Winter 2000
	Cover Story REITs at the Millennium Industry veterans look into their crystal balls. Where are REITs headed? Company Spotlight Can Crescent Get Its Groove Back? John Goff is working to restore Crescent Real Estate Equities’ reputation as a REIT that "gets it." Property Fundamentals Lack of Correlation J.P. Morgan’s Michael Giliberto provides answers to the age-old question, "Are REITs really real estate?" Awards Spotlight Best & Brightest Realty Stock Review’s eighth annual awards presentation recognized the top vote getters in a number of categories, including outstanding analysts, CEOs, and CFOs. Voters also chose the industry’s man of the year and men of the decade. Investment Analysis Applying MPT to REIT Portfolios Careful portfolio construction can make or break the performance of a pool of assets. Investment Fundamentals The High Cost of Real Estate Ownership Swapping net income for FFO might not be such a bad idea after all. By The Numbers A Fund Manager’s Worst Nightmare If it’s true that what doesn’t kill you makes you stronger, real estate fund managers may be some of the strongest folks around. Point Of View REITs and Rights Plans Criticism of REITs that adopt rights plans is simply misplaced. Investment Spotlight Spooked What happens when more than a dozen REIT UITs start unwinding in the midst of the worst bear market in a quarter of a century? The New Economy When Worlds Collide The Internet will provide investment opportunities for innovative office and retail real estate companies that embrace the changing landcape. Investment Insight LBO Math The market is beginning to understand that LBO valuation does not equal net asset value. Parting Shot Coming of Age REITs have evolved from pools of properties to focused real estate operating companies. Newsline Captec Wants to Shed REIT Status Investor's Guide Questions Back Issues Feedback

by Barry Vinocur
Cover and Inside Illustration by Kurt Vargo

The 1990s ended on a down note for real estate investment trusts. For only the second time since the National Association of Real Estate Investment Trusts began tracking data on the stocks in 1972, REITs posted their second year in a row of negative returns. (The other years of back-to-back negative returns were 1972-73.) Though no one going into the new millennium was forecasting the sort of returns that made REITs the Wall Street darlings that they were in 1996, neither were they hanging crepe.

Most analysts and dedicated REIT investors said they expect an up year for REITs in 2000. As of mid-January, the Morgan Stanley REIT Index (a total return index) was up 2.5 percent. Since mid-December - when the news surfaced that the stock tip in a wallet donated to a charity auction by Warren Buffett was a REIT (Chicago-headquartered First Industrial) - the Morgan Stanley index was up just over 11 percent. Though it would be foolhardy, or worse, to make too much of the first two weeks of trading, there’s no denying that heading into the second half of January, most analysts and dedicated REIT investors were cautiously optimistic.

Among the more conservative forecasts for the first year of the new millennium is one from Jonathan Litt and his team at PaineWebber. In a January conference call, Litt forecast roughly a 10 percent total return for REITs this year. Since the PaineWebber analysts are forecasting a modest contraction in multiples across the board, the year’s positive return - if their forecast proves correct - would come via dividends. At the end of last year, Litt and his colleagues noted, the PaineWebber Composite REIT Index was yielding 10.5 percent.

a roughly 10 percent total return for REITs this year. Since the PaineWebber analysts are forecasting a modest contraction in multiples across the board, the year’s positive return - if their forecast proves correct - would come via dividends. At the end of last year, Litt and his colleagues noted, the PaineWebber Composite REIT Index was yielding 10.5 percent.

Eric Hemel and his colleagues at Merrill Lynch stressed that their outlook for 2000 is anything but downbeat. The Merill analysts said that rates of return in the mid-teens seem "reasonable, even without the up-side of a value correction." Mary Hogan and Sheila McGrath at Dresdner Kleinwort Benson told their firm’s clients that the REIT correction was over. They forecast a 12 percent to 15 percent total return in 2000. Larry Raiman and his colleagues at Donaldson, Lufkin & Jenrette also believe 2000 will be an up year for REITs. Their forecast is for a seesaw year in which returns are down then up. They expect a total return in the 13 to 14 percent range this year.

Surveying the Landscape
In their outlook piece, the DLJ analysts wrote they expect three key events to occur in REITland in 2000. First, they expect REIT earnings growth to stop declining this year and finally settle in the sustainable 7 percent to 8 percent range. "For the past few years, REITs earnings growth has been on the decline, precipitated by a slowdown in both transaction activity and occupancy gains. The resulting impact has been a moderation in earnings growth from a high of 12.6 percent in the first quarter of 1998 to 8.2 percent in the third quarter of last year. In fact, REIT earnings have fallen on a sequential basis in each of the past seven quarters." Most striking, the DLJ analysts added, the REIT bear market has almost exactly coincided with the slowdown in earnings growth.

"This striking correlation between a slowdown in earnings growth and a contraction in trading multiples is no mere coincidence - and will likely persist until trendline results for REITs level off." Looking ahead, Raiman and his colleagues added, the operating environment for REITs is quite good. "Our strong U.S. economy continues to drive demand and disciplined capital markets continue to inhibit excess supply growth. These forces should stop earnings growth from declining. The combination of organic growth (unleveraged 3 percent to 4 percent), new development and service initiatives (unleveraged 1 percent to 2 percent), and financial leverage should cause REIT earnings to stabilize in the 7 percent to 8 percent range later in this year."

Second, the DLJ analysts expect very tight fund flows to persist in 2000, requiring the continued recycling of capital and a fluid private market for real estate assets. "Given the industry’s poor relative performance in each of the past two years, investor sentiment is not likely to change for the better any time soon. REITs will thus have to continue to live without fresh equity capital in the year 2000. Additionally, the cost of debt capital for REITs is on the rise, both in the secured and unsecured markets. As a consequence, REITs will be required to tap into internal sources of capital. Most prominently, that means increased reliance on asset sales and retained earnings."

