The Real Estate Update
By Michael Dowd (TMF Yorick)

Shopping Center Investors at Lazard Give Troubled Alexander Haagen $235 Million...
European connections, institutional investments, and U.S. REITs...

Is it love, at long last?

BOSTON, MA (June 11, 1997) -- Cole Porter loved France, New York and California, and he was pretty fond of all the things big money can buy. I think he'd have really loved Lazard Frere's recent spectacular investment in Alexander Haagen's California shopping mall REIT.(1) To tell the truth, I am pretty intrigued myself. I can almost hear him sitting at that white Steinway in his apartment in the Waldorf Towers, looking at the Billy Baldwin decor and wondering if there will be more such deals... or is this just an aberration?

Is it the rainbow or just a mirage?
Will it be tender and sweet or just a massage?
Is it a brainstorm in one of its quirks,
Or is it the best, the crest, the works?

Well, enough about 1930s high life for now, let's discuss what happened. On June 2nd ALEXANDER HAAGEN PROPERTIES, INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: ACH)") else Response.Write("(AMEX: ACH)") end if %> issued a press release saying it had: "Entered into an agreement providing for a strategic investment in the company by a fund managed by Lazard Freres Real Estate Investors LLC ("LFREI"), a real estate investment affiliate of Lazard Freres & Co. LLC, a leading global investment bank.(2) Since its founding in 1963 by Alexander Haagen, the Haagen organization has acquired, developed and redeveloped more than 100 shopping centers. The company's core portfolio and operations are currently focused in the strengthening Southern California marketplace and in selected other Western markets."

The release went on to say that LFREI had agreed to purchase $235 million in newly issued common shares at a purchase price of $15.00 per share, representing a modest premium over the REIT's recent trading range, which had been $13.75 to $14.75. "Upon full funding, LFREI will own an equity interest in Alexander Haagen Properties Inc. of approximately 38% on a fully diluted basis (57% of the outstanding common stock, subject to certain voting restrictions and a negotiated standstill agreement)."

Well before Lazard got involved, Alexander Haagen had been sporting a debt/market cap ratio of 64%, more than double its peers among shopping center REITs, which average only 31%. I think a more meaningful number is EBITDA coverage (that's earnings before interest, taxes, depreciation and amortization divided by the interest on the company's debt). Alexander Haagen's EBITDA coverage ratio has been 1.6 to 1 while its peers have 4.1 dollars in income for each 1.0 dollar in annual interest. Zowie bingo, with one stroke of Lazard's mighty pen, Alexander Haagen was out of the dreaded "Box."

What's "the Box" you ask? Well, pull up a bar stool and I'll tell you. Milton Cooper took a shopping center REIT named KIMCO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:KIM)") else Response.Write("(NYSE:KIM)") end if %> public on Nov. 25, 1991. At that moment he conclusively proved to Wall Street that REIT IPOs could be sold again, and the end of the great '80s drought for real estate liquidity was suddenly over. Cooper was smart, though. He was very careful to under-promise the amount of FFO (REITspeak for earnings) growth he could really deliver. By late 1992 it was clear that KIMCO was racking up great earnings and was going to outperform what Cooper had promised.

Wall Street's underwriting departments are pretty quick to pick up on things like that, so from late '92 through mid '94 there were a lot of wanna-be KIMCO IPOs, leading to something like a 350%+ increase in the size of the equity REIT market. There were real reasons for underwriters to woo the shopping center owners. First, there has always been an advantage to shopping center owners in holding multiple centers. You really have to own a bunch of locations if you want to get any attention from the major chains. Those tenants are the best traffic generators and the most bankable tenants, so owners need them. Consequently, the successful owners always end up with the best tenants and more centers.

In addition, there had not been nearly as much over-building of retail in the '80s as there was of offices and hotels and the like. Retail vacancies had been hanging at about 10% while office vacancies had shot up to 25%. Unlike other property categories, there just weren't very many burned shopping center investors. So with shopping centers Wall Street had both legs of the transaction -- large enough pools of property in single control to make good-sized IPOs and enough potential investors to sell them to.

Unfortunately, not all of the sponsors of these new REITs were as restrained in their promises as Milt Cooper, and there was no evidence at all of any particular restraint exercised by the underwriters. Many of these new REITs were so tightly underwritten that any burp in operations would put their dividends in immediate jeopardy. TAUBMAN CENTERS INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TCO)") else Response.Write("(NYSE: TCO)") end if %> for example, was underwritten by a group led by Merrill Lynch. It went public with only 1 to 1 dividend coverage. They only got that by annualizing the earnings for the last 90 days before it went public.

