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Management Letter 1997
TO THE SHAREHOLDERS OF SECURITY CAPITAL GROUP INCORPORATED
Security Capital comfortably achieved its objectives in 1997. The stock is now publicly traded on the New York Stock Exchange (SCZ) with an equity market capitalization in excess of $5 billion. At year-end 1997, Security Capital had only $399 million of debt including $323 million of 6.5% convertible debentures, which are "in the money" and callable during the first quarter of 1999. This positions your company with what is perhaps the strongest balance sheet in the public real estate industry.
Our Class B common stock increased in value 31.4% from $24.74 per share in the beginning of 1997 to $32.50 at year-end. This performance compares favorably with the NAREIT Equity Index, the index of the National Association of Real Estate Investment Trusts (excluding health care REITs), which had a total annual return of 20.5%. In addition, our performance for the year was close to that of the S&P 500 which had another booming year with a 33.4% return. Put in a more rational context, the NAREIT Index and S&P performance for the past five years have been 18.1% and 20.2%.
Most important, for the year ending December 31, 1997, EBDADT (earnings before depreciation, amortization and deferred taxes) was $214.28 million, or $1.66 per fully converted Class B share, compared to $137.08 million or $1.39 per share one year ago, representing a 19.4% increase in EBDADT per share for 1997. Security Capital is in the business of creating long-term sustainable growth per share in EBDADT. Management considers EBDADT to be the appropriate measure of the performance for public real estate enterprises owned in a corporate structure. EBDADT most clearly reflects the impact of both a company's operating performance and its capital structure. In addition, the conservative expensing policy of Security Capital and its affiliated investees generates an extremely "high quality" EBDADT result. Security Capital's EBDADT performance for the seven years from 1991 to 1997 is detailed on the preceding page.
Security Capital's strategy is to deploy our capital into fully integrated value-added operating companies that are committing research and development expenditures in the creation of proprietary customer-delivery systems. As a result of their total commitment to providing unparalleled products and services to their customers, our affiliated operating company investees are in the early stages of realizing solid increases in operating performance. Over time, sustainable operating growth of these enterprises will generate a better understanding in the investment community of their differentiated strategies.
Similar to other leading American industries, real estate is in the very early stages of becoming globalized. Our timing, strategy, and performance during our first seven years have been excellent. The changes taking place outside of the United States linked with Security Capital's deep operating platform create very solid opportunities for profitable future growth. Please don't forget that Security Capital deploys capital, management focus and energy with a long-term perspective. Our strategic objective (with a conservative level of debt) is to achieve total annual returns in the 15-20% range.
THE U.S. AND INTERNATIONAL INDUSTRY TODAY
In the United States during 1997, public companies dominated the allocation of both new and recycled capital within the real estate industry. This structural shift, which began in the early 1990s, confirms that public company ownership is clearly recognized today as the optimal mechanism to maximize returns from the ownership of real estate. Consolidation within focused product types (see page three of this report) played an important and positive role in shaping the industry during 1997. At the other end of the spectrum, certain companies were also acquiring new businesses with unrelated strategies in an effort to generate positive investment spreads through the use of high multiple currency. Last year, 157 public offerings of common equity raised $22.1 billion for Real Estate Investments Trusts (REITs), up from the 86 offerings in 1996 that raised $8.5 billion. The stronger REITs with investment-grade balance sheets raised an additional $9.3 billion during 1997 -- compared to $4.7 billion in 1996 -- by accessing the public unsecured debt and perpetual preferred markets. The dominance of the real estate market by institutional direct investment is a phenomenon of the past. Although the trend of capital deployment being principally influenced by publicly held real estate operating companies is still in its early stages in the United States, it is beginning to have widespread impact around the world.
The two following charts illustrate the size and makeup of public U.S. real estate companies and contrast that with the total global capitalization of public real estate companies. |
Total U.S Capitalization: $290.8 Billion
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Total U.S Capitalization: $290.8 Billion
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The U.S. public real estate industry consists of three sectors, defined principally by management's ability to create real shareholder value beyond the underlying core assets of the company.
