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Special Report
REITs Join The Club
Standard & Poor’s reversed its long-standing ban on real estate investment trusts in its equity indices, saying Equity Office Properties and five other REITs would be added to three of its indices after the market closes on October 9.

by Barry Vinocur

October 3, 2001, is a date REIT investors aren’t likely to forget. At 5:15 p.m. that Wednesday afternoon, Standard & Poor’s reversed its long-standing ban on including real estate investment trusts in its U.S. equity indices. Simultaneous with that announcement, S&P said it would add six REITs (see table on page 22) to three of its indices—its flagship index, the S&P 500; the S&P MidCap 400; and the S&P SmallCap 600—following the close of trading on Tuesday, October 9, 2001.

It was hardly a secret that S&P was considering adding REITs to its U.S. equity indices. It had been the subject of much speculation since a group, including Sam Zell, Banc of America Securities’ Lee Schalop, Morgan Stanley’s Byron Wien, Alliance Capital’s Tyler Smith, the National Association of Real Estate Investment Trust’s Steve Wechsler and Michael Grupe, and Guggenheim Real Estate’s Mike Miles, met with S&P’s Index Committee on April 19, 2001 (see sidebar on page 23), to make the case for including REITs in the S&P 500. Nevertheless, the October 3 announcement was greeted by cheers from REITsters everywhere.

“We’re floating on air,” said one veteran REIT analyst immediately after the news hit the wire. A portfolio manager whose firm invests in property-linked stocks for institutions and mutual funds joked he called his parents to tell them the news. “They have been after me to get a ‘real job’ for the past 15 years. Now I finally have one.”

In its press release announcing the decision, S&P’s Index Committee commented it had conducted a broad review of real estate investment trusts, their role in investment portfolios, treatment by accounting and tax authorities, and how investors view them. “Based on this review, Standard & Poor’s concluded REITs will be eligible for its U.S. indices, the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600. The guidelines for the selection of REITs will be the same guidelines [see sidebar on page 24] covering liquidity, financial viability, market capitalization, ownership, and industry and sector representation that are used for other companies considered for the indices.”

S&P’s policy excluding the stocks from its U.S. equity indices, the October 3 release added, reflected “REITs’ role as passive investment vehicles during the late 1970s through the mid-1990s.” But, the Index Committee’s recent review concluded the majority of REITs are now operating companies, which purchase, manage, invest in, maintain, and market real estate. (The sector mushroomed in size since the dawn of the modern REIT era in 1992-93; see graph on page 25.) “However, those REITs, which are principally passive investment companies and which do not actively manage and operate real estate properties may not be added to a Standard & Poor’s index.”

The Index Committee’s statement went on to say REITs are subject to the same economic and financial factors as other publicly traded U.S. companies listed on major American stock exchanges. “The goal of Stan-dard & Poor’s indices is to reflect the U.S. equity markets and, through the equity markets, the U.S. economy. The inclusion of REITs furthers this goal.”

The Index Committee noted REITs are treated differently than some other kinds of companies for tax purposes. Yes, the Committee said, REITs are a tax-advantaged investment; however, it added, “there are various industries with specialized or unusual tax treatments including utilities, some natural resource companies, and others.”

The S&P Index Committee also weighed in on the debate over the use of funds from operations, or FFO, vs. EPS or earnings per share (see Property, Sept./Oct. 2001, page 6). “When analysts and investors evaluate REITs, they use both a net income measure and a specialized funds from operations measure. In reviewing REITs for inclusion in its indices, and when calculating EPS for its indices, Standard & Poor’s will use net income rather than FFO. Standard & Poor’s welcomes efforts on the part of the real estate industry and securities research organizations to reach agreement on a standard definition of these accounting conventions,” S&P Index Committee Chair David Blitzer said.

The Impact of Joining the Club
Prestige aside, what does being added to an S&P index mean for a company’s stock price? S&P addressed this subject in a September 2000 study by Senior Index Analyst Roger Bos.

Bos looked at 188 companies added to the S&P 500 since 1991. For the S&P MidCap 400, the sample size was 269 companies dating back to its inception in 1991. For the S&P SmallCap 600, 403 companies had been added since the end of 1994. Bos noted that in November 1988, S&P instituted a preannouncement policy for index additions and deletions of at least one day before they become effective.

The S&P study examined the price appreciation of each stock for three time periods: (1) announcement date to effective date; (2) effective date to 10 days after effective date; and (3) announcement date to one year later (actually the month-end nearest one year after the announcement date).

“When S&P announces index changes, index fund managers must make these changes in order to minimize their tracking error for the over $1 trillion in assets that replicate the S&P indices,” Bos wrote. Tracking error—the performance of the S&P 500 as calculated by S&P minus the performance of a given fund—is the measure by which most index fund managers are judged. “Even though S&P pre-announces changes to its indices, index fund managers usually wait until the effective date to build a position in the new stock. This provides an opportunity for speculators to buy the stock on the announcement date, knowing there will be above-average demand for the stock on the effective date.”

graph For each time period studied, S&P analyzed each stock’s unadjusted and adjusted returns. The unadjusted return is simply the price appreciation. “The adjusted return is the price appreciation minus the expected return, where the expected return is the stock’s beta times the price appreciation of the respective S&P index.” In other words, Bos continued, “If a stock were being added to the S&P MidCap 400 Index, we adjusted its return for the return of the S&P MidCap 400 Index regardless of whether it came from another S&P index or from outside the indices.”