Other shopping center REITs were underwritten with dangerous debt. Many had floating rate financing that, like floating rate home mortgages, offered lower initial interest charges. Also, they posed a clear risk to the dividend if (and when) rates rose.

There was another problem with many of these IPOs that was particularly tough on retail REITs. Each shopping center owner wanted to get as much money as he could out of his IPO. The more he had to pay on his debt, the less would be left for paying dividends, and the less stock he could sell. In order to get the lowest possible rates on their debt, many issuers used REMIC financing collateralized by most or all of their assets.

That had its own risks. A shopping center or a mall can be a bear for eating capital unexpectedly. If and when a major anchor goes bust, you will immediately need a big bunch of money to re-fit and upgrade the center for a new anchor tenant. With nothing much left to hock, and almost all the dividend already promised to shareholders, there was no reserve for maneuver in bad times left for these IPOs.

During the next two years several bad things happened. The retail Chapter 11s of the mid '90s began to roll in. Tenants blew out, or at least the Street got worried about their credit. Center owners facing empty anchor stores found they didn't have the traffic to support their in-line tenants. Re-leasing of in-line stores became much harder. Meanwhile, floating rates rose. The analysts following REITs began to deduct higher and higher reserves for re-leasing and capital improvements from reported FFO. Adding insult to injury, even the definition of FFO was readjusted to make it tougher.

Alexander Haagen sold its IPO on December 20 1993 at $18 per share. The prospectus included what turned out to be some over-stressed underwriting assumptions. Then the REIT ran into some bad luck, notably fears that proved true of tenant failures in Southern California's troubled economy. The stock declined to the low $16 range by February 1994. Occasionally in 1994 it flirted with $18, but in general, battered by California's bad news, it fell below $11 in 1995. As California recovered, so did Alexander Haagen but for the last year it's been stuck between $13 and $15.50 a share. In any case, any new stock offering was likely to be dilutive to the old share holders. It had too much debt, and was therefore squarely in the "Box" where spread investing becomes impossible.

Being barred from spread investing is particularly tough on shopping centers which often get 55% or more of their rents from grocery and drug stores under long-term leases. These leases typically run 15 to 25 years and contain a percentage of sales rent adjustment clause as a form of inflation hedge. In time of low inflation, though, these retailers don't grow same store-sales very fast. So in addition to having some anchors blow out, others were growing slowly at best. Percentage rents from a grocery store used to be forecast in about the seventh year of operations. My partner Bill says now they kick in shortly after the 12th or never.

By early April 1997, Alexander Haagen was trading at $14. That converts into saying the whole REIT was selling at about a 9.9 implied cap rate. That in turn means that market cap of Alexander Haagen was about equal to the value of the properties it owned.

Its debt was equal to 64% of its market cap. That's almost private market loan-to-value, far too high for any more debt. It couldn't sell new stock, either, to buy any more real estate. Alexander Haagen had a 10.3% dividend yield, and it was also selling at a multiple of about 10.3 times CAD (FFO adjusted for reserves).

Well, the bad news of that equation is this. The absolute best you could buy a neighborhood shopping center for is about a 10% yield. Let's say a shopping center costs $10 million and generates 10% cash on cash -- $10 million x 10% = a maximum of $1,000,000 in annual CAD.

Alexander Haagen was selling for a 10.3 multiple of CAD, but any new equity sold would also require payment of a 5% commission to the Street. If Alexander Haagen wanted $10 million to buy a new center, it would have to raise $10,500,000 in new stock in order to pay the commissions to Merrill et. al. It would at best have only $1,000,000 in new cash flow for FFO. It would only be able to raise 10.3 times that cash flow in gross stock price or $10,300,000. Every such transaction Alexander Haagen closed would have left the REIT $200,000 poorer. Not unsurprisingly, Alexander Haagen didn't do much in the way of acquisitions. Equally unsurprisingly, the stock lay there like lox, waiting only for the arrival of a bagel and cream cheese to be eaten. Enter Lazard with a quarter billion dollars or so and that picture changes dramatically. The press release continues:

"The strategic capital alliance with LFREI will enable the company to capitalize on its historical market leadership by acquiring, redeveloping and developing new neighborhood, community and power centers in its traditional core markets on the West Coast and in selected other Western markets. Haagen will use the capital provided by the LFREI investment to significantly strengthen its balance sheet and to expand its portfolio of owned shopping centers."

Is it the rescue or is it the wreck?
Is it an ache in the heart or just a pain in the neck?
Is it the ivy you touch with a glove?
Or is it at long last love?

