Dow Jones Property: Investment Fundamentals

Investment Fundamentals

Analyzing REIT Convertibles
Two years into a bear market for REITs, convertibles look mighty attractive.

by Barry Vinocur
Illustration by Rob Colvin

REIT converts are attractive because they participate to a great degree in the underlying common stock's upside while at the same time providing downside protection. With that in mind, the research team at Donaldson, Lufkin & Jenrette recently analyzed more than 100 REIT convertibles from a fundamental, structural, and valuation perspective. The DLJ analysts focused on three key criteria: (1) strong company fundamentals; (2) companies that carry (at least) a Buy rating; and (3) convertible pricing that carries either favorable yield characteristics or favorable capital appreciation potential. Based on these quantitative and qualitative criteria, the DLJ analysts identified 10 REIT convertibles they believe offer compelling values.

Investors looking for capital appreciation, the DLJ analysts wrote, should focus on: Archstone's $1.75 Cumulative Convertible Preferred, which carries a 0.3 percent discount; Liberty Property Trust's 8 percent Convertible Subordinated Debentures, which carries just a 0.5 percent premium; and Equity Residential's $2.205 Series I Cumulative Convertible Preferred, which carries just an 0.8 percent premium.

The DLJ analysts underscored that they maintain a positive outlook on the common stocks of each of these companies. Specifically, they wrote, Liberty is a consistently growing office/industrial REIT located in supply-constrained markets along the Eastern Seaboard; Archstone and Equity Residential are well positioned large-cap nationwide apartment REITs. "Carrying little premium, these three convertible securities should benefit almost dollar for dollar from appreciation in the underlying common stocks." The analysts also pointed out that two of the REIT converts—Archstone's and Liberty's—include a dividend ratchet clause (see page 46). "Since Liberty and Archstone are both in positions to improve their common dividend levels, convertible holders should benefit from higher income streams as well," they added.

The DLJ analysts recommended that investors who are focused on high current income consider buying Healthcare Realty Trust's 6.55 percent Convertible Subordinated Debentures, which carry a 9.83 percent yield to maturity; SL Green Realty's $2 Preferred Income Equity Redeemable Shares (PIERS), which carry a 9.35 percent yield to maturity; Host Marriott's Convertible Quarterly Income Preferred Securities (QUIPS), which carry a 9.08 percent yield to maturity; and Simon Property Group's $6.50 Series B Convertible Preferred Stock, which carries an 8.33 percent current yield.

"Each company contains a solid collection of real estate assets and carries a strong fixed charge coverage ratio. Also, these REITs will most likely fight tooth and nail to preserve their common dividends. As a consequence, convertible shareholders—who stand senior to common shareholders—should collect high current income with a high level of security," the DLJ analysts noted.

Investors looking for balanced capital appreciation, high current income, and solid downside protection, the DLJ analysts wrote, should consider three REIT converts: Equity Residential's $2.205 Series I Cumulative Convertible Preferred Securities; SL Green Realty's $2 PIERS; and Host Marriott's QUIPS.

"EQR's $2.205 Series I converts carry almost no conversion premium, which gives this security almost total participation in the common stock's upside. Also, we estimate that if EQR's common stock were to decline 20 percent, the converts would generate a positive total return of 1.1 percent. Recall, we rate EQR's common stock Buy. EQR is the second-largest apartment REIT in the country, and it is a proven "separator" within the REIT industry. Further, the company has critical mass in its markets, which provides operating efficiencies. Its balance sheet contains a great deal of flexibility, and its earnings are quite visible. We forecast 9 percent to 10 percent trendline growth for EQR and a 12-to-18-month target price of $49. Hence, we hold a constructive view on the EQR Series I converts," the DLJ analysts wrote.

Selected REIT Convertibles Summary Convertible Securities Description ($ in millions and %, except per share figures)
Coupon	Series	Price 7/19/99	Maturity	Issue Size	YTM	Current Yield	Conversion Premium	Next Call Date (a)	Rating	Equity Market Cap	Rachet Clause	Conv. Valuation % Cheap	Yield Advantage
Archstone Communities Trust (ASN)	$21.88
$1.75 (b) Series A Preferred		$29.38	Perpetual	$112.3	6.79%	6.79%	(0.3%)	11/30/03	Baa2/BBB	$3,040.4	Yes	3.9%	0.0%
Equity Residential Properties (EQR)	$43.38
$1.750 Series E Preferred		$24.50	Perpetual	$99.9	7.14%	7.14%	1.5%	11/1/99	Baa1/BBB	$5,186.2	No	2.7%	0.6%
$1.813 Series G Preferred		$22.69	Perpetual	$316.3	7.99%	7.99%	22.6.%	9/15/02	Baa1/BBB	$5,186.2	No	6.7%	1.4%
$2.205 Series I Preferred		$28.06	Perpetual	$100.0	7.86%	7.86%	0.8%	(c)	Baa1/BBB	$5,186.2	No	0.0%	1.3%
$2.150 Series J Preferred		$27.13	Perpetual	$115.0	7.93%	7.93%	1.9%	(d)	Baa1	$5,186.2	Yes	2.6%	1.4%

