by Barry Vinocur
Photography © Gary Spector

Since making the move from the buy-side at European Investors to the sell-side as an analyst (first at Salomon Brothers before its merger with Smith Barney, then to PaineWebber, and last year to Salomon Smith Barney), Jonathan Litt has consistently been ranked among the REIT industry’s top analysts by Institutional Investor and Realty Stock Review (see page 32).

Litt and his team provide clients not only with unparalleled service, but also with the insight and tools to help guide their investment decisions. Credited by institutional investors with introducing e-mail earnings alerts that arrive nearly simultaneous with a company’s earnings release, Litt is also the brains behind The Hunter (the name suggests the role it plays in helping to uncover investment opportunities), a weekly spreadsheet that can be dynamically linked to data services, such as Bloomberg or Reuters.

Fearless when it comes to calling ’em as they see them, Litt and his team have been at the forefront of the outcry for the industry to adopt a more GAAP-like earnings measure than the current funds from operations, or FFO, per share. He also isn’t shy when it comes to shining the light on managements that stumble. Over the past several years, Litt and his team not only have called for management shake-ups, but in several recent instances have suggested it was time for flagging companies to be sold.

During a recent phone interview, Litt provided a whirlwind tour of the sector’s colorful, if at times checkered, past, retracing the rebound in REITs last year, and providing his take on where the stocks are headed.

What do you see as the drivers behind the REIT revolution that began in the early 1990s?

The key to the success of REITs in the early 1990s and why they continue to be successful today is that unlike previous vehicles that didn’t really work - such as partnerships - management has been internalized, as well as the fact that management’s compensation is tied to performance. There are a few holdouts, but for the most part, how much money a CEO and other members of senior management earn is tied to metrics, such as growth in earnings per share. At the same time, because CEOs and other members of the senior management team own shares and have stock options, they have a very real incentive to do everything they can to maximize shareholder value.

There have been some bumps along the way, 1998 and 1999, for example. Last year was a lot better. What’s your take on the past six or seven years?

From 1991 through probably late 1997, there was a tremendous opportunity to buy real estate at very attractive valuations. It went in cycles, with multifamily being the first opportunity, and office and industrial properties coming later. Then, as the cycle matured and prices began leveling off, or even declining a bit, and capital wasn’t as available because the opportunities to arbitrage the pricing discrepancy between the private and public markets disappeared, two things happened.

The first was that development started again. As development ramped up in all sectors, investors became increasingly concerned not only about the possibility of overbuilding, since historically overbuilding has been a major problem for the sector, but also there were concerns about pricing. Investors worried that with so much capital available, companies would start overpaying for properties, which, again historically, has been a problem for the sector. The result was a pretty significant adjustment in valuations.

In 1999 investors focused on the Internet, and we saw capital flood into the dot-coms, telecoms, et cetera. Real estate was the poster child for the "old economy." The result was that 1999 was another weak year for the stocks.

What about real estate fundamentals during that time frame?

The interesting thing, which most investors missed, was not only that real estate fundamentals continued to be very good throughout that two-year period, but also, and perhaps most important, there was real discipline. In other words, the feedback loop worked. There’s always a bit of overshooting, but for the most part, prices didn’t reach the insane levels seen in previous cycles because the flow of capital dried up. And we didn’t see real overbuilding because, again, the feedback mechanism worked. Neither lenders nor the capital markets were willing to fund development that didn’t really make sense.

Most REITs adapted to the changes pretty quickly. They shifted their focus from buying/developing to running their companies more efficiently and effectively. At the same time, a lot of companies began to focus on recycling capital - selling mature assets and redeploying the proceeds either into properties they believed offered significant upside, or increasingly in 1999 and into last year, into stock buybacks. When companies’ share prices are as far below their net asset values as was the case throughout the bear market that began in late 1997 and ran through the beginning of last year, buying back stock makes a lot of sense.

What triggered last year’s rebound?

