The AMB Consolidation On August 13, 1997, Anne Shea of the Curators' Fund (the Fund) sat in her office overlooking downtown Kansas City, knowing she had to decide her position on the proposed consolidation of properties managed by AMB Institutional Realty Advisors, Inc. AMB managed half of the Fund's $80 million of investments in real estate, as well as over $2.8 billion of real estate assets for other pension funds, endowments and wealthy individuals and families. Until the recently proposed consolidation, Shea had been pleased with the Fund's relationship with AMB's experienced real estate team; investing with AMB provided a cost effective, value-added means for the Fund to directly own property. The proposed consolidation, however, seemingly threatened to change everything. AMB was a leading pension real estate advisory firm with an excellent reputation. In 14 years of operations, they had never lost a client. They earned fees for advising pensions on their real estate strategies, and for providing and managing investment vehicles in which pensions were the prime investors. Despite the fact that AMB was essentially a service company, AMB had recently proposed to turn itself into a publicly traded Real Estate Investment Trust (REIT). AMB planned to persuade its clients to contribute their real estate assets to the new REIT; simultaneously, AMB would fold their advisory and management business into the new REIT. A majority of the management team at AMB would stay on to run the REIT. Shea, assistant vice president at the Fund's Office of Investment & Banking, was preparing for an AMB clients meeting in San Francisco the next day where she would have to vote on the consolidation plan. In the preceding months, AMB had presented three options to each of its clients. Clients could either contribute properties and/or additional cash in exchange for shares in the new REIT; or maintain the status quo; with this choice, clients would not contribute the properties, but would allow AMB to continue to manage the properties; or sever ties with AMB. For Shea, this meant receiving cash for the appraised value of the Fund's investment prior to the initial public offering, since her current investment was in one of the commingled funds managed by AMB. For those with separate accounts, the option was to retain the properties themselves. Shea recognized the cogency of several of the arguments put forth in favor of the consolidation by the AMB team. She was particularly intrigued with the idea that Wall Street placed a higher value on the Fund's real estate than the private markets could. Yet several concerns were nagging at her. Before she left her office for the airport, Shea reviewed for one last time the huge stack of documentation on the consolidation. AMB Prior to the Planned Consolidation and REIT In August 1997, AMB Institutional Realty Advisors, Inc. was one of the leading real estate pension fund advisory and management businesses in the United States, with over $2.8 billion under management.1 AMB served 70 institutional clients; many were pension funds with substantial commitments to real estate. Douglas D. Abbey (A), Hamid R. Moghadam (M), and T. Robert Burke (B) founded AMB in 1983. In 1997, the three founders were still active in management, occupying the positions of Chairman of the Investment Committee, Chief Executive Officer, and Chairman of the Board of Directors, respectively. Ten executive officers had an average of 22 years of experience in real estate, and an average of nine years with AMB. AMB employed a total of 116 people in offices in San Francisco and Boston. AMB did not perform custodial property management services in-house. Rather, as asset managers, AMB sub-contracted the role of custodial property management to local firms in each market where AMB held property. As was standard in the industry, property management fees, typically 2% to 3% of gross rental revenueswere paid to third party managers at the AMB controlled real estate in three commingled funds and fifteen separate accounts. Two of the mmingled funds were organized as "private REITs," which were seen as improvements on the conventional commingled fund structure.2 In several of the funds, AMB earned incentive based compensation, which reduced (but did not eliminate) the use of traditional fee structures. AMB received, on average, a fee of 70 basis points on assets-under-management. In addition, fees for acquisition/disposition advice were, on average, 75 basis points of the gross transaction amount. When incentive fees were part of the fund structure, investors would receive a "preferred return" and their money back, after which AMB would be entitled to 10% to 20% of the remaining proceeds. property level. AMB focused its portfolio on industrial properties (primarily warehouse distribution centers) and community shopping centers. Management believed that the two property types were "complementary, and that AMB had developed an expertise for acquiring, developing and operating both types. AMB controlled 358 industrial building and 33 community shopping centers (see Table A for geographic diversity of the holdings). Table A Industrial and Retail Properties by Region Region Western Southern. Midwestern Eastern. Total Industrial Properties Number Rentable Number of Square Properties Buildings Feet 32 137 12,095,376 24 91 9,498,594 23 87 10,731,130 16 43 5,008,562 95 358 37,333,662 % of Total 35.5 25.4 28.7 13.4 100.0% Retail Properties Number of Rentable %o Centers Square Feet total 16 2,615,976 41.8 10 1,757,546 28.0 4 710,652 11.3 3 1,184,462 18.9 33 6.268.636 100.0% AMB enjoyed an excellent reputation throughout its first 14 years of operations. In polls of institutional investors and their consultants, AMB was consistently ranked as an industry leader, with respect to the expertise of its management team, the structure of its funds and property portfolios, and in client confidence in AMB's future performance. Steady growth in AMB's management and advisory business in the 1980s was replaced with rapid expansion in the early and mid-1990s. AMB's portfolio, as well as its fee income, had increased by approximately 35% per annum since inception. Real Estate Investment Trusts Real Estate Investment Trusts (REITs) grew out of the Real Estate Investment Trust Act of 1960 and were designed to be a "mutual fund" for real estate, allowing small investors to own a piece of a large, diversified portfolio of properties. One key attraction of REITs was that, although they were corporations and shielded the investor from liability, they did not pay corporate taxes and thus avoided the problem of "double taxation. Another attractive feature was that, like any corporation, they could provide liquidity by listing on a stock exchange and selling shares. To qualify as a REIT in 1997, a corporation needed to meet a series of tests set out by the Internal Revenue Service. Essentially there are five key requirements a corporation, business trust, or association needed to meet to be treated as a REIT: 1. Widely Held: The REIT was required to have at least 100 shareholders of record. Five or fewer individuals could hold no more than 50% of the shares directly or indirectly. (A change in the law had allowed one to "look through" a pension fund and treat its investment as if it were made by all the pension fund's beneficiaries.) 2. Invested Primarily in Real Estate: At least 75% of the value of the Company's total assets were required to be real estate assets and "temporary" investments in cash, cash items and government securities. Similarly, at least 75% of the REIT's gross income needed to consist of income derived from investments relating to real property or mortgages or temporary investments. For example, income from operating businesses like hotels, parking garages, and concierge services were disallowed. 