Which Way From Here, Larry? When Larry Raiman downgraded REITs on February 12, he took some flack. Today, the call Raiman and his team at Donaldson , Lufkin & Jenrette made looks downright prescient. So what's Raiman's outlook for REITs now? by Barry Vinocur

Lately, Raiman is perhaps best known for downgrading REITs earlier this year. But as Raiman told us recently, just because he and his colleagues downgraded REITs doesn't mean that he's a bear on the stocks. Nevertheless, Raiman doesn't count himself among those who believe that REITs are incredibly "cheap" today, even on a relative basis. Instead, he says REITs are fairly priced.

Raiman's current thinking on the REIT market stems, in large part, from his view that it's just become a lot more challenging to make good real estate investments. He's also concerned about the impact that increased leverage, joint ventures, and development could have on the industry. And, though Raiman says he sees value in spinoffs, such as the one recently completed by Reckson Associates, he worries that the market may have difficulty correctly valuing companies that add layers of complexity.

So what lies ahead for the REIT market? Will there be an end-of-the-year rally this year? And if there's a REIT rally this year, how will it stack up vs. the end-of year rallies of 1996 and 1997? Also, what would it take for Raiman to turn bullish on REITs? For answers to those and other questions, we recently spoke with Raiman.

Four months after you made it, there's still some confusion about your February 12 call on REITs. Fill us in on what you said.

We reduced our investment rating on the group from a Buy—which is what it had been for the better part of the 18 months to two years prior to February 12—to a Market Performer rating.

What did that translate into in terms of return expectations?

To be rated a Buy, we have to believe that there's 15%-plus total return potential over the next 12 to 18 months. A Market Performer is expected to deliver a total return between 0% and 15% over the same time span. Anything that we expect to deliver a total return over the succeeding 12 to 18 months under 0% gets an Underperformer rating.

Why did you make the call?

There were two reasons why we lowered our total return expectation on REITs from a little over 15% to below 15%. One of those factors is still the case today; the other is now moot.

What were those factors?

The first was our belief that it was becoming more challenging to make good real estate investments—in other words, to buy properties that would deliver the sort of returns it takes to produce total returns of at least 15% annually. In fact, we had been writing that in our research since early in the year. So, it just got to the point in mid-February where we decided to stop speaking out of both sides of our mouths.

The second factor, which as I noted is now moot, was that we thought the sector, generally, was overpriced. That's no longer the case. REITs are fairly priced today— not cheap as some suggest, but fairly priced.

So there's no confusion, let's clarify things. Some people suggest that you went from being a bull on REITs to being a bear. That's not the way you see it, right?

Correct.

What was your reaction when analysts and investors started pounding the table in mid-March, telling all who would listen how cheap REITs looked to them?

Because REITs are cheap on a relative basis doesn't mean that they shouldn't be cheap on a relative basis.

Fair enough. But if you look at S&P 500 earnings estimates what you see is that for the first time in roughly six years, REIT earnings are expected to grow at a faster clip this year than S&P 500 earnings. Of course, perhaps you're suggesting that the broader market has to correct. I guess that would fix things. Which is it?

Actually, it's none of the above. Our chief economist says corporate earnings growth will accelerate as the European and Latin American economies strengthen. He thinks the U.S. economy has only been running on one cylinder. When those economies strengthen, he believes the U.S. economy will start running on three cylinders. As a result, he's predicting the Dow will reach 12,000. At the same time, it's our view that growth rates for REITs might moderate.

What model do you use to determine whether REITs are cheap, fairly priced, or overvalued?

We look at implicit growth rates based on our dividend discount model. That model incorporates a growth rate depending upon your return expectation between about 7% and 8%. What does it take for us to say REITs are cheap? Probably an implicit growth rate on an absolute basis that's, say, 100 basis points below that, possibly slightly more than that.

Interesting, tell us more.

What we're doing, essentially, is backing into where a stock ought to trade based on its current dividend yield and its current multiple. Say, you're going to buy Boston Properties at 341¼2. Implicitly, what investors are saying is that at 341¼2 and a dividend yield today of 4.6%, they're expecting a certain growth rate. Our model, as I noted, backs into what that growth rate is. For the overall industry today, that growth rate is about 8%. For Boston Properties, in the example, it would be about 8.5%.

Is this the standard dividend discount model?

We use the basic model of current dividend over return expectation minus growth rate, and we solve for the growth rate in the denominator. So it's the standard model straight out of a textbook.

What about other models or do you only focus on the dividend discount model you referred to?

We definitely look at other models. We look at cash flow multiples, as well as FFO and FAD multiples, on an absolute as well as a relative basis. The only model that we have gotten away from is an NAV-based model.