But while Lazard liked Haagen's properties, it looks like it may want to tactfully change present management. "Alexander Haagen, the company's 78-year-old founder, will continue as CEO and chairman, and his son, Alexander Haagen III, will remain vice chairman. In addition, the Haagen management team will be expanded to include a to-be-named real estate executive recruited to serve as president of the company and to provide a clear succession plan for the Haagen family. Following shareholder approval, LFREI will have the right to designate four representatives to a restructured 10-member Board of Directors. An eleventh Board seat has been reserved for the incoming president, whose appointment is expected by year end."

So someone new picked by Lazard will be running Haagen, and that new executive is going to have access to Lazard's international connections and mega-check book. Haagen can invest again, big time. But who's Lazard and what do they know about buying, financing and running shopping centers anyway? Well, the press release covers that too, with full PR agent ruffles and flourishes.

"Today's strategic alliance with LFREI is a watershed moment in our company's history, combining the expertise of one of the preeminent shopping center owners and developers in California with the capital markets sophistication of a leading global real estate investor," said Chairman Alexander Haagen. "This substantial infusion of new equity capital positions our company for future growth, allowing us to take full advantage of exciting opportunities available to us in recovering retail markets on the West Coast. Our association with LFREI will also give us a unique competitive advantage by providing us with superior strategic advice and efficient access to capital."

Lazard chimed in:

"As one of the most experienced retail real estate operators in California, Alexander Haagen and his management team have demonstrated a history of success in retail development and an unmatched understanding of local property markets," said Arthur P. Solomon, Chairman of Lazard Freres Real Estate Investors, LLC and Senior Managing Director of Real Estate at Lazard Freres & Co. LLC. "The company has long been one of the strongest retail operators in California. As a result of our investment, it will now have the access to capital necessary to grow its core property portfolio in the recovering Western markets."

Is it a breakthrough or is it a break?
Is it a real Porterhouse or merely a steak?
What can account for these strange pitterpats?
Could this be the dream, the cream, the cats?

If you want to speculate on that, you should all know that the Lazard people have a very strong real estate venture capital track record, dating back to the days when the brilliant, irascible Andre Meyer was Lazard's New York chief rainmaker. In real estate he was also the elder Zeckendorf's lead investment banker, and helped change the face of New York for better or worse in the post war decades. In particular, in 1953 Lazard's $3.5 million investment in Roosevelt Field was key to Zeckendorf developing the first shopping center ever built on Long Island. For what it's worth, I personally consider Meyer to have been the most intelligent and talented U.S. investment banker I know of in this half of the twentieth century, maybe only tied by Serge Semenenko.

Later Lazard took over Roosevelt field when Zeckendorf went kablooie. In a tax-free exchange it swapped the center into a Lazard advised private REIT (Corporate Property Advisors) and spent another $4 to $5 million making it an enclosed mall. By the early 1990s it had an appraised value of $21 to $23 million.

At that point, Lazard and its affiliates were involved in a variety of real estate transactions, including a huge amount of subsidized housing, but still very much focused on shopping center property. At that time, Lazard's chief real estate banker under Meyer was Disque Deane, who was also pretty talented. Under Deane and starting about 1963, Lazard became one of the largest investment banking players in shopping center investments in the country. They tended to lease anchor positions in their centers to major chains like Safeway and then to use the depreciation to cover their earnings in other areas, and to hold the residuals for their old age.

At one time, Andre Meyer (perhaps jealous of Deane's independence from his and Lazard's control) wanted to dissolve Corporate Property Advisors. However, Morgan Guaranty's trust department was finding CPA pretty useful and voted no, so that didn't happen. By the early 70s, Corporate Property Advisors had over $2 billion in assets and Deane was reported as saying his net worth was $70 million. I hear Deane's later years involved the ownership of several lovely homes in a number of countries and a substantial net worth, so his real estate expertise seems to have worked out pretty well for him.

Deane was a pretty tough guy, though. Cary Reich wrote a wonderful biography of Meyer entitled Financier in 1983. In it he reported on a developer who said, "Let me tell you what it's like to deal with Disque Deane. Deane is the kind of guy who would sell someone a field. A few months later the guy comes by and says: 'You told me I could grow nuts on it. I can't.' And Deane would answer. 'Oh my goodness. I never said that. I said you could go nuts in this field.' "

It is my understanding that it is Deane's Lazard heirs at Corporate Property Advisors who made this investment. In fact it's Lazard Freres Real Estate Investors. LFREI manages several realty investment funds including LF Strategic Realty Investors, LP, a strategic investment fund capitalized with almost $1 billion that is committing to this Haagen investment. That means hands-on management expertise and major shopping center contacts are now available to get the value of Haagen's assets moving. I have no way to tell you whether they will be successful, but I have an idea of how much it might conceivably be worth if they are. Haagen sells at 10.3 times FFO. KIMCO sells at over 13 times FFO. And with new money to spend, a new blood management may be able to add to FFO as well. For one thing, Lazard's new capital and unquestioned expertise in debt could help lower tattered Haagen's cost of funds immediately.