3. Distributes Income Annually: The REIT was required to distribute 95% of its net taxable income to shareholders (excluding capital gains). 4. Does Not Churn Assets: Gain from the sale of real property held for less than four years (as well as gains from the sale of stock and from 'prohibited transactions') could represent not more than 30% of the Company's gross income for each taxable year. 5. Operates Like a Public Corporation: A board of trustees or directors, including generally a majority of independent directors, managed the REIT and the REIT's shares were required to be freely transferable. Historical Performance of the REIT Industry The REIT industry had a checkered history. Begun in 1960, the REIT industry experienced its first growth spurt at the end of that decade. Between 1968 and 1972, REIT industry assets jumped from $1 billion to $14 billion. Most of this money was invested in short-term construction loans, and to a lesser extent in land development loans. These were called mortgage REITs, and this type of short term lending was geared to take advantage of high short-term interest rates. Many REIT sponsors found they could further enhance their returns by leveraging their investments and capturing the spread between their cost of funds and what they could charge their borrowers. Unfortunately, the flood of money available to REITs in the late 1960s and early 1970s led to some poor underwriting. Many construction and land loans went into default, and the REITs ended up owning the properties. The REIT problems were further exacerbated in the mid-seventies by: (1) increasing inflation which drove up the price of the money the REIT's had borrowed, (2) an economic downturn which reduced demand for space, and (3) severely overbuilt markets which eroded rents. As a result, between 1972 and 1974 the average share price of REITs fell 66% and the average price of mortgage REITs dropped 75%. Devastated by these losses, it took a long time before investors were willing to consider whether the problems experienced by REITs in the 1970s lay in the structure of the REIT or the quality of the REIT's investments. Gradually, however, shares in some of the better managed REITs began to recover and by the early 1980s new REIT offerings began to appear. This flow of investment dollars accelerated somewhat after passage of the 1986 Tax Reform Act, which took away many of the tax advantages of owning real estate as a limited partner, and therefore improved the attractiveness of REITs versus private limited partnerships. The real catalyst was the collapse of real estate in the late 1980s and early 1990s. Through the invention of mechanisms such as UPREITs and DownREITs, developer/owners could transfer their holdings to the public markets in the REIT format without paying huge taxes on their "recapture." They could then postpone taking losses and paying taxes by waiting out the cycle. Insurance companies could also use REITs to rid themselves of real estate holdings efficiently at the portfolio level at a time of limited buyers and scarce private capital. In the early and mid 1990s, a number of large, private developers and owners of real estate went public. For many developers, the primary motive was to pay down their outstanding debt under pressure from banks (who faced their own pressures from bank regulators). Insurance companies, confronting the reality of collapsed real estate in their portfolios, and the prospect of regulators moving in to dissect their industry, wanted out of real estate and used REITs as the vehicle. As the markets recovered, other owners saw REITs as an opportunity to increase their liquidity and cash in during a hot market. Many operators converting to REITs took advantage of changes in the law that now allowed REITs to manage their own property, eliminating a conflict that had plagued earlier REITS. What emerged was a new set of public companies internally managed by experienced real estate developers, which had begun to attract significant attention from pension funds and other institutional investors. Increasingly, the pricing spread between privately held real estate and publicly held real estate was a main attraction driving private owners to convert to public ownership. As a result of increased availability of capital and significant consolidation opportunities, investors were willing to pay a premium to the underlying net asset value (NAV") of a company's existing assets if they believed that the company could grow faster than the growth of its existing asset base. In essence, the public was starting to value REITs as any other industrial company-on a forward earnings multiple. In the case of REITs, future earnings were based primarily on the income from long-term contractual leases of existing properties. Income growth was derived by releasing existing space at higher than current rents, reducing expenses, redeveloping assets to generate incremental income and by growing externally through new acquisitions and developments. The premium, which was often referred to as "franchise value," "value in excess of NAV," or "premium to NAV" had varied over time (as further described below). The general factors that were determinants of the NAV premium, or franchise value, typically included market environment and outlook, availability of growth capital, and management's ability to create future value. As of August 1997, Wall Street valued the equity value of public real estate companies at a 26% premium to NAV.5 Consider a privately held, family real estate business with cash flow from operations (or NOI) of $100 million in August 1997. Private markets valued the assets at, for example, a 9% capitalization rate (for ease of example), or a total value of $1.11 billion. Assuming $300 million in debt (at a rate of 8%), the private NAV would have been approximately $811 million. If the markets believed the operator was capable of and planned to access new growth capital and create value going forward, they would have valued the enterprise on a forward multiple, the result being, simplistically, that the public market would have valued the equity at a value 26% in excess of NAV or approximately $1.022 billion (implying an asset value of $1.322 billion). See Exhibit 5 for a demonstration of this premium. Based on such values, the implied FFO multiple (more below) was 13.4x and the real estate cap rate on the assets was 7.6%. By "going public the private operator could potentially create value of $211 million in August 1997. Of course, some of this value had to be shared with investment bankers (the average investment banking fees of going public were in the range of 5% to 7% of the offering amount) and a value needed to be assumed for the operator's management contribution. Other intangible costs (such as daily market valuations, a need to achieve quarterly earnings targets and a significant level of disclosure and scrutiny by investors, analysts, rating agencies, etc.) clouded the clarity of the decision for many private operators contemplating "going public. In July 1997, the REIT industry set a new monthly record for public equity offerings. REIT shares as a group rose 35% in value in 1996, compared to the S&P 500's rise of 23% (see Exhibit 1). Over the preceding five years, REITs had posted higher yields and higher total returns vs. the broad market index (see Exhibit 2). Based on results through July 1997, REIT analysts were predicting another healthy year in 1997. Exhibit 3 traces the growth in total market capitalization of all REITs from 1971 to 1997. It is noteworthy that despite