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REITs feel lucky

Although REITs may have a history of lackluster stock market performance, these publicly traded members of the real estate industry are focusing more intently on their strong points and preparing for a resurgence. This industry, in the midst of a transformation, is seeing some positive trends that are reason for cautious optimism. And at the top of the ranks, several REITs are proving they are still the cream of the crop, through thick and thin.

As 1999 came to a close, REIT stocks were on track to post their second consecutive year of underperformance. "The sector is off 8% year-to-date on a total return basis," says Ross L. Smotrich, managing director of real estate securities research for Bear, Stearns & Co. Inc., New York. Backing out an average dividend yield of 8.7% implies that the sector is down 16.7% on a price basis, he says.

Multifamily - his company's primary focus for the year - was the only sector to post a positive total return, and that measured approximately 6.4%. In 1998, he says, REITs were down 16.9% on a total return basis and about 24% on a price basis. As such, the group has lost about 40% in value over the past two years.

REITs have suffered from trends evident in the broader equity market - namely that stocks trade on perception, rather than fundamentals. While the group benefited from a second-quarter rotation out of tech/growth stocks in favor of cyclical and value shares, REITs have since trended down. Because of relatively low liquidity, REIT stock performance is particularly affected by funds flow.

For the dedicated real estate mutual funds, which often are viewed as a proxy for retail investor sentiment on the entire industry, net outflows totaled $1.1 billion year-to-date. Real estate mutual funds have registered net redemptions in 16 of the last 18 months, and total assets have declined 13% to $7.8 billion. Meanwhile, institutional investors also stayed on the sidelines.

Yet, REIT fundamentals remain strong. "These are very good companies with solid growth prospects in real estate markets that should remain in equilibrium," says Smotrich. "Notwithstanding, or perhaps because of the dramatic underperformance, we continue to favor the group, driven by valuation, income potential and real estate fundamentals."

Industry trends Several industry trends are cause for optimism over the longer term. Among those trends is the migration and consolidation of assets. The migration of assets and talent into the public real estate market continues, and REITs are becoming the primary source for development, acquisitions and operating expertise. On the asset level, consolidation also is ongoing. By some estimates, 65% of the institutional quality malls in the country are owned by public companies, and similar trends are evident in the other property types.

The top 50 multifamily owners (among which 17 are REITs) control about 15% of the institutional apartment market, and eight commercial companies control about 10% of the Class-A office market. REITs are no longer small businesses; many are large, well-capitalized entities. The implication is that real estate investors increasingly will seek to align with the public companies to get the best real estate operating talent.

Institutional investment and multiple differentiation are another cause for optimism. Pension plans, both corporate and public, have long been significant direct real estate investors, though many currently are underweighted to the asset class on a portfolio basis. As planned sponsors increasingly move toward cash plans - vs. defined benefit plans - the implied need is for greater investment portfolio liquidity.

"In our view, required liquidity, higher absolute portfolio allocations and the need to access real estate operating/value creation expertise will lead more astute sponsors to make public company investments in some form, such as securities or property joint ventures, in addition to their direct real estate activity," says Smotrich.

Further, he expects institutional interest to result in valuation differentials, as the funds use their own real estate expertise to better distinguish between higher-quality companies. Ultimately, funds using their own real estate know-ledge could lead to company-level consolidation, as itchy managers and boards seek to realize the value in their stock.

Income and valuation are other industry trends worthy of optimism. Income potential should help attract institutional attention, with the average 8.7% REIT dividend yield equivalent to going-in cash returns for direct property investment. Dividends appear relatively secure, representing a 257-basis-point jump over the 10-year Treasury and an average layout ratio of 68.2%.

"Importantly, we expect significant dividend growth over the next several years as a number of higher-quality REITs approach their minimum payout ratios," says Smotrich. Valuations are attractive in absolute and relative terms, he says. REITs are trading at 70% to 80% of net asset value, and at 29% of the Standard & Poors (S&P) 500 on a relative multiple basis. Yet, the consensus expectation is for 8.3% FFO-per-share growth in 2000 (vs. 6.9% for the S&P).

