most won't do it. They'll grow the company despite what the market is saying.

STERRETT: We enjoy this wonderful advantage in our sector, which is that we can pass our earnings through to our shareholders free of double taxation. But the tradeoff is that, generally speaking, we're not allowed, or don't have the ability, to retain enough cash to self-fund. Therefore, you need to run with less leverage. You need to run with more liquidity.

STRANEVA: Steve, you are a Fortune 500 company; there are dedicated REIT investors and the general public investing in Simon. How do you convince both groups to continue to invest in Simon, and not Google?

STERRETT: One of the things we certainly tell people, number one, is that if you are a nondedicated investor, chances are you're massively under-allocated to real estate, and you ought to think about that if you're trying to get a picture of the overall economy. If you look at REITs, they have been a very efficient and very rewarding sector for the general investor. They massively outperformed the S&P over a long period of time. And a lot of it was because it was a small, immature sector. It consolidated, got more sophisticated, got better management, got better access to capital. And we certainly think there is a lot of room to run. And number two, hopefully we represent ourselves as one of the best in class. You know, it's a chance to invest in a sector that, up until the mid-'90s when REITs became public, wasn't available to the nondedicated investor. The proof has been in delivery of REIT returns. And the returns have been fantastic. Cameron, in looking at returns, you have good yields in REITs. How much should REITs push in order to have a little higher dividend and attract more investors?

CLOUGH: The REIT label is an oversimplification of the range of types of companies in the REIT space. There is the very large and growing net lease REIT sector; that's the closest thing to a collection of bonds, of various credit ratings, inside a company's portfolio. And that is a very yield-driven business model. The dividend, the sizing of the dividend relative to cash flow, should reflect that.

I think a company like Simon is quite different. It's a much more dynamic, much more complicated business. There are development opportunities, redevelopment opportunities, international growth opportunities and lots of other things that Simon can do to drive shareholder returns beyond simply returning the cash that comes to it in the form of NOI. The answer to the question should depend on the business model.

STRANEVA: What REIT sectors do you see being undervalued in today's world? It seems like investors are moving sector by sector, which changes the dynamics.

MARKMAN: The two sectors where we see the biggest opportunities are apartments and malls. And they are really two different stories. The multifamily story is that we've gone from great to good in terms of growth, and that slowing of momentum has been enough to cause people to pull back. The numbers are still strong, but the rebound in single-family combined with new supply has public investors pretty nervous. We think they've overdone it and that there is some real upside.

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In the mall sector, as Steve mentioned, the NOI growth has been great. But the real story is from 2008 and 2009, when sales were great malls achieved shockingly good year-over-year sales growth through the recession. And it's those higher sales that drive your ability to collect higher rents today. You have long leases in place, so you can't really take too much advantage of better sales right away, but you're going to get your fair share of sales growth over time in the sector. So we still think there's lots of wind in the sail of the mall sector.

STERRETT: Construction is at a historically low level. There is just no new supply coming on. So to the extent you have retailers wanting to grow footprints, you have some population growth and some GDP growth. That demand for space is going to go back to the existing physical real estate, which bears very well for existing landlords.

MARKMAN: The broader investment market overall is doing very, very well. We're at all-time highs in the stock market. So shoppers that go to Nordstrom and Saks Fifth Avenue feel really wealthy, despite the job picture and where wages have been. Now, appreciation in the single-family housing market is causing the middle-class shopper to feel more comfortable spending, too. They have equity in their home again, and that gives them confidence to shop.

STRANEVA: A year from now, is the NAV index going to be higher, the same, or lower?

CLOUGH: That is a tough one. I'll say modestly lower.

MARKMAN: Higher.

STERRETT: Do I get to break the tie? I'll say this: The one thing that I'm pretty sure of is that the earnings will be higher. And I think if you look at the current P/E ratio of the REIT industry, it's not out of whack relative to the broader market. So the fact that earnings are growing because of the improving economy will probably push the overall index higher.

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