1. The first and ultimately the leading value creation sector, which will provide the most attractive and predictable source of long-term sustainable cash flow growth and corresponding investment returns, encompasses fully integrated value-added operating companies with proprietary customer-delivery systems. The management of these companies will focus on internal growth by using their real estateassets as "operating platforms" for creating real customer franchise value, and their businesses will be the high-return performers in their respective niches. Long term, this sector will represent approximately 15% of the industry's capitalization.
2. The second sector is composed of opportunistic multi-product public companies led by individuals who have reputations that allow them to deploy capital in many unrelated directions. By using the high current multiple of their currency, creative structuring, timing and the ability to attract capital inexpensively, these companies will generate attractive intermediate-term results. Opportunistic, unrelated asset plays will be their modus operandi, as opposed to internal growth and creating long-term value-added operations. Long term, this sector will not represent more than 5% of the industry's capitalization. Returns will be excellent, but a bit choppy.
3. The third sector, characterized as "index companies" will dominate the industry's capitalization (approximately 80%). These "asset accumulators" will be forced to grow externally via sometimes-expensive (higher-than-replacement-cost) corporate or asset acquisitions as opposed to having the capacity to create "leading edge" product from within, with resulting short-term hits to the operating statement. These public index companies will provide superior investment returns, liquidity and pricing compared to that historically provided by direct institutional ownership of real estate.
The early results generated by the first sector, fully integrated value-added operating companies, will begin to influence real estate trends on an international basis by the end of the current decade. Underlying the upcoming transformation of the global real estate industry is a powerful set of socioeconomic factors which will create substantial growth and profit opportunities for the leaders among public real estate operating companies. Positive population demographics, strong economic growth and a restructuring of the trade environment within EU Europe and the "new-NATO" member countries will create a business climate that compares very favorably with return opportunities in the United States. In addition, the economic growth rates of Asia and Latin America are two to three times that of the traditional economic leaders -- the U.S., Europe, and Japan. At appropriate points in time in the future, region by region, these newly emerging political, economic and trade environments will create tremendous new demand for the products and services of fully integrated value-added operating companies.
Europe's new integration will lead to significant increase in trade and, in the process, major shifts in real estate trends. For the first time, this consolidation will create opportunities to build strong, focused and fully integrated Pan-European real estate operating companies. These new companies will contrast sharply with the currently prevailing European "property" companies characterized by highly diversified portfolios, the performance of which has been measured by antiquated appraisal methods rather than per-share cash flow growth. Similar to what existed in the United States from 1975 to 1988, historically, the "real estate customer" in Europe has been the financial institution. These institutions dictate the needs of the true customer -- the direct user of real estate, or the tenant. Lease structures (and a transition from institutional direct ownership) will change radically in Europe as new operating company leaders realize that focusing on and servicing the true customer creates real, long-term shareholder value.
In Asia, family real estate entrepreneurs dominate the public real estate industry. Until 1997, Asian real estate companies were growing rapidly and capitalizing on what appeared to be an endless growth cycle. As these markets emerge from their "shaken state" and begin to mature with more stable political and fiscal systems put in place, new capital deployment will become less entrepreneurial. Intermediate-term, significant opportunity exists to restructure existing balance sheets and execute strategies to create well-organized enterprises with the focused, customer-based initiatives and operating systems necessary to pursue the significant growth in the region.
Security Capital looks at the world's growth regions as a global chessboard. As in the past, the firm's Real Estate Research Group will lead the way with careful analysis of regional economic, political, demographic and real estate supply forces. Allocating and reallocating capital to risk-adjusted high-growth, low-competition regions of the world will ensure the most attractive sustainable returns for Security Capital.
