by Barry Vinocur
Illustration © John S. Dykes/SIS

When the bell rang to end the final trading session of 2000, REITs were at the top of the heap. For the record, the Morgan Stanley REIT Index (ticker is RMS) finished the year at 365.98, down just a bit from its all-time record high close - posted 24 hours earlier - of 372.06.

For the year, the widely followed benchmark (which excludes healthcare REITs) posted a 26.8 percent total return (see table on page 38), beating out the Standard & Poor’s 500-Stock Index, which ended the year in the red, down 9.1 percent. REITs - as measured by the performance of RMS - also outpaced the Nasdaq Composite, which had its worst year ever, chalking up a negative 38.8 percent total return, and the Russell 2000, which also finished in the red, down 3 percent for the year.

There was, however, one sector that did trounce REITs, and it was another traditional safe haven for income-focused investors: utilities. Like REITs, utilities had a disappointing 1999, finishing in the red, down 8.9 percent. But the sector came roaring back in 2000, with the S&P Utility Index posting an eye-popping 59.5 percent total return.

Dissecting 2000
REITs had their best year since 1996, when the Morgan Stanley REIT Index delivered a mind-boggling 35.9 percent total return. (The S&P 500 had a pretty good year in 1996, but not nearly as good a year as REITs. It was up 23 percent.) 2000, however, was a year of somewhat uneven returns.

The Morgan Stanley REIT Index surged in mid-December of 1999 after The Wall Street Journal reported that a stock tip tucked in a wallet Warren Buffett put up for auction at a charity event was a REIT - First Industrial. Just prior to that surge, RMS was at 266.30. The widely followed benchmark finished 1999 at 288.60, or down 4.6 percent for the year. 2000 got off to a slow start for REITs; then, in mid-March, RMS made its move. The index finished the day on March 13 at 281.81. By the end of the first quarter, it was at 296.27 (see graph and table on page 38). RMS finished the second quarter up 13.3 percent at 327.

In hindsight, it’s clear that the catalyst for the REIT rally was the "tech wreck." It didn’t hurt, of course, that when Nasdaq hit the wall, REITs looked cheap and their dividends "juicy" to nondedicated REIT investors scrambling for cover.

Fueled by the Nasdaq’s meltdown, increasing market volatility and attractive valuations, REITs staged a powerful rally on the heels of their second quarter earnings results. By early August, the Morgan Stanley REIT Index was closing in on its then all-time-closing high of 367.35 (set back on October 6, 1997). RMS closed the day on August 1 at 362.74.

After August, REITs ran out of gas. By the end of the third quarter, RMS had backtracked to 352.54. Though it wasn’t straight down from there - there was a lot of backing and filling along the way - RMS was at 341.70 heading into the month of December.

Lost in the enthusiasm over REITs’ strong performance in 2000 is the fact that, although REITs came on strong in the final weeks of the year, the stocks didn’t have an especially great fourth quarter. Yes, the Morgan Stanley REIT Index delivered a 3.8 percent total return in the final quarter. However, between the end of the third quarter and the end of November, RMS was in the red, down 3.1 percent. Put simply, had it not been for their strong finish (RMS posted a 7.1 percent total return in December, its fifth best monthly showing since RMS was launched in 1995), REITs might have headed into 2001 on a down note.

The end-of-year REIT rally was driven by several factors. At the top of the list is more death and destruction among tech stocks. As company after company pre-announced disappointing earnings guidance, Nasdaq fell further. And it wasn’t only tech stocks that gave notice that their most recent quarter’s earnings results would fall short of Street consensus. Amid the earnings disappointment, investors, analysts, and a long list of pundits had to face up to the possibility that if the economy wasn’t heading for a recession, it might suffer a harder landing than most had previously thought.

The combination of disappointment, volatility, and uncertainty - as well as the prospect of improving returns by investing in a relatively illiquid sector with an already extraordinarily tight supply/demand balance - fueled an influx of cash into the stocks from nondedicated REIT investors.

