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Management Letter 1998
A LETTER TO THE SHAREHOLDERS OF SECURITY CAPITAL
It is difficult to characterize our first full year operating as a public company with generalizations. Our operating businesses, for the most part, performed at or ahead of plan. However, since our IPO, approximately 63% of Security Capital's outstanding common stock traded hands. This "overhang" contributed to a share price drop from $32.50 on December 31, 1997, to $13.56 at year-end 1998. The principal impact on the balance sheet was that $250 million of outstanding warrants to purchase SCZ stock were not exercised.
This precipitous downward movement in the stock price has focused your management on ways to both unlock and create significant shareholder value. Management is carefully evaluating the company's balance sheet with the objective of intelligently reallocating the capital base. In addition, the company will continue to pursue the strategy of creating leading real estate operating companies and building the Financial Services Division.
For the year ending December 31, 1998, EBDADT (earnings before depreciation, amortization and deferred taxes) was $234.4 million, or $1.72 per fully converted SCZ share, compared to $214.3 million or $1.66 per share one year ago, representing a 3.6% increase in EBDADT per share for 1998, after a special charge of $8.4 million or $0.06 per share. Management considers EBDADT to be the appropriate measure of the operating performance for real estate enterprises owned in a corporate manner, as it 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 generates an extremely high quality EBDADT result. Security Capital's EBDADT performance for the seven years from 1992 through 1998 is detailed on pages 5-6.
The management team of Security Capital has built valuable expertise in identifying real estate venture capital opportunities as well as attracting and building superior organizations to execute these business plans. Management's most critical task is allocating future available capital to either new private initiatives or the purchase of our own undervalued stock. We must shift the majority of our capital into high-growth opportunities that are either 100% private or materially owned by Security Capital affiliates.
You will see Security Capital return to the company's roots of being an "incubator venture capitalist" of real estate operating companies with high return potential. The firm's role is to create new start-up private companies and be actively involved in building and growing these businesses. Existing and new companies will have an intense drive for internal growth. Their focus will be on research-based development and capital redeployment, as well as the creation of operating systems that deliver extra measures of value to their customer. This will position Security Capital to create more growth in earnings to enhance shareholder value.
You will also see the firm focus on operating margins. The '90s were boom years in the real estate industry, and Security Capital invested in the required organizational infrastructure as well as research and development to capitalize on those opportunities. Moving forward, your company will have an exciting growth strategy, with an operating base tailored to profit from new opportunities.
In summary, you should measure the future performance of management by its effectiveness in unlocking substantial shareholder value. The company will reallocate capital into investments that provide the most attractive returns. On the operating side, the focus will be on driving the internal growth of investees, creating exciting new industry-leading private enterprises and on maintaining an operating cost structure that is in balance with growth prospects. Security Capital has built an exceptional operating platform that is expected to yield exciting new growth and result in superior returns to shareholders.
Security Capital's Strategy - The Capital Division
The Capital Division's operating performance in 1998 was strong. Security Capital's share of the earnings performance of our operating investees reflects per-share growth rates ranging from 7.7% to 48.9% (with a weighted average of 15.4%) for the six direct and indirect investees operating since January 1, 1997. For the same period and companies, Security Capital's unleveraged return on invested capital increased from 10.6% to 11.6%. In addition, five exciting new operating companies were launched in 1998 by Security Capital European Realty, in which Security Capital has a 34.6% ownership position. These, combined with two new private companies launched in the United States, are expected to add very positive growth to Security Capital's performance in future reporting periods.
In the United States, after three years of research and development, our new assisted living start-up, BelmontCorp, became a reality. Patricia Will is now leading a team of 75 professionals headquartered in Houston. BelmontCorp is a compelling opportunity given that the population group of age 65 and over is projected to double in the next 30 years. Belmont Village is unique, not only because of its research-based, purpose-built design, but also because of its superior approach to serving its customer base and creating a vibrant community for seniors.
