Standard & Poor’s will decide early this fall whether to drop its longstanding rule excluding REITs from its broad stock indices, including the S&P 500. Betting in the industry has S&P decreeing REITs eligible for membership.

The eight-member S&P Index Committee has been reconsidering the exclusion since April, when it heard a pro-REIT presentation organized by analyst Lee Schalop of Banc of America Securities. The current S&P policy stems from a view of REITs as thinly traded passive entities with outside managements, more akin to real estate as an asset class than to the common stock of operating companies. REIT advocates argue that this view has been rendered obsolete by the industry’s transformation over the past decade.

If in fact the barrier falls, it is highly unlikely that REITs would be admitted immediately to membership in the 500. Rather, REIT candidates would have to wait, along with candidates from other sectors, for vacancies in the roster, which typically run 30 to 40 a year. (Last year, a record 58 companies joined the list.) But because an estimated $1 trillion is invested in index funds that mimic the S&P 500, and that therefore must add shares of newcomers, any REIT entrant would enjoy a sizable pop in its share price.

According to a study by Standard & Poor’s of 188 stocks added to the S&P 500 since 1991, between the announcement of its inclusion and the effective date a week later, the average share rose 8.52 percent (see table above). Though index-fund managers usually wait for the effective date to make their purchases, speculators and arbitrageurs bid up the shares in the days leading up to formal entry. Over the 10 days following admission, the average stock gave up some of the initial pop—it was off 1.94 percent. But in the year following the announcement, the newcomer rose 34.12 percent.

The leading candidates for early inclusion are the three largest REITs: Equity Office Properties, with a market capitalization of $13.7 billion at midyear; Equity Residential Properties, with a market cap of $7.6 billion; and Simon Property Group, a shopping mall company with a market value of $5.2 billion.

The bulk of companies in the sector, however, fall into the small to midsize range. That makes them more likely candidates for the S&P MidCap 400 and the S&P SmallCap 600 indices, which also currently bar REIT membership. Though inclusion in those clubs don’t promise the 500’s sudden value surge, memberships have their rewards. According to Standard & Poor’s study of 269 companies added to the MidCap 400 since its start in 1991, the average stock jumped 6.94 percent in the week before the effective date, sold off 2.56 percent in the following 10 days, and climbed 20.04 percent in the year after the announcement. The firm’s study of 403 newcomers to the SmallCap 600 since the end of 1994 shows the average stock bouncing 5.63 percent between the announcement and the effective date, selling off 1.97 percent in the next 10 days, but gaining 13.75 percent in the first year.

REITdom Embraces EPS
Every few years, people close to the REIT business are moved to chat about valuation tools, chiefly the need for a better measure of financial performance than funds from operations, or FFO, which is a cash-flow number that, among other things, ignores depreciation and gains and losses from other non-cash charges. The National Association of Real Estate Investment Trusts adopted FFO in 1991 as a standard supplemental measure of REIT operations, thus countering presumed drawbacks associated with net income under generally accepted accounting principles, or GAAP.

Now, Wall Street has resumed the conversation. First, in May, analyst Lou Taylor and his colleagues at Deutsche Banc Alex. Brown issued a nearly 120-page report titled “It’s Time REITs Graduate to Net Income.” Then, on July 13, three Wall Street firms—Merrill Lynch, Morgan Stanley, and Salomon Smith Barney—simultaneously issued research notes in which they advocated using earnings per share, or EPS, before extraordinary items, as an incremental valuation metric for REITs. The authors, analysts Steve Sakwa of Merrill, Greg Whyte of Morgan Stanley, and Jonathan Litt of Salomon, declared, “Going forward, we plan to publish EPS as well as FFO estimates.”

Sakwa, Whyte, and Litt argue that EPS offers several advantages over FFO in conveying a true picture of REIT operations. EPS, they point out, recognizes the impact of depreciation of real estate assets, thus addressing “one of the greatest shortcomings of FFO by gradually expensing all capitalized items.” They also say that their estimates of EPS “will include our assumptions about the size of each REIT’s gains or losses from asset sales,” giving due notice to the economics of capital recycling. And they stress that because EPS is a recognized performance metric employed throughout the investment community, its use “will provide yet another foothold for generalist investors who wish to invest in REITs.”

As Lou Taylor and his associates at Deutsche Banc Alex. Brown put it, “With the public real estate companies broadening their activities and increasing their complexity, we believe the base earnings measurement needs to change as well.”

