Fall 2000
	Cover Story Doing the REIT Thing Western Properties’ Brad Blake and Bradley’s Tom D’Arcy put their shareholders first. Now they’re looking for work. Company Spotlight Failure to Communicate The "REIT Story" is a good one. Unfortunately, many companies haven’t done as good a job as they should have in telling it. Sector Spotlight Critical Conditions Opportunities among the healthcare REITs, but be careful out there. The New Economy Plugged In Making Money in the Internet Age Tracking The Market Bye, Bye Bear Market Blues After two of the worst years in their 40-year history, REITs have staged a strong comeback. By The Numbers Much Better, Thank You Real estate fund managers may never live down the 1998-99 bear market, but at least these days they can go out in public. Washington Wire Legislative Relief No legislation in the roughly 40-year history of REITs had the potential to alter the landscape more dramatically than the recently enacted REIT Modernization Act. Investment Basics Just How Safe Are REIT Dividends, REALLY? Yield-conscious investors drawn to REITs by their "rich" yields need to look beyond what’s printed in the stock tables of their daily newspapers. Investment Insight Opposites Attract It didn’t come as a surprise to portfolio managers at LaSalle Investment Management that REITs soared when tech stocks hit the wall this past spring. Investment Fundamentals NAV Growth: A Meaningful Performance Yardstick Growing FFO and enhancing shareholder value are not always one and the same. Focusing on NAV growth is a better, though not perfect, alternative suggests Green Street’s Mike Kirby and Jon Fosheim. Editor's Note The Journey Continues ... Parting Shot Wrestling With Net Asset Value The Penobscot Group’s Frederick S. Carr Jr. questions whether the market is telling investors that NAV is irrelevant. Newsline Urban To Be Acquired By Rodamco For $3.4 Billion Investor's Guide Questions Back Issues Feedback

by Bret R. Wilkerson and Susan Hudson-Wilson

The 1970s’ REIT bear market was the result of economic recession, high inflation, and overextended balance sheets. In the 1980s, the bear market was caused by construction loans that were made in an extraordinary environment of heady competition and rapidly declining underwriting standards. What happened this time? Fundamentals were solid, and yet the REIT market experienced poor performance. This time, the REIT industry failed by telling the broader market the wrong story.

After the extraordinary downturn of the early 1990s, real estate values were heavily discounted. Capital abandoned private real estate operators, who then turned to the public market. As often happens when an asset class cycles severely, there was significant value creation on the next upside, and investors were primed to take advantage of it. Real estate’s increasing rates of return drew capital back to the asset class, giving birth to the modern REIT.

The growth story was told in many ways during the period stretching from the early 1990s through late 1997, and the market rewarded those companies that told it best. Companies talked about external growth from accretive acquisitions and spread investing. They also focused on growing market capitalization. Com-panies were creating value through economies of scale, initially via acquisitions and then increasingly through development. Later, stories focused on accelerating internal growth and maximizing the performance of individual assets. Today, much of the buzz is about the rapid growth of ancillary revenues resulting from the passage of the REIT Modernization Act.

The market heard these stories and based pricing not on the absolute growth of cash flows or values per se but rather on the rate of growth. As long as real estate and real estate company returns were increasing at an accelerating rate, the market rewarded REITs. Momentum was supportive until the first quarter of 1998, at which point the market foresaw decelerating growth. While returns would remain strong, and values and NOIs would still increase, they would do so at a slower rate. The momentum was gone. REITs had accelerated into a brick wall. The underlying properties within REIT portfolios were behaving like...well, like properties! In the stock market environment, this doesn’t cut it.

Property & Portfolio Research’s econometric models help our clients understand real estate market performance. We expected the primary driver of REIT market performance to be the level of returns of the underlying real estate. In recent years, however, that has not been so. Instead, the rate at which private equity real estate returns were increasing appears to have had a larger impact. The graph on this page shows the level of the NAREIT Equity REIT Index along with the total returns of the NCREIF (National Council of Real Estate Investment Fiduciaries) Index, representing the performance of private equity real estate. Note that there is a slight disconnect in timing, because public market pricing is forward looking and the private market is slower to re-price change.

When the NCREIF returns are lagged by two quarters to account for this, the correlation between the public and private markets is 0.91! The two moved in tandem not just on the upside of the cycle, but also have continued to do so over the past two years. When private market returns were growing at an increasing rate, capital flowed into REITs and drove up prices. When the momentum died, and private equity real estate returns were not so strong, capital flowed away from REITs.