The company is creating its communities in large metropolitan markets with excellent senior demographics and high barriers to entry. The first Belmont Village assisted living community opened in November 1998 in Houston. Situated in a prime residential area just over a mile from the renowned Texas Medical Center, more than 50% of its 155 available units have been leased during the first three months of operations. This is substantially ahead of pro forma projections. Additional Belmont Village communities are now under construction on prime infill sites in Nashville, Louisville and Memphis with planned openings in 1999. Eight additional sites are in predevelopment, with another 20 under review. Each site is an excellent infill location, with easy access to medical facilities, in a prime suburban area of a large urban market.
Two additional indirectly owned start-up companies in the United States made significant progress during 1998. CWS Communities Trust is tapping into the superior growth prospects of the manufactured home community industry, created through the limited supply of high quality – yet highly affordable – residential communities combined with a huge, unmet demand for well-located communities. Under the experienced leadership of Steven Sherwood, CWS Communities has grown from a start-up entity to an enterprise with total undepreciated assets of $235 million owned at year-end 1998 and 50 operating communities in eight states and Canada with a total of 16,912 homesites owned, under contract to purchase or managed. Approximately $259 million of the $300 million capital commitment is expected to be funded by the end of 1999.
Like most of our investees, CWS Communities will distinguish itself through both its development and operating strategies. Development, in particular, is the key to the company's future profitability and growth. Today, communities in desirable locations are difficult to entitle due to significant regulatory requirements. CWS Communities has met this challenge through rigorous research, tenacity and creative approaches during the entitlement process. In addition, unlike publicly held companies that shy away from development because of dilution to current earnings, as a private company CWS Communities is able to focus on development to build future profits once critical mass is achieved. The company has also established superior operating capabilities that result in attracting and retaining the most desirable customers and in running the communities at an efficient cost level.
Parking facilities and their operations are in the early stages of transformation in both the United States and Europe as new technologies and cost-effective operating practices are introduced. Founded in 1997, Urban Growth Property Trust, a private real estate investment trust, now has 16,429 parking spaces in 10 cities throughout the United States. The focus of Urban Growth Property is to achieve attractive current rates of return plus long-term capital gains, generally by using parking as an interim investment opportunity prior to an alternate (and ultimately) higher and better land use with enhanced returns.
An example of a prototypical parking project is the 800-space Traders Parking Garage in Chicago, located one block from the Sears Tower and the Chicago Board of Trade. The $15 million project was developed from the ground up by Urban Growth Property. Incorporating the most advanced payment, access and security technology in the world, as well as innovative design, the need for cashiers at the exit has been eliminated, allowing the garage to be operated by just one person. This strategy has significantly lowered operating costs, increased customer service, and provided a very attractive return on investment. The project was designed from the outset so that an adjacent parking project with 1,200 units could be acquired. The latter acquisition took place in June 1998, increasing its capacity to 2,000 parking spaces, yet still requiring only one attendant, further enhancing operating margins.
In sum, the six private companies in the United States all have outstanding fundamentals and growth prospects. In addition, the management teams of these private operating companies are exploring the opportunity to take advantage of their private status and add property level debt, which will enhance Security Capital's returns during the private phase of these companies' existence.
In Europe, through the Capital Division's ownership in Security Capital European Realty, exceptional progress was made in 1998 with the start-up of five high-growth operating companies. Security Capital's in-depth research identified the office, parking, self-storage and rented residential as sectors with opportunities for long-term cash flow growth.
Early last year, the $339 million acquisition of Bernheim-Comofi took place, and its restructuring began. Two of its self-storage companies, along with two others, are being merged into Access Self-Storage, the largest self-storage company in Europe. The long-term potential of this sector is compelling – currently there are over 25,000 self-storage facilities in the United States and only an estimated 200 in Europe. As the first consolidator of existing facilities, Access owns, operates or has under development a total of 52 facilities in Europe and is the market leader in London and Paris. Under the able leadership of William Palmer, Access is expected to broaden its current operations in the U.K., France and Germany to the leading markets in Europe.