Healthcare Realty Trust (HR)
6.550% Subordinated Debentures (e)		92.50	3/14/02	$67.5	9.83%	7.08%	30.2%	3/16/00	Ba2	$841.0	No	0.0%	(3.0%)
Host Marriott Financial Trust (HMT)	$10.69
$3.375 QUIPS		$38.25	12/2/26	$550.0	9.08%	8.82%	10.0%	12/2/99	B1/B	$2,436.4	No	8.6%	1.0%

Liberty Propety Trust (LRY)
8.00% (f) Subordinated Debentures		124.69	7/1/01	$96.8	(3.22%)	7.22%	0.5%	N/C	Ba2/BB+	$1,645.1	Yes	1.0%	0.0%

Simon Property Group, Inc. (SPG)	$27.13
$6.500 Series B Preferred		$78.00	Perpetual	$484.4	8.33%	8.33%	11.2%	9/24/03	Baa2/BBB	$4,611.2	No	14.5%	0.9%

SL Green Realty Corp. (SLG)
$2.000 PIERS		$23.00	4/15/08	$115.0	9.35%	8.70%	5.7%	(g)	NR	$515.6	Yes	11.5%	2.1%
(a) All securities except the EQR issues are callable to protect REIT status. (b) The Archstone Communities Trust Cumulative Convertible Preferred Securities have a ratcheting dividend feature which pays the greater of $1.75 or the when-converted common dividend equivalent. As a result, at July 8, 1999, the Convertible Preferred Securities paid an effective annual dividend of $1.9934. (c) Callable beginning October 31,1999 if EQR common stock price exceeds $38.959 for 20 of 30 consecutive trading days. (d) Callable beginning March 31, 2000 if EQR common stock price exceeds $40.7432 for 20 of 30 consecutive trading days. (e) Original issue Discount Bond. 9% YTM at issue, 94.31 accreted value at 7/19/99. (f) The Liberty Property Trust Convertible Subordinated Debentures has a ratcheting interest coupon feature which pays the greater of the regular interest payment or the when-converted common dividend equivalent. As a result, at July 16,1999, the convertible Subordinated Debentures paid effective annual interest of 9.000%. (g) Callable beginning July 15, 2003 if SLG common stock price exceeds $28.14625 for 20 of 30 consecutive trading days or with proceeds of an equity offering. Sources: Market data and DLJ Equity and Convertible Securities Group Research.

SLG's convert, the analysts added, is attractive because its low conversion premium should enable shareholders to participate in over 80 percent of the common stock's potential price appreciation. "Looking forward, if SLG's common stock achieves our 12-to-18-month target price of $24, the converts would produce a 17.4 percent total return." If that scenario proves too rosy and SLG's common declined by 20 percent, the DLJ analysts estimated, SLG's convert would still produce a break-even total return. "With respect to the underlying common, we rate SLG shares Buy. SLG is a pure play on the New York City office market, which we view as one of the strongest in the country. In addition, the company's portfolio contains embedded cash flow growth from a combination of below market leases, repositioning opportunities, and the burn off of noncash free rent allowances. These positive fundamental trends (and a 10 percent trendline growth rate) should bode well for SLG's convert," they concluded.

HMT's QUIPS, the DLJ analysts wrote, is particularly attractive because of its strong participation in the common stock's potential upside appreciation as well as its downside protection. "Specifically, should HMT's common rise by 20 percent, the QUIPS convert would participate in over 80 percent of that upside." Of equal import, they added, should HMT's common stock fall by 20 percent, the QUIPS convert would produce a negative total return of only 0.6 percent. "Our rating on HMT's common remains a Buy." Despite moderating fundamental trends in lodging, the analysts see HMT's portfolio as containing the highest quality assets among public hotel REITs. Further, Marriott International, which operates the hotels, is one of the best in the business. "We calculate that the current stock price implies a $140,000 per key valuation and a year 2000 cash flow multiple of 8.6 times, which we view as attractive."