Despite the sector’s strong performance, the flow of funds into dedicated real estate funds in 2000 was paltry, relative to inflows on the heels of previous periods of strong performance. Moreover, relative to the outflows of 1998 and 1999, last year’s inflows were, well, more than a shock for the growing cadre of dedicated REIT investors. According to AMG Data Services in Arcata, California, dedicated real estate funds experienced a net inflow of roughly $360 million in 2000.

Drilling Down
Not all sectors of the REIT market fared equally well in 2000 (see table on page 41). At the top of the heap in 2000 were hotels, which posted a 40.4 percent total return. In the runner-up spot were apartments, which posted a 36.2 percent total return. In the "show position" were office and industrial REITs, with a 33.4 percent total return. (To see how companies fared last year, see the table on pages 46 and 47.)

Looking Ahead
What should investors expect from the stocks in 2001? It depends on whom you ask. Generally speaking, the views of analysts fall into two camps. The first group, which we’ll label the cautious optimists (though some may view them as pessimists), forecasts the stocks will post total returns in 2001 in the 7 percent to 12 percent range. The second group, whom we call the unbridled optimists, is forecasting returns in the range of 17 percent to 25 percent.

In a recent note, Steve Sakwa and his fellow analysts at Merrill Lynch & Co. provided their take on 2001. The Merrill analysts forecast total returns in 2001 of 10 percent to 12 percent; a good deal, of course, depends on how the economy fares. Currently, Sakwa and his colleagues noted that Bruce Steinberg, their firm’s senior economist, forecasts 2001 GDP growth of 3 percent, with the first half of the year being weaker than the second half. If GDP growth slows to less than 3 percent, and/or woes in the technology sector continue to produce significant collateral damage, Sakwa and his colleagues wrote that they would need to revise most of their internal growth rates downward.

The wild card in all of this, to some extent, is the Fed. If the Fed dials down interest rates significantly, as some pundits now suggest will be the case, the economy could fare better than the crepe hangers suggest, and REITs, specifically, could benefit as lower interest rates will add a penny here and a penny there to their earnings.

At the same time, as the Merrill analysts stressed in their note, rising REIT prices led to a sharp decline in REIT buyback programs. And that, coupled with softening property markets (that is, rising cap rates), is likely to put a severe crimp in the capital recycling programs of many REITs - a fact which only increases the possibility that companies might return to the equity markets. No one we have run across is suggesting that widespread equity issuance would be good for stock prices.

On the plus side, Sakwa and his colleagues underscored REITs could be the direct beneficiary of the uncertainty surrounding utility stocks. Yield-conscious investors in search of stable dividends might embrace REITs, and, given the equity market cap of the REIT sector is less than $150 billion, Sakwa and his colleagues stressed that "it doesn’t take a significant amount of capital to cause a significant surge in REIT stock prices." Below is the Merrill analysts’ take on five key sectors of the REIT market.

Apartments
We remain favorably disposed toward apartments in 2001 despite the strong performance by many of the companies in this group. While many of the stocks in this group trade at or above NAV, our optimism is based on our recent supply/demand analysis of 19 major markets. The bottom line from our study was that the level of new construction in these 19 markets had fallen roughly 9 percent over the past 18 months, which leads us to believe that internal growth should remain healthy for the foreseeable future. In addition, as the economy continues to slow, the sale of existing and new homes is likely to decline, which should be a net benefit for apartment owners.

Office/Industrial
This group is the wild card for 2001 and will be heavily influenced by the rate of economic growth over the next 18 months, as well as investor psychology. While overbuilding does not currently appear to be an issue for the national office markets, most institutional investors have been heavily overweight in this sector for the better part of two years, and some are beginning to re-evaluate their sector allocation. As a result, we believe this sector could be under some pressure during the first half of the year, as investors try to sort out just how much the economy is slowing and how the meltdown in technology stocks will impact the demand for office space in certain markets such as Boston; New York City; San Francisco; San Jose, California; Austin, Texas; Los Angeles; and Atlanta.