Lack of Correlation
Fans of REITs have long argued that they offer an important means of portfolio diversification for investors because their performance demonstrates a low correlation with other asset classes. Now comes a study of historical data by Ibbotson Associates, the Chicago-based authority on asset allocation, which bolsters that argument.

In an analysis commissioned by the National Association of Real Estate Investment Trusts, Ibbotson found that REITs’ correlation with other equities, as well as long-term bonds, has been declining over the past three decades (see table below). Specifically, the correlation of REIT returns with those of small stocks, represented by the Ibbotson U.S. Small Stock Series, declined 65 percent; with large stocks, represented by the S&P 500, 61 percent; and with 20-year U.S. government bonds, 41 percent.

A sample portfolio prepared by Ibbotson consisting of 40 percent bonds, 50 percent stocks, and 10 percent Treasury bills provided an average annual return of 11.8 percent between 1972 and 2000. When the asset mix was adjusted to include 35 percent bonds, 45 percent stocks, 10 percent T-bills, and 10 percent REITs, the average return rose to 12 percent and the risk level fell to 10.9 percent. A third portfolio, adjusted to include 30 percent bonds, 40 percent stocks, 10 percent T-bills, and 20 percent REITs, produced a 12.2 percent gain in average return and a decline in risk to 10.8 percent.

An investment of $10,000 in the non-REIT portfolio in 1972, assuming reinvestment of dividends, would have grown to $219,049 by 2000, according to Ibbotson. The second portfolio, with a 10 percent REIT component, would have grown to $227,000 over the same span.

The third portfolio, with 20 percent REITs, would have accumulated $238,349—more than $19,000 over the non-REIT portfolio.

“The Ibbotson analysis shows that given their low correlation, real estate stocks are an important and effective source of diversification and are well worth investigating as an addition to many types of investment portfolios,” said Steven A. Wechsler, NAREIT’s president and CEO.

2Q01 Rents Down in All Sectors
The nation’s landlords are feeling the economic slowdown. According to the latest data from the National Real Estate Index, a private data-gathering operation based in San Francisco, rents declined across all property sectors in the second quarter of 2001. Average rents in central business districts took the biggest hit in the period, a 3.2 percent drop from the first quarter. The decline was notable because downtown rents were up 2.3 percent in the 12 months ended June. Suburban office rents showed the second-largest slide in the quarter, 2.2 percent, and were down a half-percent over the 12 months. Warehouse rents were off 0.5 percent in the quarter, retail fell 0.3 percent, Class A apartments were down 0.4 percent and Class B apartments suffered a 0.2 percent decline.

Regionally, the bursting of the tech bubble took a heavy toll in California; the state’s property owners saw rents decline in five of the six major property sectors in the second quarter. The average downtown office rent in San Francisco plunged 14 percent, and in San Jose, also a New Economy center, office rents in the central business district slipped 8 percent. Kimco Forms JV With RioCan
Two big North American owners and operators of community shopping centers are joining forces to develop retail properties in Canada. Kimco Realty Corp., a U.S. REIT, has agreed to invest $50 million (Canadian), or $31 million in American greenbacks, in a joint venture with RioCan Real Estate Investment Trust, Canada’s largest REIT, to acquire and develop projects north of the border. As part of the pact, Kimco will take an equity stake in RioCan—2.5 million shares of RioCan stock at $10.50 (Canadian) apiece—and will receive warrants to acquire another 2.5 million RioCan shares at $11.02 (Canadian) apiece, close to RioCan’s current market price. Assuming exercise of the warrants, the deal would give Kimco a 3 percent stake in the Canadian company. (See cover story on page 12 for more on Kimco.)

RioCan is Canada’s largest retail REIT, with interests in 138 properties across the country totaling 20 million square feet of rentable space. Its assets are concentrated in Alberta and Ontario; the two provinces account for 82 percent of total revenues. The typical holding is a neighborhood center anchored by a food store, but the company has recently turned its attention to “big box” properties. Indeed, Wal-Mart is RioCan’s largest tenant, accounting for 6.4 percent of the company’s revenues.

For Kimco, the venture presents a chance to offer space to American tenants seeking to set up shop in Canada. “Our U.S. tenants are expanding north and it is natural for us to expand with them,” said David Henry, Kimco’s new vice chairman and chief investment officer. The move also gives the company entrée into a market that currently provides a shade more promise than the U.S. retail scene. The market value of Canadian retail real estate is below replacement cost, and rents in the current cycle have yet to reach previous highs.