Interparking, a private enterprise led by Yves De Clercq and Baudouin Ruquois, was also acquired through Bernheim-Comofi. Headquartered in Brussels, Interparking is the leading owner/operator of parking facilities in continental Europe, with a total of 110,500 spaces in 223 facilities in six countries. The company believes that there is a significant opportunity to upgrade technology and information systems to improve property revenues and operating margins in the parking sector. In the fourth quarter of 1998, an Interparking subsidiary opened a state-of-the-art, 2,400-space garage showcasing the latest parking technology directly across from the principal terminal building at Brussels airport.
After extensively researching the rented residential (multifamily) sector, Security Capital identified the UK as the most attractive market in Europe due to the existence of an unregulated market, with strong projected demand, limited existing supply, high barriers to entry and a fragmented ownership base. London and Henley was selected as an exceptional platform from which to build the leading UK rented residential company. The only sizeable, fully integrated UK developer, owner, and operator, London and Henley enjoys an established reputation for quality and service in providing rental apartments in central London. The company currently owns a portfolio of properties operating or under construction or planning of approximately $159 million.
These companies, as well as two other companies in the office sector, are being positioned to take advantage of growth opportunities in Europe. Your management team continues to be enthusiastic about the dynamic and attractive business environment in Europe, as well as the attractive investment opportunities for long-term cash flow growth in the sectors represented by the private investees. The company has made significant progress in executing a European strategy and is well placed to take advantage of the corporate restructuring currently underway there. Coupled with the emergence of a new real estate industry focused on companies that produce cash flow growth, we will continue to build on existing private platforms and investigate opportunities to invest in new private platforms. The infrastructure that the company and its investees have established is enabling Security Capital European Realty to accomplish the objective of owning businesses that are true, fully integrated real estate operating/service companies.
Security Capital's Strategy - The Financial Services Division
The Financial Services Division derives EBDADT through earnings from fees for real estate research, capital management and other corporate and financial services. Overall revenue for the year increased 86.1% to $99.4 million, and EBDADT for the year increased to $23.8 million from $17.3 million in 1997. However, while three out of four of the Division's operating areas met or exceeded budgeted performance, the Global Capital Management Group did not reach its operating numbers in the real estate securities management area. This was a result of several factors – the general outflow of capital from the sector in the United States throughout the course of the year, lower-than-anticipated capital inflow to our capital management area, and a reduction in public market valuations – all of which adversely affected the Global Capital Management Group's fee income. As a result, management made a decision to pull back on what had been an aggressively staffed and executed marketing program for the retail distribution of real estate mutual funds. A special charge of $3.8 million was taken during the fourth quarter, primarily to cover reduction of personnel and associated costs in this area. Going forward, our strategy is to stay prepared for when consumer money begins to flow back into this end of the market.
Importantly, within the industry, the Global Capital Management Group's performance in stock selection was superior. As of December 31, 1998, the Global Capital Management Group's U.S. Composite had a three-year performance record for assets under management that significantly exceeded industry benchmarks. They have a proven investment process and track record that will allow them to grow steadily and improve operating margins through the attraction of additional separate account capital from both institutions and corporations. |
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THE REAL ESTATE INDUSTRY TODAY
1998 was a difficult year for public real estate companies in the United States. Several events influenced short-term pricing performance of the public real estate market.
In January of 1998, proposed legislative changes in Washington relating to "paired-share REITs" caught the attention of public real estate investors. Although paired-share REITs represented only five out of a total of 226 public REITs in the United States, the markets viewed all REITs as one-and-the-same. This sudden shift in proposed legislation immediately sent tremors through the market, and caused many investors to begin to exit from their public real estate holdings. The rapid exodus was founded in many ways on misinformation and confusion between the ordinary REIT structure and the paired-share structure. |
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Late in the first quarter, investors and analysts finally came to the realization that REITs cannot continue to buy existing income-producing assets at prices that would allow them to create shareholder value and maintain earnings growth. This disappointed investors who believed "attractive growth through acquisition" would continue indefinitely.
