Parting Shot What's Wrong With REITs? The events of the past few months have once again exposed a structural flaw in the REIT market. by David Sherman

However, this dynamic does make REIT investing challenging for a significant portion of the nondedicated mutual fund community. Whether "value-oriented" or "growth-oriented," mutual fund managers make their money by picking stocks they believe are undervalued and riding them up relative to other stocks. That is certainly possible with REITs, but so far only during the "sweet spot" of the property cycle (which was over by the end of 1997) or when prices have gotten so low that real estate investors, such as Goldman Sachs' Whitehall Street Limited Partnership, The Blackstone Group, or even Warren Buffett, are about to jump in and provide a catalyst for a "bounceback." This presents a difficult investment dynamic, particularly for larger funds. Not only do they have to get in near the bottom, they also have to sell REITs well before they get to a level where equity issuance starts again (or suffer deteriorating performance while the market "clears" the new supply). If the gap between the top and the bottom is no more than 25 percent and stocks are relatively illiquid, the window for making money in a time frame consistent with investors' relative performance expectations is very short.

For those reasons, we believe the aggregate demand for REITs from this group of nondedicated investors is likely to remain anemic for some time, particularly since property fundamentals are unlikely to provide any further positive catalyst to spark new demand. Further, since the supply of REIT stock currently exceeds the demand from long-term dedicated investors, we expect REITs to continue to trade at a discount to NAV until the equity market capitalization of the group shrinks to accommodate the exit of those investors who don't want to own REITs. This shrinkage (or unsecuritization) will take place naturally as REITs trade at widening discounts to NAV and the liquidity in the direct real estate market continues to provide a broad range of debt and equity property financing alternatives. The decapitalization will include an acceleration of LBO and other cash-based M&A activity, as well as some level of REIT stock buybacks funded by property sales. Of these two, we expect most of the meaningful privatization to come from LBO/M&A activity. First, there may well be opportunities for opportunistic investors to buy property cheaper through the sagging stocks than in the direct market. Second, this activity also helps the industry by taking out many of the companies that don't really belong in the public market; the remaining companies will be of higher "public market" quality and more liquid. And last, an LBO/M&A deal environment will be a lot more fun for REIT CEOs than buying back stock and shrinking. In truth, for many REIT CEOs agreeing to shrink is somewhat akin to General Patton agreeing to retreat.

Naysayers will argue that management entrenchment, tax concerns, poison pills, and a variety of other factors will keep the consolidation from happening. Maybe so, since these issues exist. In addition, REITs aren't cheap enough yet for the LBO/M&A business to heat up dramatically. However, we have come to believe the structure of the REIT group and the timing of the property and market cycles will put such overwhelming pressure on the industry to consolidate (and decapitalize) over the next several years that it will overcome those impediments.