Faulty Risk Perceptions Buoy Specialty-Market REIT

Mark Peterson was working for a Kansas City-based regional public accounting firm, Donnelly Meiners Jordan Kline. It was 1995, and he had a new client, J.C. Nichols, a publicly traded real estate investment trust (REIT). Because of improprieties, the firm had fired many top executives, including its CEO and CFO, as well as its previous auditor.

One of Peterson’s jobs was to evaluate CFO candidates. He was putting in 12-hour days and loving the experience. So he decided to be the finance chief himself. He was 30 years old.

Three years later another REIT purchased J.C. Nichols, after which Peterson went into a different industry for a few years. But when the opportunity to join Entertainment Properties Trust came about in 2004, he was more than ready to get back to the industry he knew and liked best.

Mark Peterson, CFO, EPR Properties

Peterson is now CFO of the company, which changed its name to EPR Properties about a year ago. It invests in specialty asset classes: megaplex movie theaters as well as entertainment centers anchored by theaters; public charter schools, early-childhood centers and private schools; and ski and water parks accessible from metro locations.

A common thread among those asset classes is that they’re perceived as riskier than they really are. Perceptions are that tenants of such properties are in risky industries and therefore may fail to pay their rent to EPR. But in reality that risk is low, Peterson says. The misperceptions enable EPR to price its rentals on the high side, as if the risk were real.

EPR executes sale-leaseback transactions with property operators and developers, the leases being of the triple-net variety. The rentals are priced to create a spread between them and the company’s capital-acquisition costs.

Peterson recently discussed with CFO what a REIT finance chief does, EPR’s specialty markets and how the company evaluates investment opportunities. An edited transcript of the conversation follows.

What is it like to be the CFO of a REIT?
There’s traditional accounting, SEC reporting and budgeting, of course. But to grow, REITs need to continually raise new capital to invest. By law, a REIT has to pay out at least 90 percent of its taxable income to shareholders in the form of dividends in order to avoid being taxed at the corporate level. Even then we’re taxed on that last 10 percent, so we return effectively 100 percent of our taxable income to shareholders.

That means we’re not retaining a lot of cash flow. It’s why a big part of my job is raising debt and equity funding.

How do you go about doing that?
We have big public equity offerings sold primarily to institutional investors. In the third quarter we did an offering that raised $175 million between the time the market closed one day and the time it opened the next morning. We also do what we call a “drip” program, where we dribble out smaller amounts of equity, maybe $2.5 million to $5 million, each day for a month.

On the debt side, we used to have 100 percent secured debt, using [collateralized mortgage-backed securities]. That market went away virtually overnight in 2009, so in 2010 we went through a big transformation to get access to the unsecured debt market.

To do that you have to get rated by a rating agency. You might think a specialty real estate company wouldn’t get an investment-grade rating, but because of the stability and performance of our assets, we were rated investment grade by two of three agencies. That lets us issue our bonds at cheaper rates than if we were rated as junk. We’ve raised about $800 million of unsecured debt in the public markets since 2010.

Why do your assets perform well? In other words, what is EPR’s value proposition for investors?
Most real estate investment is in the retail, office, industrial and multi-family housing spaces. We call those commodity asset classes. There are a lot of bidders for properties, and they’re easy for investors to understand because there are so many different companies to compare against.

In our space, specialty niche properties, there aren’t as many bidders. Instead of slugging it out on cost of capital through a bid process, we generally get our business through relationships with developers and operators. We’re knowledge investors, not herd investors. Our understanding of our segments’ drivers allows us to isolate investments others may overlook and to distinguish between real and perceived risk.

Why are your assets perceived as risky?
Take charter schools, for example. They’ve been around for 20 years, but people still see them as new and therefore risky. In reality, the opposite is true. These alternative learning institutions are anchored by widespread bipartisan support and societal change driven by parents’ growing demand for choice in education. The total student population at the schools is more than two million, with a waiting list of 400,000. Charter schools have been a stable asset class and continue to be.

What about megaplex theaters?
People think the box office is very volatile. And studio by studio, it can be. Some studios will have winning films, some will have duds, some will have bad years, some will have good years. But we show all the films and therefore we have steady-as-she-goes growth, not volatility. It’s a mature industry, but it’s still growing at a steady 3 to 4 percent annually.

And ski parks?
Ski hills are perceived as risky because they are weather-dependent. But we’re not in destination resorts such as Vail. For those, success is more about condo development on and around the mountain.

What we have is locations you can drive to from metro areas. If it’s bad weather this weekend you can still come next weekend, whereas if you were planning a trip to Vail and the weather was bad, you probably wouldn’t reschedule that trip. We also have 100 percent snowmaking. Plus, our price point is much lower than the destination resorts, so in recessionary times our ski hills still do well. They’re really not risky if you look at 25 years of history.

What happens if perceptions change — if people get wise to the idea that your assets aren’t as risky as they thought?
That’s exactly what happened with theaters, and it’s a great thing for us and our shareholders. If people see in 20 years of history how strong these are, and other REITs start getting into the game, the properties’ net asset values increase. Shareholders are pleased because the property was “bought low” and can be “sold high.”

How do you decide what properties to buy?
We have what we call our 5-Star Investment Criteria. First is inflection opportunity. When AMC came out with the first megaplex theaters in the 1990s people were thinking, “Who’s going to put $20 million in this box with so many screens? That’s crazy.”

And then, bankruptcies started occurring. People associated that with an unstable box office, but what really happened was that the AMC megaplexes were so popular that other theater companies were rushing to build their own. They were stuck in leases at properties with the traditional sloped floors, so they declared bankruptcy to get out of them.

That’s an inflection point: something that changes an industry. We’re looking for a change agent that’s going to cause a need for a new real estate solution. And one that will have enduring value over the long haul — that’s the second of our criteria.

The others are excellent execution, such as premium locations and [value provided by that location beyond our actual tenant]; attractive economics, or accretive initial returns and yield growth in categories of meaningful size; and a sustainable competitive advantage based on our knowledge and relationships.

What kind of relationships?
Even though theaters are becoming more mainstream, we can still get good returns on them because of our relationships with developers and operators. We don’t find our own locations. Take AMC, our biggest customer. They don’t want their money tied up in the physical plant; they want to invest it in their operations. So they come to us for financing. And they know that if we’re there for this location, we’ll be there for the next 10 they want to do. They want a financing partner for the long term.