Retail
As a general statement, we would continue to recommend that investors underweight retail REITs for a host of reasons. These include: (1) slowing consumer spending, which should lead to fewer store openings in 2001 vs. 2000; (2) store closings (due to bankruptcies as well as overexpansion by certain retailers), which could increase during the first half of 2001. The two most recent examples plaguing the retail sector are the recent bankruptcy filings by Montgomery Ward and Bradlees. While we are cautious on retail, one area we would emphasize within the sector is neighborhood shopping center REITs whose portfolios are dominated by grocery-anchored centers.

Self-Storage
It is hard to imagine that 2001 could be worse for the self-storage REITs than last year. It seems that every time we turned around in 2000, one of the companies in this sector disappointed investors with lower earnings expectations. At this point, we believe the sector is totally washed out, which is evidenced by the fact that the sector is trading at only 82 percent of NAV. Looking into 2001, we believe earnings growth for this sector will reaccelerate (albeit off a relatively low base), and investors looking for inexpensive REITs may become interested if these companies can just meet consensus estimates for the next few quarters.

Manufactured Housing
While this group slightly underperformed the Morgan Stanley REIT index during 2000, we believe it could significantly outperform during 2001. Our enthusiasm is predicated on: (1) the stocks are inexpensive, and (2) the cash flows are very stable and predictable. We believe both characteristics will be "in vogue" during 2001. The only negative point about this sector is its small market cap, which, collectively, is less than $2.5 billion.

Also in the cautious optimist camp are Greg Whyte and his colleagues at Morgan Stanley Dean Witter (MSDW). In a recent note, the MSDW analysts pointed out that in late August they had reined back their enthusiasm for the sector somewhat.

"While we continue to expect REITs to post total returns of roughly 9 percent to 12 percent in 2001, the extent to which this represents strong relative performance is dependent on general economic growth, Fed easing, and general market performance." Whyte and his colleagues added that the biggest threat to any weakening fundamentals in most real estate asset types over the next few years will be "demand" precipitated rather than the result of abundant new supply, as has been the case in the last few real estate cycles.

The MSDW analysts stressed that in a weaker economic growth environment, they expect investors to be more focused on earnings quality.

As a general rule, Whyte and his colleagues viewed EBITDA (growth) from external sources (such as acquisition, development, and disposition) as well as "other" sources (such as land sales, investment management, and lease termination fees) to have more risk.

"We believe those stocks with high multiples and higher exposure to more transactional EBITDA are at more risk of losing relative valuation. Conversely, stocks with lower multiples and less exposure to riskier EBITDA sources may gain relative valuation in a weaker economy."

This analysis, the MSDW analysts continued, is meant to provide broad conclusions and is therefore less tailored to specific company circumstances. "We acknowledge, for example, that companies with a high degree of development exposure can mitigate risk through preleasing. However, we would not be surprised if investors began affording less credit to such risk-mitigation and might instead begin favoring names with safer, albeit slower, internal growth."

Generally speaking, Whyte and his colleagues noted, "apartment and mall REITs appear to have the highest proportion of both EBITDA and

EBITDA growth from riskier sources. Industrial REITs appear to offer lower risk EBITDA, with much lower dependence on external growth and ‘other’ revenue sources."

Also in the cautious optimist camp are Larry Raiman and his colleagues at Credit Suisse First Boston (CSFB). They expect the stocks to post total returns in the 7 percent to 10 percent range in 2001. "We look down our roster of REITs and find very few home-run hitters. Rather, we see a roster full of singles and doubles hitters."

Underlying their conservative total return expectation, Raiman and his colleagues wrote, is the belief that REITs will be able to sustain their 7 percent dividend yields, if not grow them a bit. "In addition, we believe earnings growth will slow to about 7 percent to 8 percent, or about 150 to 250 basis points below the level from third quarter 2000." Finally, the CSFB analysts believe REIT multiples could contract between one-half and one multiple point (or between 5 percent and 7 percent), as positive money flows into the group are offset by negative perceptions related to declining occupancy levels and more earnings "misses."