The shift in the fundamentals of equilibrium is a final industry trend that investors should notice. According to Smotrich, some view REIT stock performance as an indication that the market anticipates a downturn in underlying real estate fundamentals from the current "cyclical peak."

"Given what we know today, however, we don't think that is the case," he says. "Real estate markets around the country are essentially in supply/demand equilibrium an equilibrium that should continue. While real estate will always be cyclical, our sense is that the amplitude of the cycles has tightened; property markets around the country are strong; the economy is solid and development remains disciplined."

Bear Stearns, says Smotrich, is focused on the core names in each property sector including those that have access to capital, a strong internal operating capability and built-in growth prospects, as well as a management team that is able to negotiate both real estate and capital market cycles. As with the broader market, however, the ultimate catalyst for the group may need to be a fundamental shift in perception.

A winning hand With that in mind, one of Bear Stearns top picks is Boston Properties Inc., which owns and operates a portfolio of 132 commercial properties totaling 35.3 million sq. ft., primarily in office buildings in the core CBD and suburban markets of Boston, New York, Washington, D.C., and San Francisco.

"We believe Boston Properties is one of the highest-quality, integrated real estate operating companies in the sector," says Smotrich. "It is deep organizationally, and is sophisticated in managing both the real estate and capital markets."

Boston Properties has a 30-year track record of successful development, operations and market timing as well. According to Smotrich, the company is evolving into more of a pure-play on tight downtown office markets. "Indeed, Boston Properties' competitive advantage is in complex urban projects," he says.

The company, which has a high-quality cash flow, should benefit from rising rents as little new construction is on the horizon in its core markets. Boston Properties also has a $1.1 billion development pipeline, which should ensure consistent earnings growth for the next several years. "From a fundamental perspective, we think Boston Properties is an excellent company, and therefore, we consider it a core holding in the sector," Smotrich says.

David Sherman, managing director and head of the REIT research team at New York-based Salomon Smith Barney, offers his top picks for the real estate industry as well. Equity Office Properties (EOP) and AMB Property Corporation are at the top of his list.

According to Sherman, EOP offers investors an excellent combination of liquidity, stability and value. "EOP provides investors who want exposure to the industry with an excellent platform for investment," he says.

The company represents what Sherman terms the "REIT utility" business model: a high-quality management team and a deep corporate infrastructure to manage its assets as well as execute a well-defined, conservative business strategy. With a total market capitalization of $13.9 billion and a long-term business model, EOP provides investors who want exposure to the industry with a starting point from which to both get in and get out, he says.

EOP also has a strong balance sheet and a great deal of capacity, according to Sherman. "The company has historically managed its balance sheet very carefully," hesays. Moreover, through the Atlanta-based Lend Lease transaction, EOP has sold interests in seven of its low-growth assets and has generated $480 million in net proceeds. EOP has plenty of financial flexibility even after completing its recently announced $250 million stock buyback program, Sherman says.

EOP's valuation is reasonable on a multiple basis and attractive at the real estate level, he adds. While EOP is one of the best-managed REITs in the business, at this price investors effectively are getting EOPs management and its franchise "for free." In fact, investors are buying the assets at an implied discount to the underlying value of the properties, Sherman says. "On a risk-adjusted basis, EOP appears to represent an excellent investment, particularly over the long term," he says.

Despite its having run up about 13% since mid-December 1999, Sherman believes EOP still has an attractive value relative to its underlying assets, particularly in view of the fact that it has a highly professional management team and is one of the most conservative plays in the office sector. "Moreover, we believe that EOP has one of the few business models that will likely survive and eventually prosper in the public real estate market," says Sherman.

According to Sherman, certain strategies undertaken by EOP also provide for votes in its favor. For example, in December 1999, EOP confirmed the details of a deal with Lend Lease.

"In a nutshell, we believe this looks like an attractive deal for EOP and, given the reported gain, demonstrates the value creation from buying assets in a weak market and selling them later during a strong market," says Sherman. "While this may seem a gratuitous comment, we have noted surprisingly small gains being reported on other significant sales made by REITs."