Total Return Analysis
Company	Convertible Security	Total Return on Convertible Assuming Common Stock Price Change of:
		-20%	0%	+20%
Archstone Communities Trust	$1.750 Series A Preferred	(6.0%)	7.9%	24.8%
Equity Residential Properties Trust	$1.750 Series E Preferred	1.1%	8.4%	21.9%
Equity Residential Properties Trust	$1.813 Series G Preferred	3.0%	9.1%	16.6%
Equity Residential Properties Trust	$2.205 Series I Preferred	1.1%	7.0%	26.9%
Equity Residential Properties Trust	$2.150 Series J Preferred	1.9%	3.2%	22.2%
Healthcare Realty Trust	6.550% Subordinated Debentures	5.2%	6.6%	10.4%
Host Marriott Corp.	$3.375 QUIPS	(0.6%)	11.0%	23.0%
Liberty Property Trust	9.000% Subordinated Debentures	(7.6%)	7.0%	25.5%
Simon Property Group	$6.500 Series B Preferred	1.9%	10.2%	19.6%
SL Green Realty Corp.	$2.000 PIERS	0.0%	10.5%	22.8%
Source: DLJ Convertible Securities Group

Company-by-Company Rationale
Each of the 10 recommended REIT converts was analyzed for the degree of expected equity participation using a proprietary upside/downside model. This model analyzes a convert's expected total return over a 12-month period—taking into account price changes in the underlying common. "For example, assuming an arbitrary 20 percent increase in the price of EQR's common stock over the next 12 months, our model predicts that the price of EQR $2.205 Series I Cumulative Convertible Preferred Securities would rise 19 percent over that same time period. This would be accompanied by a current yield of 6.9 percent and 7.9 percent on the common and preferred, respectively. Taken together, EQR's common stock would produce a total return of 26.9 percent over a one-year period while the Series I convertible preferred would also produce a total return of 26.9 percent, or 100.1 percent upside participation." If EQR's common declines 20 percent over a one-year period, the DLJ analysts noted, the stock would produce a negative 13.1 percent total return. "In comparison, EQR's Series I convert would produce a positive total return of 1.1 percent. Thus, an investor in EQR's Series I Preferred participates in much of the common's upside but with very attractive downside protection.'

Ratchet Clauses Offer Participation in Dividend Increases
Four of 10 converts recommended by the Donaldson, Lufkin & Jenrette analysts contain so-called ratchet features. These features require a convertible's coupon or dividend levels to be increased to maintain parity yields with the underlying common shares. "We find this point particularly important in the REIT sector due to the fact that REITs, by law, must distribute at least 95 percent of taxable net income to shareholders. Those REITs that try to retain as much capital as possible (and thus operate near the minimum payout level) must, therefore, increase their dividend level at a rate close to earnings growth." As a result, the four REIT converts that contain ratchet features should offer increasing income as well as capital appreciation, they added.
Issuer	Security	Note
Archstone Community Trust	$1.75 Cvt. Preferred	Ratchet clause active
Equity Residential Properties	$2.15 Series J Cvt. Preferred	Ratchet clause not active
Liberty Property Trust	8% Cvt. Sub. Debentures	Ratchet clause active
SL Green Realty	$2.00 PIERS	Ratchet clause not active

Again, the DLJ analysts underscored that each of the 10 recommended securities offers attractive upside participation along with solid downside protection. Three of the 10 were singled out by the analysts as "standing out, even within this select group."

Equity Residential's $2.205 Series I Cumulative Convertible Preferred Securities: The DLJ analysts view this convert as good value for investors seeking balanced characteristics of both equity participation and high current yield. "Assuming that our 12-month target price of $49 on EQR's common stock is achieved, the Series I converts would produce a 19.9 percent total return, representing 100.4 percent upside participation in the up case, while still producing a positive total return of 1.1 percent in the case of a 20 percent decline in the common stock price." Further, they wrote, EQR's Series I convert currently offers a yield advantage of 130 basis points over the underlying common stock.

SL Green's $2.00 Preferred Income Equity Redeemable Shares: The DLJ analysts also recommended SLG's PIERS for investors seeking both attractive current yield and equity upside participation. "With a high yield to maturity of 9.35 percent, SLG PIERS rank favorably among REIT convertible securities. Through a ratchet clause, PIERS investors are also assured participation in the event of a significant common dividend increase." SLG PIERS also offer an attractive 96 percent upside participation in the event of an increase in the common stock price to the analysts' 12-month target price of $24 while still producing estimated break-even total return in the event of a common stock price decline of 20 percent.

Host Marriott's Convertible Quarterly Income Preferred Securities: The analysts recommended investors looking for balanced upside participation and downside participation consider HMT's QUIPS. The HMT convert, they noted, offers a high yield to maturity of 9.08 percent while also offering the additional advantage of significant equity participation with the common stock. "Assuming our 12-month target price of $16 on HMT's common stock is achieved, we estimate the converts would produce a 57.6 percent total return, representing 71.5 percent upside participation." Should HMT's common decline by 20 percent, they estimated, the convert would still produce roughly a break-even total return.