SECURITY CAPITAL'S STRATEGY -- THE CAPITAL DIVISION
The Capital Division, which generates EBDADT principally from its pro rata ownership of private and public real estate operating company investments, produced 91.9% of total EBDADT for the year. Security Capital plans to deploy in excess of $1.25 billion during 1998 in very attractive growth-oriented operating businesses both in the United States and internationally. As of the end of 1997, 8.8% of the Capital Division's total investment commitment was in new private start-up enterprises. These private start-up initiatives will be a key driver of the Capital Division's future growth in EBDADT. They are expected to represent 24% of the division's total investment commitment by year end. Creating and growing new private companies with the ultimate goal of transforming them into leading public operating companies remain the principal objectives of Security Capital's Capital Division.
The Capital Division's Global Strategic Group (described fully inside the front cover of this report) oversaw strategic investments in 14 public and private real estate operating companies. To achieve returns that meet Security Capital's hurdle rate, investees are not viewed as passive investments. Rather, each investment is viewed in a dynamic context. More specifically, during 1998 each investee in the Security Capital family will either introduce a major new business as a result of prior research and development, or participate in a major consolidation or business acquisition. In addition, each investee must demonstrate the characteristics of leading operating companies in other industries. The illustration below highlights these "key operating characteristics", which are integral components of every existing and potential new Security Capital real estate operating investee. These business practices help form Security Capital's business culture and are necessary to ensure high sustainable EBDADT growth and the resulting attractive rates of return. |
Key Business Operating Characteristics
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THE CAPITAL DIVISION -- Public Companies
Security Capital has made direct strategic investments in the following public operating companies:
Security Capital Industrial Trust (SCI) (Security Capital ownership -- 36.7%) (NYSE: SCN) is the largest publicly held U.S.-based owner/operator of distribution facilities, operating in 13 countries in North America and Europe. The company creates shareholder value through the SCI International Operating Systemª , which provides exceptional corporate distribution services and facilities to meet customer expansion and reconfiguration needs in 13 countries. SCI has 102.5 million square feet of distribution space operating or under development in serving its 315 multi-location global and 2,500 local customers.
Security Capital Atlantic Incorporated (Security Capital ownership -- 48.7%) (NYSE: SCA) is focused on becoming the preeminent real estate operating company for the development, acquisition, operation and long-term ownership of multifamily properties in the Southeastern United States. SCA's portfolio of multifamily communities included 21,693 operating units and an additional 8,639 units in development or planning.
Security Capital Pacific Trust (Security Capital ownership -- 30.7%) (NYSE: PTR) is the preeminent real estate operating company focusing on the development, acquisition, operation and long-term ownership of multifamily communities in targeted growth markets of the Western United States. PTR's portfolio of multifamily communities includes 43,465 operating units and an additional 16,103 units in development or planning.
Homestead Village Incorporated (Security Capital ownership -- 31.0%) (NYSE: HSD) is creating significant shareholder value by becoming the leading developer, owner and operator of moderately priced, corporate extended-stay lodging properties throughout the United States. The company's development program targets infill locations proximate to major business centers and convenient to services desired by its corporate customers. Homestead has 71 properties operating and additional 89 properties in development or planning.
Security Capital, through SC-USREALTY, has made indirect strategic investments in the following public operating companies. (SC-USREALTY is the leading European-based, publicly traded company owning strategic positions in seven U.S.-based public and private real estate operating companies. Security Capital owns 32.9% of SC-USREALTY.)
CarrAmerica Realty Corporation (SC-USREALTY ownership -- 38.5%) (NYSE: CRE) is a national company focused on becoming the leading owner, operator and developer of value-driven office properties in key growth markets throughout the United States. Management is creating shareholder value by offering Fortune 1000 companies exceptional customer service on a national basis. The company owns 255 properties (approximately 19 million square feet of space) with another 40 office projects under construction.
Storage USA, Inc. (SC-USREALTY ownership -- 34.7%) (NYSE: SUS) is a national company focused on becoming the leading owner, operator and developer in the United States of self-storage facilities and related services. The company's strategy is to maximize rents, occupancy and profitability at each of its facilities by offering outstanding value and customer service in this highly fragmented industrial real estate niche. The company owns or manages 402 self-storage facilities aggregating 26.1 million square feet in 31 states.