With that as a macro backdrop, the CSFB analysts turned their attention to property sector selection for 2001. "Overriding all our property calls and stock selections is one main theme: recession resiliency. From a sector perspective, the apartment and industrial groups have been - and should continue to be - the most resilient product types during economic slowdowns. Following multifamily and industrial are the office and shopping center sectors, which rank third and last among the major product types."

Taking into account securities issues, such as trading multiples, debt levels, visibility of earnings, and company-specific risk attributes, Raiman and his colleagues rank the sectors as follows: multifamily as No. 1, industrial as No. 2, office as No. 3, and retail as No. 4. "We note that our rankings for office and retail may flip-flop at some point during the year. That sort of change might occur if retail REITs take a tumble after a weak Christmas season and expectations in the office group get too high."

Raiman and his colleagues noted that, for now, neither strategy really stands out, assuming a 50/50 likelihood of either a hard or soft economic landing. On a probability-weighted basis, both sets of stocks stack up about the same; both offer total returns around 10 percent. "We thus maintain a balanced strategy between the two types of companies - for now. If greater visibility emerges that all is well in the economy, and we experience a soft landing, then we would step up more aggressively on higher beta ‘hares.’ However, if greater visibility emerges that all is not well with the economy, and we are in for a hard landing or a recession, then we would favor the ‘tortoises.’ We will soon see which way to go!"

Among the "unbridled bulls," Jim Sullivan and his colleagues at Prudential Securities are perhaps the most bullish. Toward the end of 2000, the Prudential analysts wrote, "all of the major investment variables that we consider for the group appear to be favorable." Further, Sullivan and his colleagues stressed that "it is during uncertain markets that investors often gain a new appreciation of the defensive characteristics - such as stable cash flows - that equity REITs offer." Bottom line: The Prudential analysts expect REITs in 2001 to deliver a total return in the 25 percent range.

Sullivan and his colleagues stressed that, though REITs made up much of the ground they had lost in "two disappointing years" (that is, 1998 and 1999) for REIT investors, the degree of multiple expansion since the beginning of 2000 has been "relatively small." Moreover, they added, equity REIT multiples based on trailing per-share growth in funds from operations are at roughly 9x, vs. 12.4x at the beginning of 1998.

Also in the "unbridled bulls" camp are Lee Schalop, Alexis Hughes, and their colleagues at Banc of America Securities. They are only slightly less bullish than Sullivan and his colleagues.

Schalop and his colleagues are forecasting REITs will deliver roughly a 20 percent total return in 2001. The Banc of America Securities analysts base their forecast upon an average yield of 8 percent, average cash flow growth of 8 percent to 10 percent, and their assumption that there will be a slight multiple expansion next year.

In a recent note to their firm’s clients, David Kostin, Jim Kammert, and their colleagues at Goldman, Sachs & Co. acknowledged that the U.S. economy shows signs of slowing. However, they stressed they do not believe a full-scale recession will materialize in 2001. Nevertheless, they added, "we encourage portfolio managers concerned about an impending U.S. recession or a significant economic slowdown to consider seriously the Goldman Sachs REIT Recession Portfolio as a means of achieving solid returns with only modest risk."

Kostin, Kammert, and their colleagues believe their portfolio has the potential to deliver a solid 15 percent to 18 percent total return to investors during the next 12 months, and possibly much higher if industry valuations experience any multiple expansion - a forecast that places the team in our "unbridled bull" camp.

