PS Business Parks Gets Paid to Be Flexible

One REIT prospers by catering to the needs of young, fast-growing businesses.
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Hit by a double-whammy. That's what comes to mind as I cogitate over the outlook for

PS Business Parks

(PSB) - Get Report

. First off, it's a REIT, a sector that has fallen more than 10% since the beginning of the year. Second, it's a small-cap stock, with a market cap of under $700 million, and we all know what's happened to small-caps.

But, even with two strikes, it's still possible to hit a home run. Is PS Business Parks the ticket? Take a look.

Flexible Focus

PS Business Parks is the only public REIT focusing on what are called flex-space properties. Located near air- and surface-transportation hubs, these buildings lease space for office, warehousing and light industrial uses on a short-term or flexible basis. The company owns 114 properties with 11.3 million square feet, principally in five markets: northern Virginia, Dallas, Southern California, San Francisco Bay and Portland.

The company's leasing structure is unique. It has more than 3,500 tenants, the largest accounting for less than 5% of revenue. True, lease turnover is about 25% annually, high by office and industrial standards, but that figure may be a little misleading. "The turnover serves us well," said CEO

Ron Havner

at the recent

Sutro Real Estate Conference. "Our new leases are seeing 10% to 12% rent increases." In addition, more than half of the company's leases have fixed escalator clauses, with annual increases of about 5%.

It helps that the company is well positioned in high-growth regions. "PSB's dominant markets are centers of innovation," says

Sutro & Co.'s

Craig Silvers, who rates the stock as his top REIT pick. "These markets are leaders in business development, places where new companies are started, exactly the type of tenant attracted to PS Business Parks properties." Sutro has not provided banking services to the company in the past three years.

A Bulletproof Balance Sheet

Another distinction between PS Business Parks and its brethren is in the strength of its balance sheet. While the average REIT has a debt-to-market cap of nearly 50%, PS Business Parks' ratio is less than 7%. And the company refuses to lever up. "We don't look to take on additional debt," said Havner. "We don't want balance-sheet and interest-rate risks."

Analysts like that attitude. "This is the kind of balance sheet we look for: little leverage, solid retained cash flow, good management and good focus," says

Cliffwood Partners

Carl Tash.

Analysts also like the company's growth prospects. For example,

Donaldson Lufkin & Jenrette

REIT analyst Larry Raiman thinks the company can grow an average of 13% over the next two years. He estimates the company will earn $2.42 a share in 1999 and $2.73 in 2000.

Cash flow from operations looks healthy, too. Sutro's Silvers estimates the company will grow 1999 funds from operations from $2.14 a share in 1998 to $2.39 a share this year to $2.72 in the year 2000.

Just as important, both analysts think earnings are very predictable. "PSB's earnings growth should be quite tangible as the lion's share of its growth comes from internal sources," wrote Raiman in a recent report with a buy rating. DLJ has not provided banking services to the company in the past three years.

Raiman points out that an unusual feature of PSB is the company's ability to retain and reinvest its large free cash flow, the result of the company's use of accelerated depreciation and some previous acquisitions with net operating loss carry-forwards. That makes PS Business Parks one of the few REITs capable of financing its own growth. According to Raiman, "PSB should be able to retain about $34 million of cash flow in 1999 and about $45 million in 2000."

It also means the current dividend of $1 -- a yield of 4.6% -- reflects a payout that represents only 42% of estimated 1999 FFO. (The industry average is 66%.) "We expect the board to raise the dividend, although management will keep the payout considerably below average to fund future growth," says Silvers.

A Blemish or Two

PS Business Parks is a REIT with little leverage, the ability to grow organically and a good property-and-tenant mix. Indeed, it's a good story but one with some risk.

"Flex space has a higher beta than any other property types," says Cliffwood's Tash. "Rents increase rapidly in a good economy but can swoon in a slowdown. At some point, the economy will slow."

Silvers agrees a recession would hurt the company but wouldn't be dire. "During the 1990-91 recession, the company's net operating income dropped an average of 8% over two years," he says. The company's low leverage and available cash flow should mitigate the impact of any slowdown.

Potentially more critical is the small float in the stock, which trades an average of just over 17,000 shares daily. And if you remove the holdings of

Public Storage

(PSA) - Get Report

, its original parent, and large institutional holders, the public float is a scant 5 million shares. That may present a liquidity risk to investors trying to get out.

While he likes the company, Tash sees the small-cap REIT enigma continuing. "Names like this are a compelling value," says Tash. "However, I'm afraid they could become an even more compelling value in the future."

Still, Silvers thinks it's a great long-term value play. "From a total return potential, there are none better," he says.

On a Technical Note

Many of you have chimed in when I opine on specific companies, saying you like to hear (and see) the opinion of

TSC's

friendly resident technician,

Gary B. Smith

.

Your wish is my command. Gary's chart appears below. As most technicians will tell you, the trading dynamics of REITs have been perfectly awful, and those of PS Business Parks are no exception.

Next week, a look at first-quarter performance and the quarterly scoreboard -- readers vs. the REIT Roundtable and answers to some of your recent queries. Have a REIT question? Shoot me an

email, and I'll do my best to include it next week.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held any position in the stocks mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com.