the rapid growth in assets, the number of publicly traded REITs had actually declined slightly due to mergers and acquisitions of existing REITs owned. Carrying this analysis another step, the impact of the growth of REITs varied by different property type segments. As an example, a high number of all-regional malls were owned by REITs compared to only a small portion of industrial buildings. Valuing REIT StocksFunds From Operations (FFO) A flourishing REIT market in the 1990s led inevitably to a divergence of opinions on the proper way to value REIT stocks. Many analysts treated REITs just like any other public company and valued them using a dividend discount model. They focused on the current cash flow and the ability of a given REIT to increase the cash flow and the dividend. With all other types of stocks, analysts emphasized net income as the basic yardstick. With REIT stocks, however, net income as prescribed by GAAP was misleading. Historical-cost based depreciation of real estate assets, while an expense in terms of net income calculations, often did not reflect real depreciation of the assets, which tended to increase or decrease in value based on market conditions. Comparing reported net income of different REITs was therefore deceptive. To level the playing field among public REITs, the REIT industry developed a measure called Funds from Operations (FFO). To calculate FFO, analysts started with net income, added back real estate related depreciation and amortization, and adjusted for non-recurring items such as gains or losses on asset sales.? Alternatively, FFO was equal to a) Cash flow from operations (or NOI) from the properties less corporate G&A and interest expense or b) EBITDA (earnings before interest, taxes and depreciation) less interest expense (REITs do not pay tax). REIT prices were often described and compared in terms of FFO multiples, which was the ratio of price to FFO.8 Adjusted Funds from Operations (AFFO) AFFO was a further refinement of FFO, and was calculated by starting with FFO, then subtracting capital expenditures. Increasingly, analysts and industry observers were comparing REITs in terms of AFFO multiples rather than FFO multiples. The relationship between FFO, AFFO and cash flow from operations on the property level, a pre- debt standard measure in private market transactions, is presented in Table B. It is important to note that CFO was calculated before interest and principal payments, while FFO and AFFO were before principal payments, but after interest payments. The value of the firm was obviously both the debt and the equity. The FFO/AFFO computations helped one ascertain the value of the equity. Getting from CFO to FFO and AFFO Private Market Public Market Gross Property Revenue Gross Property Revenue Property Expenses Property Expenses Cash Flow from Operations (or NOI) Cash Flow from Operations (or NOI) Capitalization Rate (Market-determined) Overhead Expenses (such as office space, corporate salaries, legal and audit fees, travel) Existing Property EBITDA Asset Value Interest Outstanding Debt and other Assets/Liabilities Private Market Net Asset Value Funds from Operations (FFO) Capital Expenditures Adjusted Funds from Operations (AFFO) x Market Multiple Public Market Valuation Source: Casewriter Net Asset Value and a Premium or Discount Green Street Advisors, a firm that specialized in the valuation of REITs, had an entirely different approach to valuing REIT stock. They focused on the underlying value of the real estate and then adjusted the price to reflect the ability of management to create value. To calculate the value of the real estate (or the net asset value) Green Street applied "an appropriate cap rate to the real estate net operating income generated by the portfolio." In choosing a cap rate Green Street tried to consider all the relevant factors such as the type of property, its quality and age, location, as well as local demographic and supply/demand trends. After calculating the Net Asset Value, Green Street then carefully evaluated the following seven factors in order to determine if a REIT should trade at a premium (or discount) to its net asset value, and if so by how much. 1. Franchise Value: the ability of a management team to create value and generate FFO growth. 2. Focus by property type and/or geography: sharper focus results in higher premium. 3. Insider Ownership: In the case of AMB, the offering transactions would leave the top managers with approximately 10% ownership, above the industry median of 8%. 4. Potential Conflicts of Interest: more conflicts result in lower premiums or even discounts to NAV. 5. Liquidity: larger REITs (over $1 billion) were viewed as having far more liquidity than, for example, limited partnership interests in privately held real estate. 6. Balance Sheet Strength: debt of approximately 35% to 45% of total market capitalization was standard. The nature of assets, for example holdings of land ready for development, also had an impact on perceived balance sheet strength. 7. Overhead Costs: averaging approximately.71% of asset value. While in August 1997, nearly 70% of REITs were trading at a premium to NAV; premiums had not always been the norm. One pundit noted, "less than ten years ago, prior to the 'rediscovery' of the REIT marketplace, it was a rule of thumb in the industry that REIT market prices incorporated a 30% discount' to net asset values because the stock market did not know how to value assets when a significant component of the value is based on future rather than current income. During the last five years, the pendulum has swung to where many REIT market prices today represent 'premiums' of up to 30% over net asset value."10 Refer to Exhibit 5 for a review of historical premiums/discounts to NAV. AMB's Consolidation Plan AMB's investment bankers told AMB that, as a result of going public, the Company would likely be the eleventh largest REIT in the country (see Exhibit 6) based on current REIT multiples. This would be attractive to institutional investors who were interested in larger REITs because of their greater liquidity and stability from a larger property/income base. Refer to Exhibit 7 for trading data on the company's peers. At the same time, it was claimed, AMB's plan would create enormous value by arbitraging the private/public market value differentials. AMB proposed to have its clients exchange their property holdings for shares in a newly created REIT. As part of the transaction, AMB would exchange its advisory and management business for shares in the new REIT. Exhibit 8 displays a projected income statement of AMB's advisory and management business, which would be contributed to the REIT in exchange for REIT shares. Upon completion of these "formation transactions," the new REIT would issue shares to the public. While one of the founders planned to reduce his role in the day-to-day operations, most of AMB's management team was slated to stay on to run the new REIT. AMB needed to convince clients to contribute to the new REIT. Management had to be persuasive on four points: (1) the client would be better served by holding REIT stock, (2) the client would benefit substantially from the value created in the private-to-public arbitrage, (3) AMB's management team had the expertise and the right strategy to lead the new REIT; and (4) the value of the management and advisory business in the consolidation was a fair market value. Advantages of REIT Structure Communicating to clients the notion that publicly held REIT shares were better than privately held real estate assets was a tricky venture for AMB. After all, AMB had built its business by providing a value-added means for institutions to invest in