Regency Realty Corporation (SC-USREALTY ownership -- 39.1%) (NYSE: REG) is a company focused on becoming the leading owner, operator and developer of grocery-anchored neighborhood infill shopping centers in selected growth markets of the Eastern half of the United States. With the completion of its acquisition of the Midland Group, the company owns and manages 121 properties totaling 13.4 million square feet of retail space in 14 states.
THE CAPITAL DIVISION -- Private Companies
Security Capital has made direct strategic investments in the following private operating companies.
Strategic Hotel Capital Incorporated (SHC) (Security Capital ownership -- 30.0%) is focused on becoming the preeminent owner of luxury and upscale full-service hotel properties that are subject to long-term management contracts with leading global hotel management companies. The company uses research-driven capital deployment to identify investment opportunities in markets with high barriers to entry, develop strategic relationships with preferred operators of superior brands, and enhance operating results through active, disciplined asset management. As of February 28, 1998, SHC had made strategic investments of $1.46 billion in 19 properties located in North America and Europe.
GSG #3 (Senior Assisted Living Company) (Security Capital ownership -- 100.0%) is focused on becoming the preeminent developer, owner and operator of moderately priced assisted living facilities in the United States. The company intends to create shareholder value through its purpose-built facility design, moderate priced positioning and proprietary operating system. At year-end, Security Capital had committed $175 million to R&D and follow-on construction and operation.
Security Capital, through SC-USREALTY, has made indirect strategic investments in the following private operating companies. (SC-USREALTY does not pay dividends which results in substantial internal generation of free cash flow used to fund private to de novo start-up companies.)
Pacific Retail Trust (SC-USREALTY ownership -- 69.1%) is an $884.5-million, private-equity-capitalization company focused on becoming the leading owner, operator and developer of grocery-anchored neighborhood infill shopping centers in the Western half of the United States. The company has 53 centers and plans to become publicly traded in 1998.
City Center Retail Trust (SC-USREALTY ownership -- 100.0%) is a private company focused on becoming the premier owner, operator and developer of well-designed and well-managed urban retail properties. The company provides high-quality customer service on a national basis to top U.S. and international retailers in protected downtown and urban infill markets throughout the United States.
Urban Growth Properties Trust (SC-USREALTY ownership -- 100.0%) is a private company focused on acquiring, developing and owning strategically located income-producing land and parking garages in key urban infill locations in 14 targeted 24-hour markets within the United States.
Parking Services International is focused on becoming the preeminent international operator, developer and manager of parking facilities. The company provides superior operating and parking solutions for parking facility owners and customers on an international, regional and local basis.
CWS Communities Trust (SC-USREALTY ownership -- 83.0%) is one of the leading private manufactured housing community owners, operators and developers in the U.S., with over 14,500 spaces in 36 communities in eight states operating or under contract or development. |
Total Market Capitalization of Direct/Indirect Investees *
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* Total equity and debt of 14 start-up and public companies.
Security Capital ownership: 30.0% to 100.0%
** Reflects 25.09% leverage |
SECURITY CAPITAL'S STRATEGY -- THE SERVICES DIVISION
The Services Division, which derives EBDADT through fees from the Real Estate Research Group, the Global Capital Management Group and the Financial Services Group, produced 8.1% of EBDADT during 1997. By the year 2000, the Services Division is expected to contribute approximately 25% of Security Capital's total EBDADT. The Global Capital Management Group (GCMG) will be a key component of the Services Division's future growth. During 1997, securities under management by the GCMG grew from $1.87 billion at the end of the first quarter to $3.55 billion (see graph below). The number of separate investment entities grew from two to four. Securities under management are expected to grow at a similar rate for 1998 and the GCMG is expected to manage nine distinct investment entities (including separate account products and mutual funds) by year-end. International real estate securities investment management by Security Capital's Brussels, London, Luxembourg and new Asian offices will drive the majority of this new growth.