Today’s REITs are capital constrained. They are unable to sustain the myth of accelerating growth fueled by "accretive" acquisitions. Further, they are facing market fundamentals that will produce only modest growth in "same-store sales." What’s a REIT to do?

• Be a trader, not a holder. Buying, holding, and simply creating a larger company will not necessarily provide the best returns. REITs must focus on continually rebalancing their portfolios to maintain a consistent and reliable (although not necessarily faster growing) income stream. To a certain extent, companies will need to time real estate markets. Old guard real estate operators tend not to believe that market timing is possible, but real estate cycles generally move rather slowly and, we think, predictably.

Using our models of real estate market performance, we have examined buy and hold vs. trading strategies for 60 markets and four property types over history. The buy and hold strategy substantially underperforms the trading strategy in the vast majority of markets. Even when we relaxed the trading rules, active portfolio management generally proved more beneficial than simply holding through a cycle. This analysis was done with data over the last real estate cycle, one in which most markets cycled together, and smart trading was more difficult. Today, trading strategies are easier; there are a wide variety of market behaviors today, making it more practical and productive to trade in to and out of markets.

• Dispose of assets in unhelpful markets, not "noncore" markets. Because there are many different market cycles, REITs must harness those differences to reduce market risk at the portfolio level. While a number of companies have initiated programs of harvesting and redeploying capital, there is a focus on selling assets that are in "noncore" property types or geographies. Sales of assets have increased significantly over the past two years and impacted the average level of portfolio risk. The graph on this page shows our estimated value of the real estate sold by a sample of 107 companies tracked by our firm since 1995. In addition, we have calculated the change in risk level for each of the portfolios.

The risk level measures the portfolio level standard deviation that takes into account both the risk levels of the individual market exposures and the cross-correlations among those markets. For the subset of companies conducting dispositions each year, the percentage that decreased portfolio risk is shown on the left axis. In the past two years, sales reached record levels and acquisitions dropped off dramatically. Those also happen to be the two years in which the fewest companies reduced portfolio risk! Over the entire time period, roughly 55 percent of the companies with dispositions decreased risk vs. only 36 percent in 1998 and 53 percent in 1999. Clearly, most REITs are not using portfolio theory in order to help make asset allocation decisions. REITs must try to understand which assets and market exposures are the most productive in the context of their specific portfolios and not simply sell noncore assets in markets and property types where they do not have a major focus. In fact, a number of REITs have small exposures to noncore metros or property types that are extremely helpful in reducing the overall risk of their portfolios.

• Stress income over growth in value. Beyond the strategic methods REITs must employ to maintain consistent increases in income, they must educate investors about the long-term benefits of real estate ownership. In particular, the industry needs to become adept at telling a story that focuses on income levels and the percent of the total return that is comprised of cold, hard cash as opposed to stressing growth. As shown in the graph on page 24, income is the largest source of real estate returns, both in the REIT and private equity real estate markets. Over the past 20 years, REITs have averaged a yield of 9.3 percent, nearly as much as the Lehman Brothers Aggregate Bond Index.

To whom should REITs tell the income story? Recent increased volatility in the broader markets has brought value stocks to the attention of many investors and market strategists. While a massive flow of capital into REITs would be welcomed by most participants and provide short-term upside, it could be hazardous in the longer term when fickle capital decides to shift to another sector. The flight of nondedicated capital was a major factor in the sub-par performance of the REIT market during 1998 and last year. With the overall REIT market capitalization at approximately $135.2 billion, the sector is still extremely small in the context of the broader equity markets.

General mutual fund managers poured money into REITs in the mid-1990s, and prices rose significantly more than would have been supported by the performance of the underlying real estate. When the money flowed out, prices were decimated. REITs can do without the fickleness of nondedicated capital and the excess volatility created when that capital rotates sectors. Attempting to attract a wave of capital all at once would definitely increase volatility again-something the REIT market must strive to avoid.

While there has been no clamor for income-producing asset classes over the past 10 years, this will change. Attracting a large amount of income-oriented capital very slowly over a longer period of time would be healthier for the REIT market. The industry should target baby boomers as they approach the age at which most investors engage in more conservative personal investment styles. Slowly but surely over the next two decades, sensible investors will emerge who desire more conservative, income-oriented investments.

• Educate Wall Street about portfolio risk management. Despite significant efforts to manage asset level risk, thus far there has been little emphasis on risk management at the portfolio level. REITs still discuss diversification in terms of the number of markets and property types in which they are invested, and not enough time talking about the overall risk level of the market. How volatile are the markets in which the portfolio is invested? How do the market exposures interact with one another and affect the overall volatility of the portfolio?