Some analysts say that through the joint venture, Kimco could acquire properties at initial yields as much

as one percentage point higher that yields currently available from comparable U.S. holdings. But Canadian corporate taxes could cut into that edge; they run 43-46

percent of earnings.

The RioCan deal is considered Vice Chairman Henry’s baby, so Wall Street will view it as a test of Henry’s mettle as the successor to Kimco’s highly regarded chairman, Milton Cooper.

Prime Group Offer on the Table
Prime Group Realty Trust, an owner and operator of office and industrial real estate in the Chicago area, has been trying in vain for the past two years to liquidate some or all of its properties, hoping to realize what the REIT’s management has contended is a portfolio worth $19 a share. Its failure to cash out was underscored in early August by the collapse of a pending sale of its suburban office and industrial properties. Now, the company has received a buyout offer of $14 a share from an affiliate of Canadian fund manager CDP Capital and an affiliate of Prime Group Realty’s chairman, Michael W. Reschke. A panel of independent members of Prime Group Realty’s board is mulling the offer.

As part of the deal, the CDP affiliate, Cadim Inc., would repay a Vornado Realty Trust loan to Reschke of $62 million; the loan is falling due within weeks. The deal also would allow Reschke to retain his stake in Prime Group Realty. In all, management owns 30 percent of the company’s diluted shares (the Cadim-Reschke offer does not include a convertible preferred issue).

One investment group, K Capital Partners, has written to the independent board members urging that they reject the offer and seek other bidders. “Given that other bidders may have been reluctant to solicit the company due to Chairman Reschke’s large inside ownership,” the letter said, “the independent trustees have a fiduciary duty to the company’s shareholders to either seek other higher bids or reject this unreasonably low price.” K Capital recently acquired its 13 percent interest at $12.76-$13.50 a share.

Dividend News
Public Storage Boosts Dividend by 104.5 Percent … Public Storage (ticker PSA) recently declared a quarterly distribution of $0.45 per regular common share, representing an increase of $0.23 per share, or 104.5 percent, over the prior quarter. In addition to the quarterly distribution, the company's board declared a special cash distribution of $0.35 per regular common share. The quarterly and special distributions are payable on September 28 to shareholders of record as of September 14.

Vornado Raises Payout … Vornado Realty Trust (ticker VNO) raised its quarterly dividend to $0.59 per share, or an annualized distribution rate of $2.36 per share. The new dividend rate represents an 11.3 percent increase over VNO's previous $0.53 per share quarterly rate (an annualized distribution rate of $2.12 per share). The increased dividend was payable on August 14 to shareholders of record on August 6. In addition, VNO's board of directors declared a special dividend of $.009 per share payable to all common shareholders with the same record and payable dates as the quarterly dividend. Further, the special dividend is also payable to all unitholders except for holders of the D units in accordance with the "catch-up" provisions under which the D units were issued.

Equity Residential Increases Dividend … Equity Residential Properties Trust (ticker EQR) increased its quarterly common share dividend to $0.865 per share, an increase of 6 percent over the previous quarterly dividend of $0.815. The dividend will be paid on October 12 to shareholders of record on September 20.

EQR is also doing a two-for-one split of its common shares and operating partnership units, payable on October 11 to shareholders of record on September 21. As a result of the split, Equity Residential's outstanding common shares and operating partnership units will increase from approximately 146 million to approximately 292 million based on the currently outstanding shares and operating partnership units. Taking into account the effect of the split, EQR's quarterly common share dividend rate will be $0.4325 per share.

Highwoods Boosts Common Dividend … Highwoods Properties (ticker HIW) raised its quarterly common dividend, beginning with the second quarter of 2001, to $0.585 per share, or an annualized distribution rate of $2.34 per share. The second quarter dividend represents a 2.6 percent increase over the first quarter dividend of $0.57 per share, or an annualized distribution rate of $2.28 per share. The second quarter dividend was payable on August 23 to shareholders of record as of August 10.

Equity Office Raises Payout … Equity Office Properties Trust (ticker EOP) raised its quarterly dividend, beginning with the third quarter of 2001, to $.50 per share from $0.45, payable October 12 to common shareholders of record on September 28.

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