525 North Tryon St.
Charlotte, N.C.
Banking on a Niche
[May/June 2005]

By Darlene Bremer

Unique Focus Delivers Fast Growth to American Financial Realty Trust

Since its inception, American Financial Realty Trust (NYSE: AFR) has focused on acquiring and operating properties leased to regulated financial institutions, such as banks, brokerages and insurance companies, with terms ranging from 10 years to 20 years. Founded in 1996 by Nicholas and Shelley Schorsch as a mergers and acquisitions firm called American Financial Resource Group (AFRG), the company originally acquired operating companies in the printing, label and financial services sectors. Two years later, as part of a portfolio diversification strategy, the Schorsches began acquiring real estate properties.

1725 The Fairway
Jenkintown, PA 19046
Chairman: Lewis S. Ranieri
CEO, President & Vice Chairman: Nicholas S. Schorsch
COO & SVP-Asset Management: Glenn Blumenthal
CFO: James T. Ratner
• 52-Week High: $18.44 (3/1/04)
• 52-Week Low: $12.60 (5/10/04)
Core Markets: The company owns properties in 34 states.

"First we bought a few office buildings and a group of vacant bank branches made redundant by the merger of First Union (now Wachovia) and Core States, and in 1999 we began to acquire larger assets," Nicholas Schorsch, vice chairman, president and chief executive officer, says.

The first major acquisition made by the company was the Fidelity Building, an 882,000 square foot office building located in downtown Philadelphia. Acquired for $110 million, AFRG leased most of the building back to First Union for a 20-year term. At the time, the advent of the Internet as a commercial marketplace had led most to believe that bank branches would become obsolete, but as the 1990s progressed that promise was not realized and by the end of the decade, banks were still expanding, rather than contracting, branch operations.

"In examining the financial institution segment, it was becoming evident to us that banks needed to reposition their assets and redeploy capital toward their core business, rather than leaving money invested in owner-occupied real estate," Schorsch says.

That belief led the company to focus on acquiring entire portfolios of properties from large financial institutions and then leasing them back with net-lease, long-term leases. "We were initially surprised that the sites of bank branches vacated through mergers were still being sought after by the smaller financial institutions, and even when not leased to a bank, the sites are excellent choices for upscale retail uses," he says.

Getting Started

2610 West Sugar Creek Rd.
Charlotte, N.C.
From the beginning, the company's goal has been to build a safe, long-term, low-risk portfolio with excellent credit quality.

"With 20-year net leases signed by financial institutions, we could acquire 20-year fixed financing for our acquisitions," Schorsch says. In addition, the company sold its non-bank assets to maximize value, which allowed AFRG to focus on financial institutions.

Then, in September 2002, AFRG consolidated $270 million of its bank-specific assets, and, along with Lewis Ranieri, one of the pioneers of mortgage-backed securities, created American Financial Realty Trust (AFR), and simultaneously raised $405 million in a private equity placement of 40 million shares.

"With the additional equity capital, we were in a position to make even more acquisitions," Schorsch says. By this time, AFR had acquired more than 300 bank buildings and branches in multiple states, largely in "bulk sale" transactions. It was a risk, but the company saw an opportunity to develop a niche that focused entirely on acquiring properties and leasing them to financial institutions.

"Our strategy is not a typical ‘buy and sell' approach, but one that allows us to build a tremendous pool of real estate assets that would encourage banks to continue to do business with us," Schorsch says.

Public Momentum

For the company to continue to grow, the next logical step was to go public. In June 2003, seven months after its private equity placement, the company conducted an IPO for an additional 65 million shares.

"If the business model we'd established was to succeed long-term, we needed more capital," says Glenn Blumenthal, senior vice president of asset management and chief operating officer. Investors bought all of the available shares, which were priced at $12.50, a 25 percent premium over the $10 per share price of the private equity placement.

"The initial share price [of $12.50] was based on the $750 million of assets in our portfolio at the time, and by year's end the portfolio had more than doubled in size and our stock price was over $17," Blumenthal adds.

Currently, the company's stock trades around $15.00 per share, with approximately half a million shares traded per day.