directly held private real estate. For years, then, they had concurred with clients on the advantages of private holdings. In fact, the largest growth spurt in AMB's history had occurred simultaneous to the rise of the public REIT market, indicating that their new clients may have chosen AMB's private market expertise as a preferred alternative to REIT stock. AMB argued that the consolidation and public offering would allow investors to be part of an operating company with growth options rather than just owners of a collection of assets. In addition, AMB highlighted the benefits of the expected liquidity and transparency of the publicly traded shares. Liquidity was thought to be a powerful draw for the commingled fund investors who had found it difficult if not impossible to exit the funds. When they did exit, the cash proceeds, net of broker and disposition fees, were often at a discount of 20% to 30% of the reported appraised asset values. AMB also asserted that the REIT structure would provide clients with better alignment of interests with management, and a more diversified and larger property portfolio. Private/Public Market Arbitrage In essence, AMB argued clients would benefit from a "pop" in asset values simply by contributing properties to the REIT and allowing AMB to go public. Current market multiples on industrial and retail REITs were approximately 12.3x and 13.5x forward 12 months FFO and AFFO, respectively (see Exhibit 9). AMB would go public at approximately 11.5x forward 12 months FFO and 12.75x forward AFFO, representing an approximately 8% IPO discount on the market multiples. AMB hoped that the stock would trade at the same or even a premium multiple to its peers within months of the offering (typically referred to on Wall Street as the "fully distributed" multiple). At the same time, the private market capitalization rate for AMB's portfolio was estimated to be approximately 9.5% (projected 1998 cash flow from operations from existing properties divided by the private market valuation of the properties). See Exhibit 13 for the private equity valuation in more detail, including the funds that Anne Shea was an investor in. Based on third party appraisals, the pre-IPO value of the equity of the funds that Anne was an investor in was $704 million and constituted 56.6% of the pre-IPO value of the equity of the firm. Management Challenges AMB confidently insisted they could handle the management challenges of public ownership that emphasized short term, quarterly growth. They offered a market and growth oriented strategy based on achieving operating efficiencies, further acquisitions, and property renovation, expansion and development. See Exhibit 10 for management's strategy as it was presented to clients. In terms of organizational structure, AMB was be set up as an UPREIT (umbrella partnership real estate investment trust) as were approximately two-thirds of all real estate companies that had been through initial public offerings.11 In addition, the company would incorporate a substantially wholly owned investment management subsidiary, to provide on-going advisory and asset management services to third party owners, including any current clients that chose not to contribute properties to the REIT. Valuing the Advisory and Asset Management Business There were two components to valuing the advisory and asset management business of a going concern. After hiring valuation consultants to perform a discounted cash flow analysis, and to study comparable transactions, AMB settled on a value of $92 million for the going concern, excluding the incentive fees (discussed below). The entire $92 million was to be paid in stock of the new REIT and would be locked up for a period of two years. Second, AMB sought compensation for the "back-ended, incentive fees they would forego by completing the consolidation. Instead of seeking payment up front at the IPO, AMB attempted to mirror the current arrangements they had in-place with certain investors, including certain commingled funds, such as the Curator's Fund. The most important concept to carry over to the new agreements was that the incentive fees be paid to AMB only after the investors had full liquidity and a right to sell their shares. Clients whose assets were subject to incentive fee contracts would hold approximately 4.2 million shares (known as Performance Shares, essentially convertible into common shares) in escrow for up to 24 months. Dividends during the two-year period would be paid to the clients. AMB's founders and top executives would be entitled to the Performance Shares if the stock price and dividend payments exceeded benchmarks set up at the IPO. If the benchmarks were not surpassed, the Performance Shares would be removed from escrow and returned to the clients who had originally contributed the properties to the REIT. If the benchmarks were surpassed, all or a portion of the Performance Shares would be transferred to AMB's founders and top executives12. Payment of the incentive fees would therefore only be dilutive to the contributing clients who had incentive fee agreements with AMB. This scheme would not impact any other client shareholder or the public. Exhibit 11 shows the breakdown of ownership interests between clients and AMB before and after the IPO and Exhibit 12 shows the expected sources and uses of the IPO. The values of the asset management business and the incentive fees were reviewed and opined upon by outside third- party experts, in a process controlled by six independent directors representing clients. In addition to the shares and the Performance Units, top management at AMB would receive stock option grants on another 1.8 million shares with a strike price equal to the IPO price and a ten-year expiration, consistent with the market practice. The Curators' Fund The Curators' Fund (the Fund) managed $1.7 billion of assets on behalf of educational institutions. The Fund's asset allocation model called for a 5% allotment to real estate. Anne Shea, assistant vice president, was charged with deploying the 5% into real estate assets, with a focus on stable properties with current income and very low downside risk. To date, Shea had avoided the trend toward pension investment in public REITs. Instead, she had placed 2.5% of the Fund's assets in the Current Income Fund (CIF)13 of AMB Realty, and 2.5% in a similar commingled fund of another pension real estate advisor. Shea was well aware of the pricing differentials between the private and public real estate markets. In discussions with AMB and her other advisors and consultants, Shea had learned that the pricing differential was making it increasingly difficult for AMB (and all institutional advisors) to find attractively priced real estate. The REITs, with their lower cost of capital, could and did simply outbid traditional buyers. However, when confronted with what she saw as AMB's "if-you-can't- beat-them-join-them" attitude toward REITs, Shea remained skeptical. Shea's first problem was with asset allocation issues. She had seen evidence that REIT stocks were negatively correlated with private real estate returns, thus eliminating diversification benefits. But she had also seen evidence in direct contrast, showing a positive correlation between REIT stocks and private real estate returns. It seemed that the jury was still out on the issue, because structural changes and recent growth and changes in composition of the REIT market made most historical data irrelevant. Shea also knew that pooling all of AMB's real estate would dilute the Fund's investment in stable properties, because the consolidation would result in mixing the stable, Current Income Fund properties with riskier properties