Associated Estates Realty Corporation
Dear Fellow Shareholders:
We are disappointed with certain aspects of our operating performance in 1997. Rent growth was lower than expected in all of our regions, and our average economic occupancy for the core market-rate portfolio was the lowest we've posted in several years. Thus, substantially all of the shortfall in our growth in Funds From Operations (FFO) per share was the result of our inability to increase rents in line with our original four to five percent rental growth objective.
The following is a more detailed review of our 1997 performance. This letter also addresses what we are doing in 1998 to strengthen our performance, including the acquisition of privately-owned MIG Realty Advisors, Inc., one of the nation's preeminent multifamily asset managers and pension fund advisors.
1997 Performance
Total revenue increased 15.2 percent while the size of our property portfolio grew 11.1 percent in 1997. Funds From Operations (FFO) increased 2.9 percent to $34.7 million or $2.14 per share. Average economic occupancy in the core market-rate portfolio was 94.0 percent for the year, and average net collected rents for the core portfolio market-rate properties increased 1.8 percent to $579 per suite. While we projected rent increases in our core market-rate portfolio of four to five percent in 1997, lower than expected inflation and the dynamics of some of our markets thwarted our ability to increase rents as aggressively as we had planned. Simultaneously, while we anticipated a slight increase in vacancies in conjunction with our rent growth objective, higher than expected vacancies further depressed our overall rent growth.
During 1997, we entered two new markets - Indianapolis, Indiana and Cincinnati, Ohio - and continued to expand our presence in Michigan as well as in Columbus and Toledo, Ohio. We added eight properties containing a total of 1,762 suites to our portfolio in 1997, and we purchased a 316-suite apartment community in Toledo, Ohio in February 1998.
In connection with the MIG acquisition, we added three additional properties to our portfolio in February 1998, containing a total of 1,004 suites, located in Florida, Georgia and Maryland. The transaction also contemplates the acquisition of MIG's property management and investment advisory businesses, eight additional properties currently managed by MIG, and the potential acquisition of as many as three development properties in Florida. The acquisition will nearly double the size of our portfolio to approximately 36,000 owned and managed suites.
While most of our growth beyond our core portfolio is through the acquisition of existing properties, we have extensive experience with new construction. Developing new properties can be an important part of our growth, particularly in situations where either we cannot buy a property that meets our criteria or we see a niche within a market or submarket to develop a product that otherwise does not exist. In late 1997, we completed construction of the 324-suite Bradford at Easton development in Columbus, Ohio, while two other development properties - The Residence at Barrington in Aurora, Ohio and The Village of Western Reserve in Streetsboro, Ohio - are scheduled for completion in 1998. Expansions to three Michigan properties are also under way. These properties are discussed further in the "Acquisitions and Development" section of this report.
In 1997, almost all of our market-rate properties became linked to our headquarters through LISAĻ, our proprietary automated leasing information system. Developed in 1995 by our leasing consultants, business managers and marketing staff, the program has become a tremendous help in terms of gathering marketing and leasing data and in reducing the amount of paperwork at each property, leaving more time for leasing agents to service existing customers and attract new ones. During the year, we completed the implementation of PeopleSoft financials, budgets, human resources and payroll systems. Our next step will be to link these systems with Yardi's rent collection system.
The most efficient and cost effective way to keep the Company growing is to use internally generated funds - cash generated from operations after dividends. In 1997, the annual dividend was $1.86 per share (or $.461/2 per quarter), representing a current yield of approximately 9 percent. Based on our disappointing core performance in the fourth quarter of 1997 and the continued slow growth into the first quarter of 1998, your Board maintained the dividend at $.461/2 per share for the first quarter of 1998. Historically, we have reviewed our dividend policy annually, at the beginning of the year. For 1998, in consideration of the MIG transaction and anticipated improvements in our core operating performance, your Board is expected to further review the dividend policy in subsequent quarters.
In addition to cash generated from operations, we have funded our growth through a combination of debt and equity financing. During 1997, we issued four Medium-Term Notes (MTNs) for a total of $50 million and completed an equity offering of 1,750,000 shares which generated net proceeds of approximately $38.9 million. Our total market capitalization is currently in excess of $750 million. We have charted a steady growth path by maintaining a conservatively structured balance sheet. Our financing resources presently include $292.7 million available under our shelf registration statement, including $82.5 million on our MTN program. Currently, 87 percent of our wholly owned properties have no mortgages. A reduction in pricing on our line of credit in April 1997 allowed us to reduce our short term borrowing costs, and at press time, we were negotiating an increase in the amount of our line of credit and additional pricing improvements.
1998 and Beyond
Although our operating performance in 1997 was below expectations - particularly, occupancy and our margins - we believe that we are on the right course. The market fundamentals in our region remain solid, and we have some exciting new development projects coming on line. We have invested heavily in state-of-the art technology to streamline our procedures, reduce paperwork, and provide us with more timely data.
With respect to our existing portfolio, we are identifying opportunities to reposition several properties, including some of our government-assisted properties, and to sell our congregate care facilities. We are also negotiating with some of our joint venture partners to buy their interests in these properties or sell them ours. Our budgeted projections for 1998 of a two to three percent increase in rents in our core market-rate properties, and a corresponding increase in expenses, reflect our more realistic expectations based on last year's actual results.
We will continue to try and buy apartment properties with functional suite layouts that can be operated with maximum efficiency. We expect to continue to grow primarily through single property acquisitions. At the same time, we expect to have 500 to 700 suites under development, which relates to approximately $50 million in construction annually.
Historically, we have been valued as a Midwest company, and we continue to be very committed to the Midwest. We believe the region is quite resilient and does not really peak or bottom out like many of the other markets. At the same time, with the acquisition of MIG, our focus will expand beyond the Midwest. MIG offers a research driven growth capability with skill and experience in multiple markets across the country, and a strong history as a multifamily investor and operator on behalf of many of the nation's leading pension funds. We expect our internal growth rate to rise with the introduction of higher growth cities in the Southeast and Southwest while our steady, stable assets clustered around Cleveland, Columbus and Detroit balance the potential income volatility that might be expected in some of these other markets. The combination, we believe, will broaden our geographic platform, better deploy our capital in markets with different growth dynamics, and allow us to take advantage of the secular shift of pension fund ownership of real estate assets through public companies.
In addition to acquiring quality assets through the MIG transaction, a number of talented employees will be joining us as well. Larry E. Wright, currently Chairman of MIG, will become Executive Vice President of AEC. Larry is also expected to be elected to the Board of Directors. Larry has been directing the day-to-day operations of MIG since 1982 and has over 24 years' experience in the real estate business. Louis E. Vogt will assume responsibility for all Company operations. As Senior Vice President and Chief Operating Officer of MIG since 1992, Lou has been responsible for property management, asset management and acquisitions. James A. Cote' will become President of MIG Realty, Inc., a new wholly-owned subsidiary of AEC, and will continue to be responsible for developing advisory and co-investing business and maintaining current relationships with institutional investors. Experienced key personnel in capital markets, research, strategic planning and financial reporting will also be joining us from MIG.
Real estate is a long-term business, and our strategy continues to be long-term value creation. It is with that perspective that we expect to continue to grow. We appreciate your continued support and confidence.
Sincerely,
Jeffrey I. Friedman
Chairman, President and CEO
March 17, 1998
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