You're abandoning NAV? Say it isn't so.

We don't believe we have a good handle on true replacement costs, as well as the value of the bricks and mortar. We could capitalize current cash flows and put a multiple on it, but my experience with several stocks caused me to question the real value of an NAV-based model.

Tell us what happened.

We had been following Crown American since its IPO. Roughly two years ago, we had an NAV for the stock that was approximately $14 based on cash flows and debt levels that were in place at the time. What happened was that the company had increasing leverage, but it didn't have any growth in cash flow. Crown's NAV dropped to $7 per share. At the end of the day, I wasn't sure that the intrinsic value of Crown's assets declined by roughly half over that time frame. I decided that the methodology that we were using, and I think others may be using as well, is quite cyclical and very sensitive to short-term changes in cap rates and leverage ratios. But when you look at the bricks and mortar, I'm not sure that values are either that cyclical or volatile.

What you're saying, then, is not that you don't think NAV is valuable, but that you don't think you can come up with a reliable number?

Exactly. NAV is absolutely a valuable valuation tool. I'm just not sure that we know the best way to come up with the number.

Let's assume that you know what NAV is for every company in your coverage universe. Which companies deserve to trade at premiums to their NAVs, and which ones don't?

In the current environment, the companies that deserve to trade at premiums would be the ones that have demonstrated they have franchise value—to be more specific, companies that have a demonstrated ability, say, to add value through development, or the rehabbing of properties deserve to trade at premiums. Companies that don't have those skills, or that are totally dependent on acquisitions for growth, should trade at, or below, their NAVs.

Is there a quantitative way to determine whether a company adds value, or is it solely a subjective determination?

Let's take the apartment companies, for example, because many of them have been operating in an environment that has been in equilibrium for the past couple of years. We have an apartment database that details the same-store results broken down by revenue, expenses, cash flow, and net operating income by quarter for roughly the past two years. When you look at that database, what you find is that some companies are just "out-operating" other companies. You need to look at it by geographic region, but when you do that, for example, you see companies in the Sun Belt that are just doing a better job in day-to-day operations than others. So, yes, there's definitely a way to quantitatively determine which companies have proven that they add value.

How about an example?

When you look at the same-store operating results for Camden Property Trust they're irrefutable. In almost each and every quarter, Camden has generated above trend line same-store results. And Camden is doing that while operating in commodity-like markets, such as Houston, Dallas, and Austin.

What about other sectors? Are you able to make the same determination for, say, office REITs?

For now, it's most easily quantified in the apartment category. But over the course of the next few years, it should also easily be quantified in the office business because the financial reporting is pretty substantive. It's least quantifiable in the retail business because same-store results and operating trends are not disclosed by the retail REITs.

OK, so REITs, in your view, are fairly priced today. Not cheap. Fairly priced. So what would it take for you to go from being neutral to being a bull?

One of either two things. Either a continuation of what has occurred over the past few months, which has been stock prices going down a little bit, as well as earnings levels going up a little bit, and dividend levels up a little bit.

Do you see that happening?

The most likely scenario is a continuation of the current scenario wherein growth rates continue, the REITs continue to grow dividends, and earnings and stock prices lag that growth. If that happens, then REITs would fall into a period where they are cheaper than fairly valued.

Any other bumps or potential bumps on the horizon?

Two recent accounting pronouncements are likely to begin impacting REIT earnings. The first (FASB 128) requires all companies to report earnings on both a basic and a diluted basis. (That takes into account options and other employee benefits.) The other, more recent pronouncement forces REITs to expense, rather than capitalize, all in-house acquisition-related costs. Those pronouncements are going to require analysts to fine tune their earnings estimates. In most cases, the changes won't be major ones, but it's something to keep an eye on.

For now, it's also tougher to get equity offerings done. If companies are unable to raise additional equity at attractive prices, they may have to scale back their acquisition targets. So, if anything, going forward, there's likely to be a greater prospect that companies will fall short of earnings estimates rather than blow them away.

If companies have to scale back their acquisitions that could have a very material impact on earnings.

I think it's a very real concern. In recent conversations with CFOs and CEOs at several companies, they told me that they are discussing this in their strategic planning sessions. They tell me that they are quite concerned. In some instances, companies with a pipeline of acquisitions are considering either scaling back or not executing some of the deals because they don't have access to appropriately priced capital.

If that happens and, as a result, companies start missing their earnings estimates, we could get into a vicious cycle in which earnings estimates are missed. If companies miss estimates, investors will get disappointed, so stock prices will go down, and, of course, the cycle might then perpetuate itself. To some extent, I think we're already starting to see this happen to some of the office/industrial REITs.