The Goldman analysts explained they culled through their firm’s 53-company formal stock coverage universe to create Goldman’s REIT Recession Portfolio, an equal-weighted portfolio of seven companies (Equity Office, Equity Residential, Public Storage, CarrAmerica, AMB, Cousins, and Weingarten). They reported that the seven REITs had the following investment attributes: (1) expected 2000-2002 CAGR (compound annual growth rate) in FFO per share of 9.2 percent; (2) an annualized dividend yield of 5.8 percent; (3) equity capitalization averaging $4.2 billion; (4) real estate under development accounts for only 7 percent of gross assets; (5) stocks in the REIT recession portfolio trade at 83 percent of their estimate of NAV; and (6) average debt-to-total market capitalization of 31 percent and a fixed-charge coverage ratio - after considering dividend distribution as a REIT corporate obligation - of 1.7x. They added that the portfolio trades at an average multiple of 10.2x their 2001 FFO estimate, a 20 percent premium to the REIT industry average.

In summary, Kostin, Kammert, and their colleagues noted that they selected the common shares of those companies offering a combination of high durability of cash flow, minimal development exposure, and strong balance sheets.

"The expected FFO per share growth for the companies in our REIT recession portfolio averages 9.3 percent in 2001 and 9.1 percent in 2002. Perhaps more importantly, the basis for this growth stems from releasing existing space at higher rents and recycling capital, not acquisitions or development. In fact, current development activity accounts for only 7 percent of gross assets."

Finally, the Goldman analysts stressed they had checked the debt maturity schedule for each company. "For the overall recession portfolio, approximately 5.4 percent and 7 percent of the total debt outstanding matures in 2001 and 2002, respectively."

Perhaps more importantly, the fixed-charge coverage ratio, as noted, defined as (FFO + interest expense + preferred dividends – net income) / (interest expense + preferred dividends) averages 1.7x.

The REIT research team headed by Jay Leupp at Robertson Stephens also falls in the "unbridled bull" camp. In a note to their firm’s clients, Leupp and his colleagues wrote, "We expect REITs to post total returns of 17 percent to 20 percent in 2001."

Building upon the performance momentum achieved in 2000, the Robertson Stephens analysts predicted equilibrium-like real estate fundamentals, a favorable interest rate climate, and still-compelling valuations in many real estate stocks will align to deliver respectable returns to patient investors.

"Consistent with our expectations, REIT performance in 2000 was led primarily by large-capitalization operators in the office and apartment sectors. We expect 2001 to be much more of a stock pickers’ market. While we are still partial to certain parts of the office and apartment sectors, we believe excellent investment opportunities exist in the industrial, regional mall, and diversified sectors."

While market capitalization and liquidity will retain significant weight in their investment rating process, Leupp and his colleagues stressed they believe now may be an ideal time to focus on some of the sector’s well-run mid-capitalization ($0.5 billion to $1.5 billion) companies.

"While Fleet Economics is predicting modest 2.6 percent GDP growth in 2001 with an increasing possibility of a recession, we stand by our 17 percent to 20 percent total return prediction. Our reasoning is straightforward: over the long term, real estate share price and dividend growth are driven by earnings (FFO/share) growth, which is in turn driven by property-level real estate fundamentals (absent lackluster property management, of course)."

Unequivocally, Leupp and his colleagues continued, real estate fundamentals remain in good health. "At present, vacancy levels in all major property types - apartments, office, industrial, and retail - remain below 10 percent and are, on average, 50 percent below the record vacancy levels of 1991-92 (when the last economic slowdown/ recession occurred)."

They noted that sector valuations remain attractive. "We estimate REITs are trading at 8.5x to 9x our 2001 FFO/share estimates, at a 6 percent to 8 percent discount to net asset value, and are sporting an average dividend yield of 7.4 percent."

The Robertson Stephens analysts are predicting 8 percent to 9 percent 2001/2000 earnings growth, which is likely to accelerate if vacancy levels remain low and/or interest rates continue to fall. "An additional source of earnings upside is likely to be driven by aggressive use of taxable REIT subsidiaries (TRSs), which, as of January 1, 2001, can be utilized by REITs to own and operate businesses that provide non-real estate products and services to REIT tenants."