How to Beat the REITs Part 2: Operations

For most private owners, the sudden presence of a public REIT next door is very bad news.

But not for David Hillman. The founder and CEO of Southern Management has watched the big REITs muscle into its Mid-Atlantic markets over the last 20 years, gobbling up the most desirable assets with a bottomless stomach, and driving up prices beyond his reach.

Yet, what makes the REITs intimidating—their size and structure—can also make them vulnerable, he says.

“If a REIT owns a building next door to me, I’m the happiest guy on the planet,” says Hillman, who founded the Vienna, Va.-based company in 1965. “They’re very good at getting investors to buy their stock. But the last thing they care about is the customer—they just nickel and dime them to death.”

In fact, the presence of a REIT right next door can actually be an advantage, Hillman says. The first thing to do, though it seems counter-intuitive, is to stop advertising.  
“The REIT will spend more on advertising than they will on maintenance, they’ll generate plenty of traffic,” says Hillman. “The small guy just has to make sure that his property has really terrific curb appeal.”

And if a REIT builds a new development right next to your existing asset, that can also play to your strength. The rents charged on a new product will invariably be higher than those on your existing asset. And it won’t take long for renters to run afoul of the REIT’s rent growth Modus Operandi.

“Anything you build today is going to need a significant premium over our in-place rents, so we’d welcome it, because it would give us something to sell against,” says Ian Mattingly, director of acquisitions and asset management at Dallas-based LumaCorp. “And once their renters get that 8 or 10 percent rent increase at the end of the year, they’re coming across the street to us.”

Localized
Being knee-deep in operations breeds a level of local knowledge that’s irreplaceable.

One supposed advantage that REITs have is “access to information,” a deep level of research that measures a submarket’s fundamentals and trends. But that research may not be worth the paper it’s printed on.

“The on-the-ground information a smaller private holder has is far more valuable, current and relevant,” says Matthew Lester, founder and CEO of Orchard Lake, Mich.-based Princeton Enterprises. “The information furnished to REITs lags what I already know in a particular marketplace.”

For instance, Intel recently transferred hundreds of workers from California to its Austin facilities, but didn’t announce the move publicly. While that information might not show up in official metrics, owners and lenders active in Austin knew about it and planned accordingly.

Even in a primary market, there are plenty of pockets in and around town that the REITs won’t consider. Having a wellspring of local knowledge allows you to make smarter investment decisions.

“They might not see the population growth in an overall market,” says Mattingly. “But since we can get in there with local knowledge and understand that this location is different than two streets over, we can really go after these sub-submarkets.”

Being a long-term holder can also be a marketable advantage. Many REITs have relatively short investment horizons. And while REITs keep their properties in tip-top shape, they’re disinclined to invest in infrastructure if it doesn’t provide a return.

“REITs focus on things that are going to bring more revenue. We’re able to sell the fact that we’re going to maintain things that don’t necessarily increase revenue, like HVAC systems and roofs,” says Cindy Clare, president of the management arm of McLean, Va.-based Kettler Inc., which owns 7,875 units along the east coast. “We do much more of that because we’re looking at a long-term hold, not at quarter to quarter results.”

Creative Programs
Smaller owners can also use their flexibility to implement programs most REITs would never dream of. For instance, Southern Management pays the utility costs on 80 percent of its 25,000 units.

Since the company is buying electric in bulk on the wholesale market, it realizes a 40 percent discount compared to retail costs. And by locking in a price for the long term, it’s able to predict where prices are going to be. The utility cost is baked into the rent, but it adds a level of convenience—and cost savings—for the resident, and has become one of the company’s marketing tools.

One way that Princeton Enterprises has gained a competitive advantage is by taking certain functions, like bad debt collections, in house.

The company would typically recover between 3 percent and 5 percent of bad debt using a third-party service. But under it’s own initiative, the company is now recovering about 15 percent. For an annual bad debt bill of about $1.5 million, the company is now getting about $225,000 back, as opposed to the $60,000 it recovered using third parties.

The Village Green Cos has lowered its operating expenses each year since 2008 by bringing a variety of previously sub-contracted services—renovation, landscape architect, interior decorator, advertising, green building experts—in house. The company also now trains its maintenance staff in electrical, HVAC and plumbing work, raising their compensation in the process, so that very little is now farmed out.

“We’ve reinvented ourselves in how we hire, train and compensate people,” says Jonathan Holtzman, chairman and CEO of Farmington Hills, Mich.-based Village Green Cos. “This recession taught us how to dramatically reduce our operating expenses—we’re not relying on rent increases, we’re relying on NOI growth in part from lower expenses.”