In terms of stock prices, the catalyst, I guess you could say, was what has been called the tech wreck. As investors fled the dot-coms and other tech stocks, they looked around and saw that "old economy" real estate not only was trading at very attractive valuations, roughly a 20 percent discount to net asset value, but also that the stocks offered very attractive yields. As capital came into the sector, stock prices rose, and the result was that last year was the best year for the sector since 1996, when the stocks were up roughly 36 percent.

There’s been a lot of discussion over the past several years about increased transparency and the better flow of information being good for the sector and the stocks. Do you agree?

Yes, the flow of information is a lot better, and that has been a major factor in the discipline we have seen over the past several years, and that we continue to see today. And, it’s not just the transparency that comes from having public companies, though that’s been important. It’s also the better flow of information, for instance, about new construction. When I first started in the business in 1994, I would get a tape from a firm that provided us with data. I gave that tape to my IT department. A few days later I had the data. If I decided after a first pass at the data that I wanted to focus on a specific market, say, Atlanta, I went back to the IT department and in another few days, I had the data on Atlanta that I wanted. Today, I can call that information up on my desktop, and so can anybody else who wants access to that data.

The economy is center stage today. I realize that you’re not an economist, but what’s your view regarding the economy and how a slowdown/recession would impact real estate, generally, and REITs, specifically?

Our firm isn’t currently forecasting a recession, but you cannot ignore the possibility. In fact, we have written several pieces over the past few years on what happens to real estate in a recession. What some investors may have lost sight of, however, is that whether or not the economy meets the technical definition of a recession, it may feel like we’re in a recession, or worse. In other words, it might not feel as bad if GDP went from, say, 2.5 percent growth to minus 1 percent growth as it will if we go from a GDP of 5 to 6 percent down to 2 to 3 percent. However you look at it, though, the economy is slowing, and that will have an impact on real estate.

The good news is that if you look back at previous economic downturns, real estate is in better shape today than it has been heading into previous slowdowns. Supply and demand are in reasonably good balance, and the sort of "funny money" that in past cycles had driven real estate values to unsustainable levels isn’t a factor today.

Fund flows were negative in 1998 and 1999. According to AMG Data Services, dedicated real estate funds had net outflows of roughly $1.3 billion in both of those years. REITs had a great year in 2000. The Morgan Stanley REIT Index [ticker is RMS] was up 26.8 percent. The broader market had a lousy year. You would have thought individual investors would have poured money into the sector. That didn’t happen. According to AMG, net inflows into real estate funds last year totaled under $400 million. What’s your take on that data?

There are a couple of ways to use the AMG data. First, the flow of funds into the sector last year was, well, modest. There’s no debate about that. However, the other way that we use the AMG data is as a barometer of investor sentiment. Fund flows, as you pointed out, were negative in 1998 and 1999, and then last year, the tide turned. Money started coming into the funds. We expect that trend to continue and probably pick up momentum in 2001. We’re not counting on it, but we think the increase could be very significant as investors take stock of how their portfolios performed last year, and they look around to find those sectors that are either undervalued or reasonably valued and have good underlying fundamentals.

"Old economy" stocks like real estate will start looking better and better?

You can certainly make a very strong case for that.

What’s your forecast for REITs this year?

We’re forecasting a 10 to 15 percent total return this year. Our Blue Chip REIT list [see below] should again exceed the industry average.

You and your team introduced your "Blue Chip REIT List" in January 1999. How did those stocks do last year, and what makes a company a "Blue Chip REIT?"

Let’s look at some of the major sectors within the REIT market. Since your group was early to suggest that, despite concerns about the economy and several high-profile retailer bankruptcies, investors shouldn’t ignore retail, let’s start there.

We view retail real estate as a retailer that is constantly remerchandising its store. The remerchandising is accomplished by removing tenants that are declining and bringing in tenants that are rising. It sounds simple enough, but the key ingredient to making it work is having real estate that is well located and dominates its markets. As such, the companies that own these malls will be best positioned to remerchandise the tenants.