Since 1995, Security Capital has made significant research and development expenditures to create the research and operating platforms of the GCMG. Today, the GCMG and the Real Estate Research Group have over 50 professionals in five offices around the world. The GCMG integrates extensive property market research with in-depth evaluation methodologies to provide a unique and extremely sound method of identifying value in real estate securities. In addition to specialized teams focusing on real estate research and financial performance, a disciplined framework for analyzing and evaluating public company management strengths and growth strategies is critical to GCMG's research-driven investment process. Security Capital U.S. Real Estate Shares (see first year's performance shown on the bar chart below) is the GCMG's first mutual fund. It is now publicly available through America's leading no-load distributors. By the end of 1998, the GCMG expects to have three additional highly focused mutual funds available to the public.
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Growth in Total Capital
Under Management by GCMG
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Performance Backed by Experience
Security Capital U.S. Real Estate Shares
Comparative Returns vs. Industry Benchmarks
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Investment Entities 1997
SC-USREALTY
SC-GLOBAL REALTY
SC-Preferred Growth
SC-US Real Estate Shares |
Source: Security Capital Global Capital Management Group,
Bloomberg L.P., NAREIT, Wilshire Associates, Inc.
For more information on SC-US Real Estate Shares, you can
contact us toll-free at 1-888-SECURITY or contact your own
mutual fund representative. |
THE FUTURE
The continued future success of Security Capital will be a function of our ability to continue to attract, develop within our unique culture, and retain leading international business executives. During the past year, our 14 directly and indirectly owned operating companies made excellent progress building superior depth in their management teams. The success achieved in our Capital Division under the leadership of Tom Wattles, Todd Mansfield and Jeremy Plummer was outstanding. As important, the Services Division, under the leadership of Jeff Cozad, Tony Manno, Don Suter and Paul Szurek, enjoyed exceptional performance. Enormous gratitude goes to each of these superior executives.
Each year, management has emphasized that the significant shift underway in the global real estate industry is still in its infancy. As a result, there is enormous opportunity to create an organization that will ultimately lead this immense and constantly evolving global industry. The mission and resulting economic benefits are clear. Execution, then, is the key. Security Capital's success relies on our ability to continue to build deep global management teams in both the Capital Division and Services Division.
Your management team will continue to thoroughly research promising opportunities in different parts of the world to achieve attractive rates of return for our shareholders. Our ongoing commitment to research and development will ensure our ability to build an operating capability that creates value for our companies and their customers. This will create "corporate franchise value", which translates into increased revenue per customer, greater profitable market share and superior sustainable growth in per-share performance.
A high percentage of public real estate companies dividend the majority of their annual cash flow to shareholders. This necessitates constant accessing of the equity markets (and the issuance of new shares) in order to fund growth. Security Capital's management is very bullish on the firm's future. Rather than paying a dividend on our common stock, growth, to the extent possible, will be funded with conservative debt and internally generated cash flow. As a consequence, this non-dividend strategy has necessitated approximately 10% of our valued "early shareholders" to exit via the public markets. These fine institutions have been our friends and their support has been appreciated. Fortunately, new institutional capital desirous of participating in the early stages of the real estate industry's global transformation has joined as new shareholders.
As Security Capital continues to expand around the world, your management team is dedicated to strengthening our exceptional operating platform. You can now monitor our progress daily at Security Capital's web site, www.securitycapital.com, by directly accessing press releases, quarterly and annual reports, and our mutual fund information. Our Annual Meeting will be held in Chicago on May 21, 1998. As in the past, we will spend about two minutes on "official business", and then spend several hours really getting into our company, its strategy and the state of the industry. Your forthcoming proxy materials will explain how you can obtain the card you will need for admission.
Security Capital's people at both the operating and board levels are deeply committed to making your company the leader in the global real estate industry. All of our colleagues, the Board of Directors, and Shareholders deserve significant thanks for your continued support.
William D. Sanders - Chairman Chairman
March 31, 1998
C. Ronald Blankenship - Operating Committee |
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