from AMB's "Value-Added Fund," although this would be offset with the company's dividend, which she was told would provide her an approximately 7.3% annual return on her investment, about 2% below the expected levered yield she expected to receive from her investment in the Current Income Funds (although the fund's yield would likely be more volatile). She had to consider the risk profile of the resulting portfolio, and whether it matched the Fund's needs. The second major issue for Shea was the state of the REIT market. She worried that the phenomenal performance of 1996 and 1997-to-date was not sustainable. In particular, she thought that the premium to Net Asset Value that the public markets had placed on REITs would be reduced or even eliminated altogether if the market ever stopped treating REITs as growth stocks. Investors might put no premium at all on a stable income stream of a non-growth stock. While it looked like a good time to go public (refer to Exhibits 9 and 12) she wondered how long the REIT "rally" would last and what the floor price of AMB's shares would be should the market soften. Shea also decided to check for herself the calculation of the gains from the private-to-public arbitrage. For her private market valuation, she had been provided back-up (see Exhibit 13 for relevant data). She could apply the cap rate to the cash flow from operations, and subtract debt to get to net asset value. For her public market valuation, she needed to generate a corporate or REIT financial projection. Based on AMB's track record of acquiring and/or developing $600 to $800 million of properties per year, she believed that management's projection of acquiring $600 million (including $150 million of developments) in 1998 was reasonable. Additionally, AMB had already committed to close on $267 million of assets concurrent with the IPO (as a use of IPO proceeds), which would also contribute immediately to projected 1998 income. She could then apply the FFO and AFFO multiples to arrive at the net asset value. Finally, she could compare the private and public market values and determine for herself the exact nature of the arbitrage opportunity. Exhibit 14 was provided to Shea as a basis for ascertaining the public market valuation and the resulting private-to-public arbitrage. Even if she agreed that the Fund would get a "pop" by going public, she had to consider the cost. There were investment banking fees, legal fees, and audit fees to be considered, as well as an initial 8% pricing discount offered to new investors at the initial public offering. Shea argued that a number of unpredictable events had to turn out right, and risks had to be managed for the gain to truly accrue to the Fund. First, the stock would have to maintain or increase in price after the IPO. Second, the Fund and all contributing investors would be subject to a 12-month "lock-up period in which they could not sell shares; thus, they would be subject to fluctuations in the stock market, the REIT market, and the real estate market. Third, as soon as the lock-up period ended, there was a potential risk- known as overhang"that some or all of the largest investors would attempt to liquidate at the same time, putting significant price pressure on the stock as a result of a supply/demand imbalance. A new REIT was especially vulnerable to overhang pressures from its largest institutional owners. Shea knew that any calculation of a gain had to be cost and risk-adjusted. She also wondered whether she should take comfort in the fact that management's lock-up expired 12 months after hers. A fourth concern for Shea was the folding of AMB's advisory and management business into the REIT, and the simultaneous formation of an investment management subsidiary. She questioned the reasonableness of the $92 million valuation assigned to the AMB advisory and management business and to a lesser extent the Performance Units and the additional value of the stock options. The new investment management subsidiary would manage existing assets in separate accounts for clients not contributing to the consolidation. Was there a conflict in whether the REIT or the separate account got a particular deal? A final concern was her exit options if she voted to sever ties with AMB. Unlike separate account holders, who could simply take their properties to another advisor, or even allow the new AMB subsidiary to manage them, the investors in the Current Income Fund owned shares rather than property. AMB offered to buy out any shareholder with cash that did not vote to contribute to the REIT; the buy out price would be in cash and at the private net asset value, prior to the initial public offering. While she was glad she had the opportunity to sell her fund shares for cash at their private market NAV (and not pay any broker commission or closing costs for selling the assets at NAV), she was having difficulty determining whether she should take the cash or reinvest her money in the AMB IPO. The Decision Anne Shea had more questions than answers as she prepared for her trip to the clients meeting in San Francisco. She welcomed the prospect of discussing the consolidation with other potential investors. She particularly relished the opportunity to present her list of questions and issues to AMB management in a public forum. While she remained skeptical, she was ready to listen carefully to management's arguments. First she wanted to confirm the calculation being shown to her. She needed to look at the value of the private net asset value (Exhibit 13) and compare it to the post IPO equity valuation for the Funds based on the projected AFFO, the current market multiple, and the proposed new $300 million from the IPO. She also knew this would be stepped up by an 8% discount once the shares were fully distributed. Would she really get a big premium by going through with this? Had she identified the risks? Was the premium, if there was one, worth it? Above all, Anne Shea wanted to make the right decision for the Curators' Fund. Exhibit 1 Annual Performance of Major Asset Classes Int'l Stocks 32.6 4.8 22.6 Year 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Large Cap Stocks 6.6 % 18.4 32.4 -4.9 21.4 22.5 6.3 32.2 18.5 5.2 16.8 31.5 -3.2 30.6 7.7 10.0 1.3 37.4 23.1 Bonds 1.4 1.9 2.7 6.2 32.6 8.4 15.1 22.1 15.3 2.8 7.9 14.5 9.0 16.0 7.4 9.8 -2.9 18.5 3.6 Small Cap Stocks 23.5 43.1 38.6 2.0 25.0 29.1 -7.3 31.1 5.7 -8.8 24.9 16.2 -19.5 46.1 18.4 18.9 -1.8 28.4 16.5 -2.3 -1.9 23.7 7.4 56.2 69.4 24.6 28.3 10.5 -23.5 12.1 - 12.2 32.6 7.8 11.2 6.1 Real Estate Securities 10.3 35.9 24.4 6.0 21.6 30.6 20.9 19.1 19.2 -3.6 13.5 8.8 -15.4 35.7 14.6 19.7 3.2 15.3 35.3 Cash 7.2 10.4 11.2 14.7 10.5 8.8 9.9 7.7 6.2 5.5 6.4 8.4 7.8 5.6 3.5 2.9 3.9 5.6 5.2 Source: Ibbotson Associates Business and Operating Strategies The Company focuses its investment activities in hub distribution markets and retail trade areas throughout the United States where opportunities exist to acquire and develop additional properties on an advantageous basis. The Company believes that the industrial property sector is well- positioned to benefit from strong market fundamentals and growth in international trade and that the retail property sector will benefit from limited new construction in "in-fill" locations and from projected growth in personal income and retail sales levels (in-fill locations are those typified by significant population densities and low availability of land resulting in limited opportunities for new construction of competitive properties). The Company seeks to capitalize on these current conditions in the industrial and retail property sectors by implementing the following business and operating strategies: National Property