Both the company and its shareholders received various benefits from the IPO. According to Schorsch, going public allowed AFR to demonstrate to the marketplace that the company's business model provided stable growth in cash flow with limited risk, due to the high credit quality of its bank tenants. Shareholders received shares in a company with nearly 90 percent of its revenue derived from long-term leases with "A" credit companies and a low (less than 3 percent annually) lease rollover rate.

According to industry analysts, AFR's strategy has worked well for the company in many respects since the IPO.

"AFR has demonstrated that a product flow exists and its stock, which is relatively attractively valued, currently trades at 14 times our 2005 adjusted funds from operations (AFFO) estimate, while the whole group we cover is trading at 16.8 times our estimate," says Paul Puryear, managing director, real estate research for Raymond James Financial.

One disappointment, however, has been the company's yields relative to the marketplace. "The asset pricing that AFR has experienced has been higher than the company probably envisioned, but then real estate prices across the board have held," Puryear says.

And if AFR's AFFO growth rate has been slower than anticipated since the IPO, that can be attributed to the difficulty in finding attractively priced assets combined with the relatively slow recovery, in general, of the office market.

Future Strategies

AFR held $500 million of assets in 2002, $2.1 billion in 2003, and nearly $4 billion at year-end 2004, for a 600 percent growth rate over three years. The number of properties the company owns in 34 states and 120 markets has grown from 259 in 2002 to 959 in 2004, and square footage has increased from 7.1 million square feet in 2002 to approximately 33 million square feet in 2004. Dividends have grown from $0.22 in the fourth quarter of 2002 to $0.26 in the fourth quarter of 2004, and total capitalization has grown from $2.6 billion in 2003 to $4.4 billion in 2004. "We attribute such a rapid growth rate to a market that has a tremendous need for the product we offer and for the customer-centric business model our company pursues," Schorsch says. He also credits the company's growth to the skills and dedication of its management and employees, and the relationships the company has built with its tenants, customers and shareholders.

The company's strategy of focusing on financial institutions has positioned the company to make numerous acquisitions. In 2004, according to Schorsch, financial institutions owned $92 billion of real estate, which has historically been considered a drag on their capital.

"As banks try to move their real estate assets off their balance sheets, we have built a platform that allows them to sell their holdings to us, expand their business with needed capital, and have flexible occupancy options with leases that extend beyond the normal three-year business cycle," he says.

Even while banks are divesting their real estate holdings, they are in the process of expanding their branch operations around the country. For example, Bank of America opened 180 new branches last year, Fifth Third Bank Corp. announced 70 new branches for 2005, and Washington Mutual is planning to open more than 200 new branches over the next few years. Since AFR already has a large portfolio of branch properties that are available for lease and fitted for banks, and has capital to acquire other vacated branches, the company is in a unique position to take full advantage of that opportunity.

AFR's future growth strategy is to continue to commit the company's balance sheet to properties occupied by financial institutions and to work with strategic partners and strategic properties on a broad-based deployment across all 50 states.

"Our goal is to plan all new expansion in advance and to develop product lines that service all of the regulatory, flexibility, lease structure, and capital needs of our financial institution customers," adds James Ratner, senior vice president of finance and chief financial officer.

Impact on Performance

According to John Kim, real estate analyst with Banc of America Securities, the market has reacted cautiously to AFR's sizeable acquisition activity, and even reacted negatively when the company announced its $705 million State Street Financial Center acquisition in 2003 because, at the time, it was the highest price per square foot in the Boston market.

"We believe this represented a shift in acquisition strategy. With so much market activity, it is difficult to gauge the quality of the company's acquisitions, and vacancy has remained high relative to its peers," Kim says.

In addition, at its current leverage level, Kim believes that AFR would likely need to raise additional equity to fund future acquisitions. "The company's business model and somewhat niche strategy potentially makes it an attractive investment, particularly if it can create value with its vacant spaces through successful leasing and/or selling at a profit," he adds.

However, office REITs that own and operate properties nationally have not typically realized tremendous economies of scale, and are often at a disadvantage to the leading competitors in the geographic markets.

