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This story was excerpted in U.S. 1 Newspaper on March 31, 1999. All rights reserved for the author.

In Real Estate, Vision Counts, Too

by Peter D. Linneman

A frequent topic of casual conversation at gatherings

of real estate owners is the lack of visionary managers in other industries.

The common view — which is probably correct — is that there

are only a handful of visionary leaders in industries such as auto,

steel, banking, or rails. Yet almost every operator of real estate

who participates in these conversations believes that they are a visionary

leader. One can only wonder at the fortunate happenstance that when

the Almighty was passing out visionary leadership skills, every other

major industry was only granted three to six great leaders, but the

real estate industry was blessed with 4,192 (or at least every ULI


The truth is that the real estate industry has — at most —

a handful of visionary leaders who also possess the ability to sell

their vision to their employees and the capital markets. It is essential

that the industry’s assets become concentrated in the hands of this

select group if it is to become a strong industry.

As was the case in other industries in the early years of their transformations,

the real estate industry has far too many mediocre operators, controlling

too many assets. The consolidation of capital-intensive industries

has historically been particularly rapid during periods of industry

distress. This is because in periods of distress only the strongest

can effectively access the capital needed to survive and grow. In

normal times the consolidation process continues, though at a slower

rate, as some weak operators see the handwriting on the wall and sell

their assets while they still have real value. As a result, they receive

prices greater than their assets are worth to them, but less than

they are worth under the control of the strongest industry operators.

These consolidation dynamics are at work in the real estate industry

today. As the industry recovers, the "forced" consolidation

process will slow — until the next period of industry distress.

In fact, one of the reasons industry evolutions take so long is that

it takes several periods of industry distress to fully shake out the

weakest operators.

In capital-intensive industries the relative importance

of "great ideas" to the "capital required to execute these

ideas" is low. Thus, in order to generate the greatest value from

the limited capital allocated to the industry, it is essential to

generate the biggest bang per "great idea." When capital was

irrationally allocated to the real estate industry was possible for

even the most mediocre operators to survive and prosper. However,

real estate has now joined the ranks of all other industries where

capital is more or less efficiently rationed — perhaps for the

first time in its history. Once capital demands a return, only those

most skilled at predictably generating returns ultimately survive!

It is particularly important in capital-intensive industries like

real estate to concentrate asset control under a few visionary operators.

Real estate owners should realize that collections of assets, without

the ability to obtain visionary-driven growth, always trade at steep

discounts. The in obvious examples of this phenomenon are closed-end

mutual funds, which generally trade at 20 to 30 percent discounts

to their liquidation values. This is because value derives from the

visionary enhancement of assets, rather than the mere holding of assets.

Those operators with the ability to add the greatest value to their

assets — as Warren Buffett has done at Berkshire Hathaway —

will ultimately outbid mere asset collectors for managerial talent,

tenants, and additional properties.

The value of managerial vision (and the ability to sell this vision)

in the real estate industry will increase as consolidation occurs,

cash flow payout ratios to owners decrease, more equity is used in

the capital structure, and binding debt operating and financing covenants


Why? If a property company borrows heavily and pays out its entire

cash flow, it has little borrowing capacity, and therefore is restricted

in its operations by debt covenants. This, in turn, means that when

management identifies value-enhancing opportunities (which generally

require the deployment of significant amounts of capital), they cannot

be executed without time-consuming and expensive capital market activities.

Since capital market "windows of opportunity" do not generally

coincide with operating and investment "windows of opportunity,"

many value-enhancing opportunities slip away for the lack of timely

capital. As a result, firms constrained in their ability to exploit

opportunities without going back to the capital markets will be valued

at discounts, while those with ready access to capital will be priced

at premiums.

Peter D. Linneman is the author of "Forces Changing

in the Real Estate Industry Forever," published by the Wharton

Real Estate Review. The remarks above have been excerpted from that

article. Linneman spoke last week in East Brunswick at the New Jersey

chapter of the National Association of Industrial and Office Properties.

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