Company. The Company believes that its national strategy enables it to increase or decrease investments in certain regions to take advantage of the relative strengths and attractive investment opportunities in different real estate markets. Through its presence in markets throughout the United States, the Company has developed expertise in leasing, expense management, tenant retention strategies and property design and configuration. Two Complementary Property Types. Management believes that its dual property strategy provides significant opportunities to allocate capital and organizational resources and offers the Company an optimal combination of growth, strong current income and stability through market cycles. Select Market Focus. The Company focuses on acquiring, redeveloping and operating properties in in-fill locations. As the strength of these markets continues to grow and the demand for well-located properties increases, the Company believes that it will benefit from the resulting upward pressure on rents. Research-Driven Market Selection. The Company's decisions regarding the deployment of capital are experience and research-driven, with investments based on thorough qualitative and quantitative research and analysis of local markets. The Company employs a dedicated research department using proprietary methodology and systems. Property Management. The Company actively manages its Properties through its experienced staff of regional managers, each of whom makes all major business decisions regarding the Properties. The Company typically outsources property management to a select group of third-party local managers with whom the Company has established strong relationships. Management believes that by utilizing third-party property managers, the Company is better able to service its customers and more efficiently manage its costs. Disciplined Investment Process. The Company has established a disciplined approach to the investment process through operating divisions that are subject to the overall policy direction of its Investment Committee. AMB has also established efficient and effective proprietary systems and procedures to manage and track a high volume of acquisition proposals and transactions. Renovation, Expansion and Development. Management believes that value added renovation and expansion of properties and development of well-located, high-quality industrial properties and community shopping centers will continue to provide the Company with attractive opportunities for increased cash flow and a higher risk-adjusted rate of return than may be obtained from the purchase of stabilized properties. Financing Strategy. The Company intends to operate with a Debt-to-Total Market Capitalization Ratio generally of less than 45% and plans to structure its balance sheet in order to obtain an investment grade debt rating. Upon consummation of the Offering, the Company's Debt-to-Total Market Capitalization Ratio will be approximately 28.2%. The Company expects to obtain a $500 million unsecured credit facility for acquisitions (including, if completed, the Pending Acquisition) and for general corporate purposes. Strategies for Growth The Company intends to achieve its growth objectives of long-term sustainable growth in Funds from Operations ("FFO") per share and maximization of long-term stockholder value principally through the following: Growth Through Operations. a The Company intends to improve operating margins by capitalizing on the economies of owning, operating and growing a large-scale national portfolio. With respect to all Properties, during 1998, leases encompassing an aggregate of 10.5 million rentable square feet (24.1% of the Company's aggregate rentable square footage) are subject to contractual rent increases resulting in an average rent increase per rentable square foot of $0.70, or 6.1%, for an aggregate increase of $3.7 million. Based on recent experience and current market trends, management believes it will have an opportunity to increase the average rental rate on Property leases expiring during 1998 covering an aggregate of 6.2 million rentable square feet (5.6 million rentable square feet excluding the Pending Acquisition Properties). Growth Through Acquisitions.b The Company believes its significant acquisition experience and its extensive network of property acquisition sources will continue to provide opportunities for external growth. Management believes there is a growing trend among large private institutional holders of real estate assets to shift a portion of their direct investments in real estate assets to more liquid securities such as common stock and units in publicly traded REITs. The Company believes its relationships with leading pension funds and other institutional investors will provide an important source of acquisition opportunities. Growth Through Renovation, Expansion and Development.C Management believes it has the market expertise and access to identify and acquire value added properties and on a selective basis to develop new properties. The Company has developed the in-house expertise to create value through acquiring and managing value added properties and believes its national market presence and experience will enable it to generate and capitalize on such opportunities. 6. What should Curators Fund do in this situation? Do you think the stock is an attractive purchase at the proposed IPO price? The AMB Consolidation On August 13, 1997, Anne Shea of the Curators' Fund (the Fund) sat in her office overlooking downtown Kansas City, knowing she had to decide her position on the proposed consolidation of properties managed by AMB Institutional Realty Advisors, Inc. AMB managed half of the Fund's $80 million of investments in real estate, as well as over $2.8 billion of real estate assets for other pension funds, endowments and wealthy individuals and families. Until the recently proposed consolidation, Shea had been pleased with the Fund's relationship with AMB's experienced real estate team; investing with AMB provided a cost effective, value-added means for the Fund to directly own property. The proposed consolidation, however, seemingly threatened to change everything. AMB was a leading pension real estate advisory firm with an excellent reputation. In 14 years of operations, they had never lost a client. They earned fees for advising pensions on their real estate strategies, and for providing and managing investment vehicles in which pensions were the prime investors. Despite the fact that AMB was essentially a service company, AMB had recently proposed to turn itself into a publicly traded Real Estate Investment Trust (REIT). AMB planned to persuade its clients to contribute their real estate assets to the new REIT; simultaneously, AMB would fold their advisory and management business into the new REIT. A majority of the management team at AMB would stay on to run the REIT. Shea, assistant vice president at the Fund's Office of Investment & Banking, was preparing for an AMB clients meeting in San Francisco the next day where she would have to vote on the consolidation plan. In the preceding months, AMB had presented three options to each of its clients. Clients could either contribute properties and/or additional cash in exchange for shares in the new REIT; or maintain the status quo; with this choice, clients would not contribute the properties, but would allow AMB to continue to manage the properties; or sever ties with AMB. For Shea, this meant receiving cash for the appraised value of the Fund's investment prior to the initial public offering, since her current investment was in one of the commingled funds managed by AMB. For those with separate accounts, the option