But is this the beginning of something much, much bigger?

Is it in marble, or is it in clay?
Is what I thought a new Rolls an old Chevrolet?
Is it a saphire or simply a charm?
Is it... or just a shot in the arm?

To get beyond this one transaction, Lazard's relationship with European upper-income investors is intriguing to think about. We have all long noted that the U.S. REIT is low leveraged. Wealthy Europeans are more comfortable with that format than the traditional high leverage American format private investors are used to. It is likely that we will have more offshore money coming this way.

My partner Bill Campbell (WGCAMP) also notes that Lazard has a long real estate investment relationship with RODAMCO. That giant Dutch pension fund sponsored REIT also buys shopping centers, but unlike the Corporate Property guys, they are more passive investors.

But while money is probably on the way into U.S. REITs, there are some who think the next step is likely to be U.S. REIT money flowing back across the Atlantic and buying European properties. La Salle's Director of Research Jacques Gordon has been pretty persuasive in arguing that an allocation into European property will improve the expected yield of a U.S. real estate portfolio.

My partner Bill in particular notes that European real estate, notably French, is in the throes of an over-built, failed bank crisis that looks a lot like the US property market did in 1989. He strongly believes U.S. REITs and REOCs can find spread investing opportunities abroad that could extend their growth though the next five years or so. All you have to do is figure out the inter-country tax issues. With a couple dozen billion dollars in transactions coming, Bill thinks some lawyers have already figured them out. I once built a deal using the Irish docks district tax exemption that wiped out nearly all taxes between U.S. property and a German investor group. If I could do it you can bet your bottom mark (or shilling or lire) that they can.

Is it today's thrill or really romance?
Is it a kiss on the lips or just a kick in the pants?
Is it the gay gods cavorting above,
Or is it at long last love?

Soooo, REITsters, now for the good stuff. Where was Cole Porter when he first thought of the tune "At Long Last Love"? Who do you think first sang that Cole Porter song? And when? Well I know YOU know, but some of my other readers may not, so I'll tell them.

Porter was riding horseback at the Piping Rock club in Locust Valley in October 1937. He insisted, against his groom's advice, on riding a very mettlesome and edgy horse. The horse reared at the sight of some bushes and fell over on Porter, crushing one of his legs. It tried to rise and then fell again, crushing the other leg. Porter was taken to a hospital in shock where he remained unconscious for two days. After he recovered consciousness he said, "When this horse fell on me, I was too stunned to be conscious of great pain, but until help came I worked on the lyrics for a song called 'At Long Last Love.' "

The song was first sung on stage to Lupe Velez by a young Clifton Webb in Porter's 1938 hit, You Never Know.

Will Lazard and Haagen work out? Will there be a great flow of European funds into U.S. REITs? Will U.S. REITs buy a lot of European property? Well, maybe Cole Porter was right. You really never know, do you?

Respectfully,

TMF Yorick

(1) The press release notes Alexander Haagen Properties, Inc., is a fully integrated, self-managed and self-advised real estate investment trust, is a leading developer, owner and manager of retail shopping centers, primarily in Southern California. The company, based in Manhattan Beach, California, currently owns or controls an 8.3 million square foot portfolio consisting of 38 properties and has a total market capitalization before the LFREI investment in excess of $650 million. The Haagen portfolio includes two regional malls, eight promotional and power centers, 14 neighborhood and community shopping centers, and 14 single-tenant retail facilities.

(2) Finally a bit of disclosure. While I have long been fascinated with Lazard and Andre Meyer, I have never actually done any business with the firm. However, my firm has (only recently) been doing a some speculative work with some of the good folks at Lazard and I've been involved in that. Still, they take the Chinese walls very seriously and the very ethical people I have been in touch with had nothing to do with -- and did not know about -- the Alexander Haagen deal until it hit the papers. All I know about the Haagen deal is what I read in public journals, and most of the background on Lazard was from Cary Reich's Financier, published by William Morrow in 1983. The information on Cole Porter comes from COLE, published by Holt Rinehart in 1971.

Michael Dowd ([email protected])

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