Unnerved by Target’s disappointing earnings report in February, we checked in with Burland East, a perspicacious 57-year-old who has spent more than 30 years investing in commercial real estate. East specializes in real estate investment trusts, or REITs.
We were worried. After all, the best-known index of REITs, a mouthful called the FTSE NAREIT All Equity Index, is about 20% invested in retail space. With Macy’s, JCPenney and Sears closing hundreds of stores this year, that had to spell trouble for REITs.
Indeed, East gave a grim prognosis. “What’s happening to retail is not instant death exactly. It’s more like Alzheimer’s. The core idea of a mall — driving to it, buying something and going home — is vanishing.”
None of this bothers East. He has a secret sauce for real estate investing, and retail stores are not a big ingredient. As you probably know, REITs specialize in one property type only, such as shopping malls, timberland, data centers or self-storage facilities, giving investors like East a chance to design pure plays for his portfolio. For example, he invests only limited amounts in retail REITs, i.e., less than 10% of his overall assets.
His secret sauce? Simple. Invest in properties where you can charge the tenant higher rent. He’s identified four conditions for when that’s likely: Only a few companies have the know-how to build a facility; high barriers to entry exist for new developers; high barriers to exit exist for tenants; and tenants have a healthy underlying business. (Of course, there is no guarantee that any investment will achieve its objectives, generate profits or avoid losses.)
Think about the last time you sat in a dentist’s chair. Millions of dollars of equipment surrounded you, from the autoclave that sterilizes surgical tools and dental instruments to the X-ray machine to the chair itself, bolted to the floor. Like many tenants of medical office buildings or research laboratories, dentists find moving an expensive hassle. East puts dentists and other medical office building tenants in the “high barriers to exit” category. He believes, given the choice, they’ll pay higher rent rather than move.
Or consider cell phone tower companies. The three largest that own, lease and operate these towers are all structured as REITs: American Tower (NYSE: AMT), Crown Castle International (NYSE: CCI) and SBA Communications (NASDAQ: SBAC). The tenant, which is a mobile phone company, has few options if it thinks its rent is too high. That’s in stark contrast to, say, the more than 4,000 suppliers of apartment buildings. If rents get too high, there’s no barrier to exit — the tenant moves.