was to retain the properties themselves. Shea recognized the cogency of several of the arguments put forth in favor of the consolidation by the AMB team. She was particularly intrigued with the idea that Wall Street placed a higher value on the Fund's real estate than the private markets could. Yet several concerns were nagging at her. Before she left her office for the airport, Shea reviewed for one last time the huge stack of documentation on the consolidation. AMB Prior to the Planned Consolidation and REIT In August 1997, AMB Institutional Realty Advisors, Inc. was one of the leading real estate pension fund advisory and management businesses in the United States, with over $2.8 billion under management.1 AMB served 70 institutional clients; many were pension funds with substantial commitments to real estate. Douglas D. Abbey (A), Hamid R. Moghadam (M), and T. Robert Burke (B) founded AMB in 1983. In 1997, the three founders were still active in management, occupying the positions of Chairman of the Investment Committee, Chief Executive Officer, and Chairman of the Board of Directors, respectively. Ten executive officers had an average of 22 years of experience in real estate, and an average of nine years with AMB. AMB employed a total of 116 people in offices in San Francisco and Boston. AMB did not perform custodial property management services in-house. Rather, as asset managers, AMB sub-contracted the role of custodial property management to local firms in each market where AMB held property. As was standard in the industry, property management fees, typically 2% to 3% of gross rental revenueswere paid to third party managers at the AMB controlled real estate in three commingled funds and fifteen separate accounts. Two of the mmingled funds were organized as "private REITs," which were seen as improvements on the conventional commingled fund structure.2 In several of the funds, AMB earned incentive based compensation, which reduced (but did not eliminate) the use of traditional fee structures. AMB received, on average, a fee of 70 basis points on assets-under-management. In addition, fees for acquisition/disposition advice were, on average, 75 basis points of the gross transaction amount. When incentive fees were part of the fund structure, investors would receive a "preferred return" and their money back, after which AMB would be entitled to 10% to 20% of the remaining proceeds. property level. AMB focused its portfolio on industrial properties (primarily warehouse distribution centers) and community shopping centers. Management believed that the two property types were "complementary, and that AMB had developed an expertise for acquiring, developing and operating both types. AMB controlled 358 industrial building and 33 community shopping centers (see Table A for geographic diversity of the holdings). Table A Industrial and Retail Properties by Region Region Western Southern. Midwestern Eastern. Total Industrial Properties Number Rentable Number of Square Properties Buildings Feet 32 137 12,095,376 24 91 9,498,594 23 87 10,731,130 16 43 5,008,562 95 358 37,333,662 % of Total 35.5 25.4 28.7 13.4 100.0% Retail Properties Number of Rentable %o Centers Square Feet total 16 2,615,976 41.8 10 1,757,546 28.0 4 710,652 11.3 3 1,184,462 18.9 33 6.268.636 100.0% AMB enjoyed an excellent reputation throughout its first 14 years of operations. In polls of institutional investors and their consultants, AMB was consistently ranked as an industry leader, with respect to the expertise of its management team, the structure of its funds and property portfolios, and in client confidence in AMB's future performance. Steady growth in AMB's management and advisory business in the 1980s was replaced with rapid expansion in the early and mid-1990s. AMB's portfolio, as well as its fee income, had increased by approximately 35% per annum since inception. Real Estate Investment Trusts Real Estate Investment Trusts (REITs) grew out of the Real Estate Investment Trust Act of 1960 and were designed to be a "mutual fund" for real estate, allowing small investors to own a piece of a large, diversified portfolio of properties. One key attraction of REITs was that, although they were corporations and shielded the investor from liability, they did not pay corporate taxes and thus avoided the problem of "double taxation. Another attractive feature was that, like any corporation, they could provide liquidity by listing on a stock exchange and selling shares. To qualify as a REIT in 1997, a corporation needed to meet a series of tests set out by the Internal Revenue Service. Essentially there are five key requirements a corporation, business trust, or association needed to meet to be treated as a REIT: 1. Widely Held: The REIT was required to have at least 100 shareholders of record. Five or fewer individuals could hold no more than 50% of the shares directly or indirectly. (A change in the law had allowed one to "look through" a pension fund and treat its investment as if it were made by all the pension fund's beneficiaries.) 2. Invested Primarily in Real Estate: At least 75% of the value of the Company's total assets were required to be real estate assets and "temporary" investments in cash, cash items and government securities. Similarly, at least 75% of the REIT's gross income needed to consist of income derived from investments relating to real property or mortgages or temporary investments. For example, income from operating businesses like hotels, parking garages, and concierge services were disallowed. 3. Distributes Income Annually: The REIT was required to distribute 95% of its net taxable income to shareholders (excluding capital gains). 4. Does Not Churn Assets: Gain from the sale of real property held for less than four years (as well as gains from the sale of stock and from 'prohibited transactions') could represent not more than 30% of the Company's gross income for each taxable year. 5. Operates Like a Public Corporation: A board of trustees or directors, including generally a majority of independent directors, managed the REIT and the REIT's shares were required to be freely transferable. Historical Performance of the REIT Industry The REIT industry had a checkered history. Begun in 1960, the REIT industry experienced its first growth spurt at the end of that decade. Between 1968 and 1972, REIT industry assets jumped from $1 billion to $14 billion. Most of this money was invested in short-term construction loans, and to a lesser extent in land development loans. These were called mortgage REITs, and this type of short term lending was geared to take advantage of high short-term interest rates. Many REIT sponsors found they could further enhance their returns by leveraging their investments and capturing the spread between their cost of funds and what they could charge their borrowers. Unfortunately, the flood of money available to REITs in the late 1960s and early 1970s led to some poor underwriting. Many construction and land loans went into default, and the REITs ended up owning the properties. The REIT problems were further exacerbated in the mid-seventies by: (1) increasing inflation which drove up the price of the money the REIT's had borrowed, (2) an economic downturn which reduced demand for space, and (3) severely overbuilt markets which eroded rents. As a result, between 1972 and 1974 the average share price of REITs fell 66% and the average price of mortgage REITs dropped 75%. Devastated by these losses, it took a long time before investors were willing to consider whether the problems experienced by REITs in the 1970s lay in the structure of the REIT or the quality of the REIT's investments. Gradually, however, shares in some