In terms of the total dollar value of money managed to replicate an index, the S&P SmallCap 600 is much smaller than the S&P MidCap 400, which in turn is much smaller than the S&P 500. “There are a number of conclusions we would expect to see as a result of how much money is tied to each index,” Bos wrote. “First, since the S&P 500 is a much larger index than the other two, we would expect that a stock being added to the S&P 500 would receive a larger boost in its share price than a stock being added to either of the other two indices.

“Second, if a stock is moved from the S&P 500 to one of the other two S&P U.S. indices, the amount of selling by S&P 500 fund managers would far outweigh the buying by fund managers of the S&P index to which it is being added. The likely result of this decrease in demand is that the stock’s share price would fall.”

graph Even though addition to, or removal from, an S&P index should not be considered a buy or sell recommendation by S&P, Bos concluded, the market has determined the relative importance of S&P’s various indices by how much money is invested to replicate the indices.

The S&P study’s findings went pretty much as expected by Bos’ observation relating to how much money was indexed to each of the three indices (see table on page 23). Upon announcement that a stock is being added to the S&P SmallCap 600, on average, it tends to go up in price by 5.63 percent from the time the announcement is made to the time when the change takes place. For the S&P MidCap 400, the same number is 6.94 percent, and for the S&P 500, it’s 8.52 percent.

Behind The Scenes
Now that the ban on REITs in S&P’s U.S. equity indices has been lifted, we figured it was a good time to quickly review the events leading up to their inclusion in the benchmark.

Though there’s been a good deal of talk about REITs and the S&P 500 for years, the path to the October 3 announcement began last November when Lee Schalop, who heads the REIT Research Team at Banc of America Securities, put a call in to David Blitzer, who heads S&P’s Index Committee. (Our recounting of these events is based on interviews with a number of participants in the process, most prominently Blitzer himself.)

S&P gets lots of calls—as you might expect—from companies that think they ought to be included in the S&P 500, as well as industry groups that want their industry represented in S&P’s flagship index, Blitzer told us.

Schalop made a series of calls to Blitzer and from time-to-time sent him REIT-related research and papers he thought S&P’s index chieftain might find interesting. Schalop’s spade work paid off earlier this year. On April 19, Schalop and a group that included Sam Zell, Morgan Stanley’s Byron Wien, Alliance’s Tyler Smith, Guggenheim Real Estate’s Mike Miles, and NAREIT’s Steve Wechsler and Mike Grupe made their case in front of Blitzer, a number of other S&P Index Committee members, and several other S&Pers. The presentation and Q&A session lasted roughly two hours.

Blitzer told us the presentation was impressive. The folks at S&P also were impressed that Zell was there for the event. Blitzer reported there was a lot of buzz when Zell entered the building. “Sam Zell made a huge impression,” he told us.

In the end, however, it came down to gathering data and surveying folks on the Street as well as at universities. Blitzer said S&P was still getting e-mails up to the last minute. “We received several on Tuesday, October 2,” he said.

The rest, as they say, is history, and a very sweet chapter in REIT history it is.

Making the Cut
The Standard & Poor’s Index Committee examines five main criteria when looking for index candidates: trading analysis and liquidity, ownership, fundamental analysis, market capitalization, and sector representation.

Before reviewing the criteria, a note about the universe from which S&P index candidates are drawn. Selection begins with Standard & Poor’s Stock Guide Database of over 10,000 companies. Screened out of the universe are stocks headquartered in foreign countries, American Depository Receipts (ADRs), American Depository Shares (ADSs), closed-end funds, equity derivatives, tracking stocks, and until October 3 of this year, real estate investment trusts.

The five criteria S&P uses when evaluating candidates for possible inclusion in one of its equity indices as well as for its ongoing evaluation of index members to ensure they continue to measure up to S&P’s yardsticks are:

Trading Analysis—One major criterion for a good benchmark is that it be investable. Standard & Poor’s attempts to ensure this by choosing only stocks with sufficient liquidity to be included in its indices. The liquidity measure Standard & Poor’s analyzes is a version of share turnover calculated as average monthly volume divided by shares outstanding. At a minimum, this number should be 0.3 for New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) shares and 0.6 for Nasdaq shares. (Nasdaq effectively double counts its volume by treating the two parts of a transaction separately.)

Ownership—Another factor in making S&P indices investable is the size of the float available to the public. Standard & Poor’s would like to ensure that a sufficient amount of stock is available to investors to replicate the index. To do this, Standard & Poor’s looks for index candidates that meet the following two conditions: (a) no single entity may hold more than 50 percent of the outstanding shares, and (b) multiple entities may not hold more than 60 percent of the outstanding shares. Such entities do not include open- or closed-end mutual funds.