In addition, many of the same Wall Street research analysts began to voice their concerns that the real estate markets were once again in the early stages of "over-building". These early reports created further anxiety among the investment community and significantly impacted the flow of new equity capital into the public markets.
Finally, the commercial mortgage backed securities (CMBS) industry's very aggressive lending practices were brought to a screeching halt. This cessation in lending was precipitated, not by very aggressive mortgage lending on the part of the few leaders, but rather by the shake-up in the credit markets precipitated first by the Russian devaluation and then the unraveling of Long-Term Capital Management.
The major changes in both the public real estate equity markets and the CMBS markets had dramatic impact on the operating strategies of public real estate companies. New acquisitions by REITs were greatly diminished. Many new development projects, both publicly and privately owned, were canceled and operating strategies were greatly modified. Historically, during the 1970s and 1980s, the change in sentiments and actions would have taken three to five years. Today, however, because of the real-time information system brought about by the public markets, real estate cycles will be far less severe and will mirror those of other major industries. In sum, while 1998 was a difficult year in terms of public company pricing, it created a solid foundation for future capital deployment that will create a far healthier real estate environment for both public and private capital deployment.
The public markets are applying extremely low valuations to real estate securities today, levels that are unprecedented during periods of healthy real estate and economic fundamentals. A simple indicator of this conservative pricing is the spread between 10-year Treasury Bills and the cash flow yields for real estate securities. This spread is currently at historically high levels indicating, in our view, an extreme level of investor anxiety about future performance for these real estate companies. In contrast, our research suggests that, while earnings and cash flow growth will moderate from the peak levels recently achieved, the outlook is healthy –' in the 8-11% range for 1999 and 2000 –' and highly durable. The combination of current yield, healthy performance and earnings durability presents a unique opportunity for both income- and total-rate-of-return-oriented investors. |
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THE FUTURE
Creating industry leading operating companies that focus on generating internal growth has been the focus of your company's management since our founding. 1998 was a year of significant positive accomplishment for the operating entities of the company. However, public market pricing for Security Capital could obviously not have been more disappointing. The 1990s phenomenon of unlimited equity capital for the public real estate sector played an important part in Security Capital's growth. This can no longer be part of the firm's business model. Last year's negative public markets have had a dramatic impact on shaping your management's thinking and actions.
In the Capital Division, we have built an enterprise of 17 exceptional real estate operating companies. Their future performance, however, will now be measured against a much higher set of capital return objectives. Those entities that do not measure up must be "reallocated" into either Security Capital's very under-valued stock or highly attractive existing and new start-up businesses. Management of the Capital Division feels that our ownership should either be very significant in those operating entities that create very attractive capital returns or they should not be owned. This process of evaluation and execution is the highest order of the day and will be carried out intelligently in order to maximize shareholder value.
The Financial Services Division made excellent progress in building a superior operating platform during an era of capital abundance. Its focus now is to thrive in a period when the flow of public capital into the marketplace has been depressed. A superior foundation of people and strategies has been put in place to allow the Financial Services Division to meet its objective during differing capital market conditions. The securitization of the global real estate industry is still in its infancy. While capital flows changed during 1998, real time pricing, liquidity and the rational evolution of customer-focused public real estate operating companies will drive real estate securitization to a point of dominance in the future. This bodes well for an organization focused on being the leader in providing services in this evolution.
The future success of Security Capital will be driven by the outstanding group of professionals currently in place driving the operations of the company. Our colleagues are committed to industry leading excellence and to achieving the ambitious goals that we have set for your company. They are exceptional individuals who are due enormous gratitude.
Our Annual Meeting will be held on May 20, 1999, at 9:30 a.m. (Central Time) at the Renaissance Chicago Hotel at One West Wacker Drive in Chicago.
The Board of Directors and colleagues of Security Capital understand our mission and are deeply committed to achieving results that all of our shareholders deserve.
William D. Sanders C. - Chairman
March 26, 1999
Ronald Blankenship - Vice Chairman
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