Third, the DLJ analysts expect increased consolidation this year. "We believe the set of qualitative and quantitative factors should materialize to drive transaction activity to a more feverish pace. From a qualitative perspective, the status quo will no longer be enough for many anxious management teams." Public company executives, they added, may finally become fed up making less money than their private market counterparts.

If their outlook proves correct, Raiman and his colleagues wrote, "continued weakness in share prices in the first half of the year would produce further contraction in trading multiples. At that point, REITs would be trading one notch lower - and would be cheap enough to effectuate LBOs in a profitable manner." Taken together, the DLJ analysts added, the "three events" lead them to believe that consolidation and transaction activity should begin to heat up this year. "The result could be a much-needed reduction in the number of companies and alternatives in the REIT industry."

Hemel and his colleagues at Merrill noted that despite two years of disappointing returns, they continue to emphasize a role for REITs in a U.S. equities portfolio. They backed up their statement with seven reasons.

First, they pointed out that relative to the Standard & Poor’s 500-Stock Index, REIT earnings multiples are approximately 56 percent of where they were - on average - over the past six years. "REIT earnings yields today are approximately 500 basis points above 10-year Treasurys vs. a 273 basis point average over the last six years. REIT dividend yields are approximately 380 basis points above the S&P utility yields vs. a six-year average of 203 basis points. Finally, even after their recent run-up, REIT stocks are trading at a 17 percent average discount to our estimated net asset values."

Second, Hemel and his colleagues expect average FFO growth of 10.6 percent between 1998 and 1999 and 8.7 percent between 1999 and 2000. For their Buy-rated stocks, they added, growth between 1999 and 2000 should average closer to 11 percent. Third, among the Merrill analysts’ Buy-rated stocks, the dividend yield and five-year growth rates are correspondingly 7.5 percent and 9.6 percent. Fourth, they pointed out that rent growth exceeds inflation in almost every property category in almost every market. "It appears that apartment construction activity has leveled in recent months, and office construction peaked early last year."

Fifth, Hemel and his colleagues wrote that they expect the best performing real estate markets in 2000 to be those markets - already expensive - where upwardly mobile professionals, particularly in high technology, want to live and work. These metropolitan areas include, most notably, the San Francisco Bay Area, Los Angeles, Boston, Washington, D.C., and Seattle. "All evidence shows that technological changes are fostering "clustering" as opposed to cost-minimizing decentralization."

Next on the Merrill analysts’ list, "share repurchase activity in the REIT sector provides an additional data point supporting our valuation perspective." By mid-December, Hemel and his colleagues noted, a majority of REITs had authorized share repurchase programs. "We believe year-end financial results will confirm that buy-backs, once authorized, were pursued aggressively."

Finally, the Merrill analysts wrote, the near-term stock price performance of the sector likely will depend unavoidably on broader market issues, particularly the performance of value vs. growth and small cap vs. large cap. "The poor performance of REITs over the last several years is largely attributable to their technical characteristics - particularly their characterization as value stocks and their low market capitalizations (relative to the S&P 500). Dramatic outperformance - were it to occur - will almost certainly result from a change in the market’s mood regarding the importance of value, the merits of high dividend yields, and the view of ‘defensiveness’ as a positive attribute."

In their outlook piece, Dresdner Kleinwort Benson’s Hogan and McGrath noted that "the tech craze of today bears some striking similarities to the REIT cycle of the 1990s. Like technology, the commercial real estate industry was transformed with the help of Wall Street in the 1990s. Growth was explosive in the early years, but valuations and expectations soared, companies got greedy, the Street got nervous, momentum players exited, and valuations collapsed."

Hogan and McGrath added, "There is no question that real estate has recovered in the United States; growth prospects are moderating, but we feel this is reflected in the current valuation." Second, they point out that the average REIT dividend yield is 8.4 percent, with an average dividend payout ratio of 67 percent. Third, Hogan and McGrath note that the average REIT trades at 7.2 times 2000 FFO estimates. "We estimate the average five-year growth rate at 7 percent to 8 percent." Moreover, the Dresdner Kleinwort Benson analysts stressed they believe quality REITs possess many appealing characteristics, including positive earnings growth, stability of income, and attractive dividend yields.

"Should you swap out of your tech holdings and into REITs? We’re not saying that, but don’t give up on REITs yet. We believe REITs can deliver total returns in the 12 percent to 15 percent range in 2000. While we realize that in this market many investors would consider a 15 percent return one bad day, we consider this return attractive on a risk-adjusted basis," Hogan and McGrath wrote. At some point, they added, an industry yielding 8-plus percent with steady 7 percent growth potential at a 7 multiple will be appealing.

Not everyone shares that rosy outlook, however. Though they were in the minority heading into the new millennium, a number of veteran REIT investors suggested it’s possible that REITs could suffer a third year in a row of negative returns. As they see it, if REITs have performed poorly the last two years, in the face of relatively speaking strong fundamentals, there’s no way to go but down as property prices come under pressure as REITs, opportunity funds, and others start to sell a large number of properties. Several industry veterans said it was inevitable that property prices would decline in order to clear the market of pent-up selling demand. On top of that, they said, fundamentals are moderating.

The "good news," in their view, is that thus far the discipline imposed on the market by the massive wave of equity securitization of real estate that began in the early 1990s had for the most part managed to keep overbuilding in check. "The feedback loop, for the first time in the modern history of real estate, appears to be working," said one institutional investor.

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