Even though the majority of AFR's assets are net-lease, which require lower maintenance costs, the company's staffing requirements are still probably lagging, which can impact performance, according to Christopher Haley, managing director of Wachovia Securities.

Samplings of what analysts are saying about American Financial Realty Trust

Rating: BUY2 (2/25/05)
12-month Projected Target Price: $16.50
"We believe that AFR's good external growth potential and 14-year stable leases remain compelling factors. … We are maintaining our 2005 and 2006 AFFO per share estimates at $1.14 and $1.20, as reimbursements and straight line rent adjustment for the next three quarters are offset by increased operating expenses. Further, we are assuming $200 million in acquisitions and equity issuance of 5 million shares in 2006."

Banc of America Securities
Rating: NEUTRAL (2/25/05)
12-Month Projected Target Price: $15.00 "We believe AFR trades at a 24 percent AFFO discount to the office sector, partly due to the unnecessary complexity when comparing AFR to its peers, volume of moving parts and limited operating history. ... In the past six months, same-store occupancy increased 290 basis points to 87.2 percent, and same-store revenue increased 1 percent. However, AFR appears poised to continue aggressive external growth, which will require a meaningful equity infusion given its current leverage."

Legg Mason
Rating: HOLD (2/28/05)
12-Month Projected Target Price: NA "In our view, AFR has an improving story, with strong earnings and dividend growth in a unique niche. This is offset by an unusually high execution risk profile embedded in the growth program. … (We) believe the stock could have significant upside potential if the company can maintain its exclusive acquisition strategy and tenant credit quality."

Raymond James & Associates, Inc.
Rating: MARKET PERFORM (2/25/05)
12-month Projected Target Price: NA "We continue to struggle with the key question in our evaluation of American Financial: Is this company making money for investors? We suspect that the answer is yes, but based on what we regard as comparable metrics we conclude that the shares are fully valued are therefore downgrading AFR shares to Market Perform from Outperform."

"What is important is that the company continues to execute its strategy, and that it can close transactions quickly with its available capital, so its operating platform is quickly catching up," Haley says.

With the sale of a 30 percent minority interest in the State Street property recently at a 10 percent imputed profit, investors' concerns about the original purchase price have been somewhat mitigated.

"The sale was another example of the company's capital recycling program, which mitigated market concerns that AFR would need an immediate infusion of capital to bring its leverage down," Haley says.

The State Street sale, along with others announced since, has illustrated, in Haley's view, that AFR is becoming more prudent and efficient with its capital planning. However, AFR's sole focus in the financial institution segment increases some investors' concerns. It can be argued that, if banks fail, AFR would be severely hurt.

"There are also concerns over the residual value of the company's assets if bank tenants decide to leave, particularly in the larger buildings in AFR's portfolio," he says.

With such fast growth over such a short period of time, the AFFO growth per share has actually been slower than anticipated, according to Puryear.

"Although the investment rate in the company has been substantial, it is still unproven whether the return on investment is going to meet shareholders' objectives," he says. The market, he adds, is waiting to see if AFR can lease or sell its assets and create higher yields.

Friedman, Billings, Ramsey & Co., Inc. analysts cited in a recent report three areas where AFR will be challenged to improve results in 2005. First, the company has to redeploy equity from the sale of a minority interest and the sale of largely vacant properties. Second, the company received about $5 million in one-time income in 2004, and thirdly, AFR has a piece of debt that it will refinance in June of 2005 at a higher fixed rate.

"At about an 87 percent occupancy rate, AFR has room to work toward improving returns. We believe, however, that the company's run-rate of earnings will lift to an annualized rate of $1.40 or better over the next four or five quarters," says Merrill Ross, FBR managing director.

In a small amount of time, AFR has transformed itself from a small, privately held company with a few assets to a publicly held REIT with a great number of properties across the country. The company assumes some risks in its focused strategy, but these risks are mitigated by its long-term leases to high-credit companies, improved capital planning, and the discounted valuation of its stock, Schorsch concludes.

"As banks continue to divest their corporate real estate, we believe that our strategic relationships, growing visibility within the banking industry, and flexible acquisitions and lease structures position us well for continued growth," Schorsch says.

Darlene Bremer is a regular contributor to Portfolio.