Fundamental Analysis—The profitability criterion is four quarters of positive net income on an operating basis. Sometimes, Standard & Poor’s will include a company that would be profitable except for a loss due to a merger or an acquisition.

Market Capitalization—As a size consideration, Standard & Poor’s uses the market capitalization of a company to decide the appropriate index for it to be in. Here are some general guidelines Standard & Poor’s uses for each of its indices: For the S&P SmallCap 600, Standard & Poor’s generally looks for companies with market caps in the range of $300 million to $400 million, going up to about $1 billion. These are not absolute rules; sometimes, companies with market caps below $300 million are deemed worthy of addition. Also, for certain high market cap sectors, such as technology, Standard & Poor’s may add companies with market caps of up to $1.5 billion to the S&P SmallCap 600. For the S&P MidCap 400, the market cap range is from roughly $1 billion to $5 billion. From a market cap range perspective, this is the most difficult of the three indices to manage because most companies do not stagnate. Finally, for the S&P 500, there are no capitalization restrictions. The guiding principle for inclusion in the S&P 500 is leading companies in leading U.S. industries. Generally, companies are over $4 billion, although Standard & Poor’s sometimes adds companies below this range. That said, most companies added to the S&P 500 have market caps much larger than $4 billion.

Sector Representation—A final criterion is the economic sector in which the stock is classified. The Index Committee tries to keep the weight of each sector in each index in line with the sector weightings of the universe. In this case, the respective universe is all the stocks in the Standard & Poor’s Stock Guide Database, with the exceptions previously noted.

Standard & Poor’s ongoing analysis of index members includes monitoring for what it terms “lack of representation.” Put simply, S&P asks itself, “If the index was created today, would this company be included?” If the answer is no, the stock would seriously be considered for removal.

Just because a company meets all five criteria does not guarantee its inclusion in one of the indices. Companies also may be added even if they do not meet all five criteria. In addition, the fact that a company no longer meets the above criteria does not guarantee that it will be removed from the index.

While removal from an S&P index is often caused by very low relative market capitalization, very low share price, or financial distress, many more stocks are removed from S&P indices as a result of corporate actions than all of the preceding reasons combined. From its inception in 1926 to September 15, 2000, 1,001 companies exited the S&P 500, the overwhelming majority as a result of mergers and acquisitions.

Taken from General Criteria for S&P U.S. Index Membership by Roger Bos and Michele Ruotolo, Standard & Poor’s, September 2000.

“While it is true that many stocks subsequently give back some of this gain in the 10 days after the effective date, on average, there is still a net gain vs. the price before the announcement. For example, the average stock being added to the S&P 500 goes up 8.52 percent from announcement date to effective date, but then declines 1.94 percent from effective date to 10 days later, for a net gain of 6.42 percent from announcement date to 10 days after effective date,” the S&P study’s author wrote. The study also looked at average returns over a one-year period to get a long-term picture of how index additions are performing.

Unadjusted returns, however, fail to take into account the general market conditions (as measured by the three respective S&P indices). In other words, Bos explained, unadjusted returns contain an upward bias as a result of the generally rising market environment experienced during the period of the study. The table on page 23 also shows the same data after subtracting the expected return.

Though more modest, adjusted returns are still generally positive. “Adjusting for general market movements, being added to the S&P 500 means an immediate boost in share price of 5 percent [(1+0.0849) x (1-0.0323) -1] and another increase of around 4 percent over the following year,” Bos added.

S&P Says
No question the focus for some time has been on S&P’s flagship index. Speaking at New York’s University’s annual REIT Mergers & Acquisitions conference in March of this year, Sam Zell commented on REITs and the S&P 500. Echoing a statement he had made many times before, the chairman of three publicly traded REITs (Equity Office Properties, Equity Residential Properties, and Manufactured Home Communities) told a packed house, “The question isn’t if, only when a REIT will be added to the S&P 500.”

In addition to Equity Office, which replaces Texaco in the S&P 500 Index (Texaco is being acquired by S&P 500 Index component Chevron in a transaction expected to close on October 9), five other REITs will be added to two other S&P indices.

graph Hospitality Properties Trust and New Plan Excel will replace Arris Group and MasTec in the S&P MidCap 400 Index. (Arris Group and MasTec are being removed for lack of representation; see sidebar on page 24.) Colonial Properties Trust, Kilroy Realty, and Shurgard Storage Centers will replace Mayor’s Jewelers, SpeedFam-IPEC, and International FiberCom in the S&P SmallCap 600 Index. (Mayor’s Jewelers, SpeedFam-IPEC, and International FiberCom are being removed for lack of representation.)

Standard & Poor’s will continue to maintain and publish the Standard & Poor’s REIT Composite Index (see “Tracking the Market for Publicly Traded Real Estate Stocks” on page 76 and the table on page 77). The REIT Composite is maintained separately from Standard & Poor’s other U.S. indices. Some REITs included in the REIT Composite may also be included in the S&P 500, S&P MidCap 400, or S&P SmallCap 600 Indices.

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