Regional mall REITs trade at two-thirds of the valuation of our Blue Chip REIT list, despite having similar growth rates. Furthermore, similar to office companies, mall REITs have a sizable loss to lease, as rents expire at 20 percent discounts to market rental rates. Even in a soft retail environment, mall REITs should be able to register solid FFO growth simply by rolling their leases to market.

We believe some of the best values in the REIT sector may be in the regional mall sector; however, these stocks are not for the faint of heart. Every tenant failure is analyzed and discussed in the marketplace with excruciating detail.

Office/industrial has been a hot sector. What’s your outlook for those companies?

Despite evidence, as we discussed earlier, that the U.S. economy is slowing and an increasing opinion that we may, in fact, be headed toward a recession, we are actually forecasting another year of 10 percent-plus growth for the office and industrial REITs.

We expect the mixed office and industrial sector to report the strongest FFO per share growth at 12.1 percent, led once again by the West Coast-focused Spieker Properties and Mission West. Above-average growth expectations for Boston Properties (up 10.3 percent) and Equity Office (up 13.1 percent) help to propel the focused office growth forecast to 10.6 percent.

We also look for the industrial sector to grow slightly faster than 2000’s pace, at 9.4 percent, with both AMB and First Industrial expected to report double-digit growth.

Why so bullish?

Underlying our confidence in the office and industrial sectors is the embedded growth in most REIT portfolios. With lease terms averaging five to seven years, vacancy rates of 5 to 6 percent, and solid market rent growth through the 1990s, in-place rents are well below market for many office and industrial REITs. Further, we view the rent growth and occupancy assumptions in our earnings estimates as conservative. We believe the frenzied rent growth of early 2000 has subsided and that rents in many of the hottest markets have plateaued. That said, they have plateaued at near-record levels, which we believe bodes well for this and the coming years.

Multifamily REITs, generally speaking, had a great year in 2000. Is there more gas in that tank?

Multifamily REITs were up 35.6 percent last year vs. 26.8 percent for the Morgan Stanley REIT Index. In 1999, the multifamily sector generated premium total return performance, a 10.5 percent increase vs. a negative 4.6 percent total return for RMS. The multifamily industry has clearly benefited from having among the strongest supply/demand fundamentals of all REIT sectors.

We expect the multifamily REITs to continue the trend of 10 percent-plus FFO growth in 2001. However, one point of concern is technology. We believe the volatile technology industries could foreshadow a broader concern of ours: that a continued weakness in the technology industry could negatively affect rent growth, particularly for REITs heavily invested in tech-oriented markets.

Market rents should moderate to some degree in 2001, regardless of what happens to the tech market. Thanks to the supply-constrained characteristics of most tech-oriented markets, as well as favorable demographic trends that support multifamily demand, we believe any additional rent moderation tied specifically to technology will be minimal.

As a result, we expect the multifamily REITs to have another solid year in 2001. We would expect high-quality names like AvalonBay and Charles E. Smith Residential to be among the first stocks new investors look to when entering the sector in 2001.

Bottom line: We expect the multifamily sector to outperform the broader REIT index by 200 to 300 basis points in 2001.

What about the healthcare REITs?

The healthcare REIT sector registered a 23.6 percent return vs. 26.8 percent for RMS last year. Despite the mild underperformance, we take some solace from the positive total return. However, the healthcare sector was down 15 percent and 25 percent in 1998 and 1999, respectively, so there’s more lost ground to be made up.

In 2000, individual company total returns in the sector were all over the map. Five REITs generated positive returns ranging from 7 percent (Nationwide Health Properties) to 50.5 percent (Healthcare Realty), while five others registered a total return decline, all of which were in the double digits. The dichotomy of returns in 2000 was rooted in the REITs’ exposure to troubled or bankrupt healthcare operators and the implications that has had on income statements and balance sheets. Those REITs with the least exposure to bankrupt nursing home tenants generally outperformed in 2000.

Our focus this year would be on those healthcare REITs with the strongest management teams and the safest dividends. One name that satisfies both is Health Care Property Investors. With a diversified portfolio and a well-respected management team, HCP has raised its dividend for 61 consecutive quarters.

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