Is that an argument against REITs? After all, if these companies weren't REITs, they could retain earnings, which would certainly reduce their need to continually raise equity.

That's right. The REIT vehicle is hypocritical from the get-go. As an asset, real estate is capital intensive, and the REIT structure is a distribution-intensive vehicle. So, you're overlaying a distribution-intensive vehicle onto a capital-intensive organization. In a down portion of the cycle, that will only magnify the issues you're citing, and it could cause a problem for certain companies. There probably will be some companies that will be better positioned. They will have lower payout ratios and they will be able to access attractively priced capital. Those companies should be able to ride out the down portion of the cycle. They may even be able to take advantage of some of their competitors' misfortunes.

If companies are cut off from capital, what's the chance that some of them might de-REIT?

I guess that might happen. But I think it would be a rare occurrence. It's more likely that we'll see more companies leverage up, or more mergers, or possibly some companies go private if the capital is available.

Quite a few companies have either entered into joint ventures or are considering that option as a means of spreading risk and getting certain activities, such as development, off their balance sheets. Does any of that concern you?

The concern over how REITs handle the accounting that relates to joint ventures and development is justified. Both raise a number of issues, including: Does a company expense or capitalize land costs, real estate taxes, and insurance costs in a pre-development phase? How does it account for the fee streams in a joint venture? How does it account for soft development costs, such as personnel and preliminary design costs? Those are real issues. They're going to make the lives of analysts and investors a lot harder.

Those issues also could have an impact on multiples. In other words, investors might become a bit more cautious with respect to what they're willing to pay if they aren't quite sure what they're getting.

Complexity isn't de facto bad, however. If you can sort through the complexity, sometimes you uncover an opportunity.

I think that's correct. Those companies that structure their joint ventures in a clean efficient manner, where there are no conflicts of interest, will fare better. Investors may be able to buy them on the cheap in the short term. Eventually, the market will sort that out, and any inefficiencies in pricing should disappear.

Any examples come to mind?

We're in the midst of writing a report on Reckson, which should be released shortly. That report will underscore both the risks and the opportunities in Reckson's spinoff of Reckson Service Industries. One of the points that we will make in that report is that Reckson has become a more difficult company to analyze because it has investments in so many different businesses. The risk, as we see it, is that Reckson might end up trading at a discount to its intrinsic value because it's become a more confusing story than it once was. Put another way, Reckson could trade at a premium multiple because it generates above average growth, but it could still trade at a discount to where it should trade based on intrinsic value because now it's just a little more difficult to analyze.

Some analysts argue that coming up with a number for what Reckson's worth is an exercise in futility because it's no longer just conventional bricks and mortar. They say companies such as Reckson should be valued based on a cash flow model.

You could make that case. If you did, I wouldn't say you were wrong. But I would point out that if the marketplace doesn't fully understand the businesses that a company is in, it might not assign the "correct" multiples to the cash flow from those businesses.

We've covered a lot of ground. Now it's time for the big question. Which way do REITs go from here?

You could have a rebound and decent performance in the second half of this year. The timing might even be similar to last year. I just don't think the rebound will be as strong as it was in 1997.

Why not?

Because I think the fundamental investing climate for real estate just isn't as good today. So, the stocks don't deserve to trade up as much as they did last year and the year before that.

Where are the best investment opportunities today?

We still believe the office business and the industrial business have the best prospects and, therefore, should fare the best. We think retail may lag. And we think the apartment group will pretty much be a market performer; it may trade up a bit, not a lot.

What about CBD office REITs vs. those that focus on the suburban markets?

Rather than segregate companies solely by whether they focus on CBD or suburban properties, I'd take them company-by-company. For instance, a Boston Properties could do quite well because it's CBD based, and it's a larger-cap company. I also suspect that a Mack-Cali, which is suburban driven but somewhat insulated from new construction, might do well later this year.

When you say retail will lag, you're talking malls, factory outlets, and strip shopping centers?

Mostly malls and community centers. We don't really officially cover the factory outlets.

Any other preferences?

I might spin your question a bit differently. Rather than ask what stocks are likely to perform best, you could look at it in terms of market caps. Looking at it that way, I think if we see better performance in the second half of this year, it's likely that large caps would do better than small caps.

How do you define a large-cap REIT?

Several billion dollars in size at this point. A Spieker Properties, for instance, that has an equity market cap of about $2.9 billion and a total market cap of well over $3 billion is definitely large cap. Mack-Cali, with an equity market cap of about $2.5 billion, is another large-cap name in the office sector. And, of course, there's Crescent, which has an equity market cap that's roughly $4.5 billion.

You didn't mention Equity Office.

It's definitely a large-cap name; it's just not a company that we follow. Not yet, that is.