of the better managed REITs began to recover and by the early 1980s new REIT offerings began to appear. This flow of investment dollars accelerated somewhat after passage of the 1986 Tax Reform Act, which took away many of the tax advantages of owning real estate as a limited partner, and therefore improved the attractiveness of REITs versus private limited partnerships. The real catalyst was the collapse of real estate in the late 1980s and early 1990s. Through the invention of mechanisms such as UPREITs and DownREITs, developer/owners could transfer their holdings to the public markets in the REIT format without paying huge taxes on their "recapture." They could then postpone taking losses and paying taxes by waiting out the cycle. Insurance companies could also use REITs to rid themselves of real estate holdings efficiently at the portfolio level at a time of limited buyers and scarce private capital. In the early and mid 1990s, a number of large, private developers and owners of real estate went public. For many developers, the primary motive was to pay down their outstanding debt under pressure from banks (who faced their own pressures from bank regulators). Insurance companies, confronting the reality of collapsed real estate in their portfolios, and the prospect of regulators moving in to dissect their industry, wanted out of real estate and used REITs as the vehicle. As the markets recovered, other owners saw REITs as an opportunity to increase their liquidity and cash in during a hot market. Many operators converting to REITs took advantage of changes in the law that now allowed REITs to manage their own property, eliminating a conflict that had plagued earlier REITS. What emerged was a new set of public companies internally managed by experienced real estate developers, which had begun to attract significant attention from pension funds and other institutional investors. Increasingly, the pricing spread between privately held real estate and publicly held real estate was a main attraction driving private owners to convert to public ownership. As a result of increased availability of capital and significant consolidation opportunities, investors were willing to pay a premium to the underlying net asset value (NAV") of a company's existing assets if they believed that the company could grow faster than the growth of its existing asset base. In essence, the public was starting to value REITs as any other industrial company-on a forward earnings multiple. In the case of REITs, future earnings were based primarily on the income from long-term contractual leases of existing properties. Income growth was derived by releasing existing space at higher than current rents, reducing expenses, redeveloping assets to generate incremental income and by growing externally through new acquisitions and developments. The premium, which was often referred to as "franchise value," "value in excess of NAV," or "premium to NAV" had varied over time (as further described below). The general factors that were determinants of the NAV premium, or franchise value, typically included market environment and outlook, availability of growth capital, and management's ability to create future value. As of August 1997, Wall Street valued the equity value of public real estate companies at a 26% premium to NAV.5 Consider a privately held, family real estate business with cash flow from operations (or NOI) of $100 million in August 1997. Private markets valued the assets at, for example, a 9% capitalization rate (for ease of example), or a total value of $1.11 billion. Assuming $300 million in debt (at a rate of 8%), the private NAV would have been approximately $811 million. If the markets believed the operator was capable of and planned to access new growth capital and create value going forward, they would have valued the enterprise on a forward multiple, the result being, simplistically, that the public market would have valued the equity at a value 26% in excess of NAV or approximately $1.022 billion (implying an asset value of $1.322 billion). See Exhibit 5 for a demonstration of this premium. Based on such values, the implied FFO multiple (more below) was 13.4x and the real estate cap rate on the assets was 7.6%. By "going public the private operator could potentially create value of $211 million in August 1997. Of course, some of this value had to be shared with investment bankers (the average investment banking fees of going public were in the range of 5% to 7% of the offering amount) and a value needed to be assumed for the operator's management contribution. Other intangible costs (such as daily market valuations, a need to achieve quarterly earnings targets and a significant level of disclosure and scrutiny by investors, analysts, rating agencies, etc.) clouded the clarity of the decision for many private operators contemplating "going public. In July 1997, the REIT industry set a new monthly record for public equity offerings. REIT shares as a group rose 35% in value in 1996, compared to the S&P 500's rise of 23% (see Exhibit 1). Over the preceding five years, REITs had posted higher yields and higher total returns vs. the broad market index (see Exhibit 2). Based on results through July 1997, REIT analysts were predicting another healthy year in 1997. Exhibit 3 traces the growth in total market capitalization of all REITs from 1971 to 1997. It is noteworthy that despite the rapid growth in assets, the number of publicly traded REITs had actually declined slightly due to mergers and acquisitions of existing REITs owned. Carrying this analysis another step, the impact of the growth of REITs varied by different property type segments. As an example, a high number of all-regional malls were owned by REITs compared to only a small portion of industrial buildings. Valuing REIT StocksFunds From Operations (FFO) A flourishing REIT market in the 1990s led inevitably to a divergence of opinions on the proper way to value REIT stocks. Many analysts treated REITs just like any other public company and valued them using a dividend discount model. They focused on the current cash flow and the ability of a given REIT to increase the cash flow and the dividend. With all other types of stocks, analysts emphasized net income as the basic yardstick. With REIT stocks, however, net income as prescribed by GAAP was misleading. Historical-cost based depreciation of real estate assets, while an expense in terms of net income calculations, often did not reflect real depreciation of the assets, which tended to increase or decrease in value based on market conditions. Comparing reported net income of different REITs was therefore deceptive. To level the playing field among public REITs, the REIT industry developed a measure called Funds from Operations (FFO). To calculate FFO, analysts started with net income, added back real estate related depreciation and amortization, and adjusted for non-recurring items such as gains or losses on asset sales.? Alternatively, FFO was equal to a) Cash flow from operations (or NOI) from the properties less corporate G&A and interest expense or b) EBITDA (earnings before interest, taxes and depreciation) less interest expense (REITs do not pay tax). REIT prices were often described and compared in terms of FFO multiples, which was the ratio of price to FFO.8 Adjusted Funds from Operations (AFFO) AFFO was a further refinement of FFO, and was calculated by starting with FFO, then subtracting capital expenditures. Increasingly, analysts and industry observers were comparing REITs in terms of AFFO multiples rather than FFO multiples. The relationship between FFO, AFFO and cash flow from operations on the property level, a pre- debt stand