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 Barry Vinocur
Illustration by Steve Breen

After back-to-back years of negative returns, investors hoped this year would be a better one for REITs. There was some reason for hope, too. The second of two 1999 Warren Buffett-induced rallies-the first happened in the spring-had provided an end of the year shot in the arm for the stocks. But when the rally didn’t extend into this year, investors prepared for the worst. Then something strange happened. There had been a lot of discussion about tech stocks vs. REITs last year, and though some market veterans urged caution, as winter faded into spring, REITs started to gain momentum. By the time the Nasdaq hit the wall in mid-April, REITs were in full bloom.

Investors and analysts cite a long list of reasons for this year’s REIT rebound. That list includes, but by no means is limited to: (1) the stocks were so-o-o-o cheap that investors could no longer ignore them; (2) risk-adverse/yield-conscious investors sought refuge in REITs amid the Nasdaq selloff; (3) after two years of declining earnings growth, investors came back to the stocks amid a reversal of that trend; (4) the REIT Modernization Act will fuel growth when the legislation takes effect at the beginning of next year; (5) investors finally believed that it really is different this time; that lenders and developers won’t engage in across-the-board overbuilding; and (6) the exceptionally strong earnings growth of a number of companies, especially those with significant holdings in high barrier to entry markets such as New York and San Francisco, focused investors’ attention on the stocks.

Though a favorite pastime, explaining the market’s moves is hardly a science. For instance, long before this past spring’s rally took hold, countless research reports as well as newspaper and magazine articles proclaimed that a REIT rebound had to be just around the corner because the stocks were so cheap that value investors would certainly jump into REITs with both feet, even if others didn’t.

Further, though cynics abound, it’s been clear for some time that whatever the reason(s), lenders and developers have been reasonably restrained since the debacle that gave rise to the early 1990s real estate bear market. The sort of nasty overbuilding that has plagued the industry for decades is being held in check-though every now and again it rears its ugly head-for now, at least.

The bottom line is that putting one’s finger on the "why" behind this year’s REIT rebound is far from an easy task. That said, the catalyst for this year’s REIT rally was the Nasdaq selloff. As a result, REITs have become known as the quintessential anti-tech stocks. Last year, Todd Canter, Keith Pauley, and Bill Morrill of LaSalle Investment Management (Securities) showed that when REIT stocks zigged, tech stocks zagged, and vice versa (see "Opposites Attract," on page 63). Further, a recent research note by Prudential Securities’ Lou Taylor provided further support for the christening of REITs as anti-tech stocks.

Where’s the Money?
For all of the talk about this year’s REIT rally-and the fact that thus far REITs look to be anti-tech stocks-one question remains unanswered. Why hasn’t the flow of funds followed the REIT rally? Yes, for the stocks to go up there have to be more buyers than sellers, and the buyers have to be willing to pay increasingly higher prices. So, money has to be coming into the market. However, to a large extent, the dollars that have flowed into the stocks this year aren’t the sort of "sticky cash" that most folks thought they would see once there was no longer any doubt that after several head fakes, the rally was for real.

Tracking the flow of funds isn’t straightforward, however. Much of the information is anecdotal at best. The one exception is the flow of funds into and out of mutual funds. Like most others, this magazine’s sister publication, Realty Stock Review, relies on AMG Data Services in Arcata, California, for that information. Through late August, AMG reported that year-to-date inflows into dedicated real estate funds totaled $476 million. After significant outflows over the past two years-last year alone, $1.3 billion was withdrawn from real estate funds-the stemming of the tide is noteworthy and no doubt welcome, but compared to the inflows seen during past years when REITs posted strong returns, this year’s total-at least thus far-seems rather paltry. Institutions don’t seem to be piling into REITs either, at least not based on conversations with market veterans.

What has happened, however, is that an increasing number of institutions and mutual funds appear to be more actively trading REITs than in the past. This has produced increased volatility. According to several market veterans, funds such as ProFunds’ UltraSector funds (one is tied to the Dow Jones REIT Index), which target daily returns that are 150 percent of the index they track, impact daily performance not only because of their underlying strategy but also because of REITs’ relative illiquidity.