• Educate investors about the role of real estate in the broader portfolio. The investing public must be further educated about real estate’s role in portfolio asset allocation. The academic community has worked hard on the topic, and most large institutional investors include some real estate in their portfolios. While the exact amount of real estate required for an efficient portfolio depends on the investor’s risk and return requirements, a clear need exists for real estate exposure along a large portion of the efficient frontier. The general investing public thinks about asset allocation in terms of stocks, bonds, and cash-but not real estate. Perhaps, this is because many people think of their home as their real estate exposure. Perhaps, because REITs cannot be valued and analyzed with methods and terminology comparable to other equities (not earnings, but FFO/AFFO, and a continually changing definition of that), they are too confusing for many to be bothered with.

In any case, REITs must bear the burden of answering the question, "Why real estate?" They must emphasize and demonstrate that adding real estate and REITs can reduce the volatility of the overall portfolio, that real estate can be used as an (albeit imperfect) hedge against inflation, and that the asset class provides a reasonably consistent income stream. Forget that REITs sometimes outperform the broader market. Let that be the gravy.

Wall Street plays an important, if not central role, in this process, as well. Here’s what the "Street" needs to do.

• Stop giving companies credit for focus. In recent years, many analysts wanted REITs to focus on a single geography and property type. This was the ideal for Wall Street, which could then target companies with a clean exposure to a market cycle. However, the REITs that followed this strategy found it didn’t work. Many individual market cycles are simply too severe for a company to survive. Constraining a REIT’s investment set to a single property type or a given set of markets within one region dramatically increases the risk level of the portfolio and dooms the REIT to failure. Encouraging focus does not allow a company to move in to and out of markets in the most efficient manner, and does the REIT a great disservice.

• Give credit to portfolios that provide a low volatility of cash flows. Companies that have created intelligently allocated portfolios and are actively managing portfolio risk levels should be rewarded with higher multiples. Rapid growth rates should not be encouraged; they should be questioned. REITs that can manage slow-paced, steadily increasing income growth have a much more sustainable and practical strategy than those that jump on the newest fad in rapid value creation.

• Take a long-term view. One quarter or one year is not enough. Real estate is a long-term asset, and emphasizing one quarter’s earnings over those of the long run forces REITs to satisfy analysts’ expectations today, perhaps at the expense of a productive overall strategy. This occurred particularly in the expansion phase of the mid-1990s, when REITs focused acquisitions on those metros with phenomenal demand growth to boost FFO in the next quarter. Unfortunately, many of the markets with the fastest growing demand have also been the ones with the most aggressive supply response, and now many companies are faced with exposures that are dragging down their portfolios.

Investors must all make some changes in the way they look at REITs and other non-REIT real estate operating companies. Investors must: Realize that REITs are income stocks, not growth stocks. And what’s so bad about that?

• Own up to the volatility of the public markets. While publicly traded real estate has a level of volatility that is probably higher than the true risk of real estate, the appraisal-based nature of private equity pricing probably understates risk. REITs are a part of the broader equity markets, and immense amounts of capital will occasionally move in to and out of the sector. Private equity investors do not face the daily pricing of real estate that clearly adds to the interim volatility of REITs. This public market volatility does not reflect the underlying cash flows, nor is it reflective of fundamental changes in the slow-moving real estate markets. It is, however, a fact of the public market, and the price that must be paid for investing in what is sometimes a more liquid and higher yield quadrant of real estate. Some of the volatility can be managed, however, by creating portfolios of REITs.

• Know that REITs are only a part of a real estate asset allocation. This applies primarily to institutional investors. The whole loan, CMBS (commercial mortgage backed securities), and private equity markets are all significantly larger than the REIT market, and investing across the quadrants is an excellent way to reduce the overall risk of real estate allocation. Each of the quadrants serves a different purpose in a real estate portfolio, and each brings different benefits and challenges to real estate investors.

What happens if the various parties fail to complete their respective to-do lists? Has the REIT industry learned its lesson about overpromising and underdelivering? If not, and if steps such as those presented are not taken, we believe the market will continue to suffer because of it.

The growing pains of the REIT market during 1998 and 1999 provided lessons. The actual behaviors, benefits, and problems of real estate must be clearly communicated. Companies running their portfolios so as to reduce the volatility of cash flows are most likely to be successful over the next several years during which there will be a plethora of very different cycles in different markets and property types.

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