Why It’s Not Too Late to Buy REITs

The CS First Boston analysts acknowledged that real estate stocks had already been very strong this year, up 19 percent through September 5. They further acknowledged that this type of performance is unusual. "Real estate stocks have generated a total return in excess of 20 percent only 10 times in the past 28 years (since the National Association of Real Estate Investment Trusts began keeping track in 1972). Moreover, real estate stocks have generated a total return in excess of 30 percent only five times over the same period: 48 percent in 1976, 36 percent in 1979 and 1991, 35 percent in 1996, and 31 percent in 1983. But the current environment of positive catalysts and low valuations is also unusual." Schalop and his colleagues added that a number of positive catalysts had emerged since the beginning of the year that should continue to move the stocks upward. "First, real estate companies have new opportunities to increase growth from technology by either increasing revenue (selling new services) or lowering costs (operating efficiencies). Second, while overbuilding remains a problem, it appears to be decreasing on the margin as capital availability diminishes, especially on the private side. Third, the growth rate trend has stabilized; unlike the past few years, when the year-ahead growth rate was lower than the current year, the growth rate for 2001 is slightly ahead of the growth rate for 2000-9 percent vs. 8.4 percent. In addition, results were strong in the first half of 2000, and we expect the strength to continue." The CS First Boston analysts added that they continue to like companies with improving growth prospects. "We recommend that investors focus on companies with the opportunity to increase their growth rate. This includes companies in supply-constrained markets and companies that can generate improved growth through ancillary services or sophisticated financial transactions. It specifically excludes companies that are cheap-whether measured on an FFO multiple or discount/premium to net asset value-if those companies don’t otherwise have the ability to generate higher levels of growth."

And, REITs’ relative illiquidity is only one issue, they add. Another is that the major REIT indices, such as Morgan Stanley and NAREIT, are market-cap weighted. A handful of stocks comprise a very significant portion of those indices. Equity Office and Equity Residential, for instance, together make up more than 10 percent of the Morgan Stanley Index (see page 84). Further, the top 15 names (the Index has 123 members) account for roughly 45 percent of the Index.

Head Room?
Since it blew through 360 on August 1 to close at 362.74, the Morgan Stanley REIT Index has been moving down to sideways most days. (The Index’s all-time closing high of 367.35 was set back on October 6, 1997.) As we went to press, the Index was just south of 350.

Though impressive, the Morgan Stanley REIT Index’s showing on August 1 (it was up just over 1.7 percent that day; the Russell 2000 was down 0.6 percent) was, according to our sources, the result of a $25 million buy program executed by Vanguard during the last hour of trading. Again, this underscores how relatively small amounts of cash put into key names can have a major impact on the Morgan Stanley REIT Index. (Cohen & Steers Realty Majors-another benchmark that tracks 30 large REITs-was up 2.6 percent on August 1.)

Day-to-day gyrations aside, an increasing number of sell-side analysts have gone on record recently with their views that the stocks are at "fair value." In a recent note to their firm’s clients, Morgan Stanley Dean Witter’s REIT research team wrote that "the stocks appear at, or are fast approaching, ‘fair’ value." The MSDW analysts went on to say that it might not be until third-quarter 2000 earnings results are announced that the stocks move ahead. Moreover, like others, the MSDW analysts stressed that any upward movement by the Morgan Stanley REIT Index is likely to be the result of the "further bifurcation of stock valuations between the ‘haves’ and the ‘have nots.’" This bifurcation, they added, might just make 2001 the year that consolidation moves ahead (in earnest).

As you would expect, not everyone shares that view. Lee Schalop and his colleagues at CS First Boston recently told their firm’s clients that despite the sharp run-up in REIT prices this year, (see the tables on pages 40 and 41 to see how the stocks in the Morgan Stanley REIT Index have performed this year) they believe the stocks could go higher-a lot higher, in fact. Schalop and his fellow analysts-Alexis Hughes, Dimitri Gavriel, and John Saunders-wrote that while performance as strong as they were now predicting (see sidebar above) would be unusual, they were raising their 2000 forecast for the Morgan Stanley REIT Index from 350 to 375, another 9 percent increase.

Like many others, including the MSDW analysts, the CS First Boston analysts agree that there will continue to be a bifurcation of multiples. Schalop and his colleagues believe, however, that this bifurcation will be based on underlying market strength.

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