AMB's success is no bluff Salomon Smith Barney's other top pick, AMB Property Corp., meets all of the company's criteria of a core REIT holding: strong management; long-term and a total return-focused approach to its real estate; a clean balance sheet with only 35% leverage; a track record of smart capital raising; and minimal event risk.

According to Sherman, AMB has a deep corporate infrastructure that can execute the company's clearly-defined and relatively conservative business plan. Unique to AMB, however, is its more than 16-year history as an asset manager for the pension fund community.

"This history and the relationships AMB has established along the way help AMB to raise capital outside the traditional public equity markets and to finance property development and/or stock repurchases, regardless of the sentiment in the public equity markets," says Sherman.

Furthermore, in an industry that likes to buy and hold properties, AMB is a leader in asset sales. In 1999, AMB divested $627 million in assets, mostly retail properties. AMB also realized a $65 million gain on gross value, which equates to a comfortable return on investment (ROI) in the mid-teens. At the real estate level, AMB targets in-fill locations that enable it to realize above-average, same-store growth (5.9% for the first nine months of 1999). AMB's lower risk, more defensive industrial assets should be less cyclical and provide better risk-adjusted returns throughout the real estate cycle.

"No stock story is risk-free, and AMB is no exception," says Sherman who believes the primary risk with AMB is that the 35 million overhanging shares held by continuing investors could continue to exert pressure on the share price. Continuing investors, who held 68 million shares after AMB's IPO, have sold 33 million shares (48.5%) since November 1998.

"While these statistics give us reasonable comfort that much of the overhang has burned off, it is possible that additional shares will shake loose in the future," Sherman says.

At $19.81, AMB trades at a 13.9% discount to NAV vs. a 5.7% discount for the average core REIT, says Sherman. Recent heavy selling by AMB's continuing shareholders has depressed the share price disproportionately, and continues to create a buying opportunity.

Consolidation enters the game There are numerous opportunities for portfolio growth among the top REITs. REIT executives like Ken Bernstein, president of Acadia Realty Trust, New York, do not hesitate to speak out on the strength of REITs. "Acadia is well-positioned to take advantage of profitable opportunities for growth," says Bernstein.

In 1998, through a reverse merger, RD Capital and Mark Centers Trust merged to form Acadia Realty Trust. The transaction involved a contribution of $280 million in gross assets and a cash infusion of $100 million. As a result, total market capitalization of the public company more than doubled, shareholder equity increased by a factor in excess of three and the debt ratio was significantly reduced, says Bernstein.

"We're a company with strong fundamentals, focused on opportunity," he says. Structured as an UPREIT - "umbrella partnership" REITs which specialize in the operation, management, leasing, renovation and acquisition of shopping centers and multifamily properties - Acadia's portfolio is comprised of 57 properties with more than 11 million sq. ft., including 2,273 apartment units. The REIT's strengths include an experienced management team with a proven track record, a portfolio of high-quality retail and multifamily properties and the financial stability and resources to enhance existing assets while selectively making new investments.

"One of the most compelling reasons we're strong is our half a billion gross asset value and our 7% per annum increase," Bernstein says. "We have one of the highest earnings growth projections in our peer group."

Bernstein says Acadia's small size helps it create stronger growth prospects and better turnaround possibilities.

"It is highly unlikely that too many companies will be able to access financial capital in the near future," he says. "Those doling out the capital probably will only look at the larger blue chip companies at first. That's a reality to be recognized."

A slight slump in the real estate market in recent years can be cured, Bernstein says. "Most likely, consolidation will have to play a part in the real estate recovery. There has, overall, been too much entrenchment by management. They've had their heads in the sand," he says.

The REIT market as a whole will have to pare down, Bernstein continues, and improve the quality of management while changing how management behaves vis a vis the investment community. "Until that happens, we won't see the numbers we saw a couple of years ago," says Bernstein.

Acadia is doing its best to defy the undercurrents. "We built a great management team and have done an excellent job of turning around our assets," says Bernstein, adding that the last piece of the puzzle is the disconnection between asset value and where Acadia's stock is trading. "We're not alone in this dilemma," says Bernstein. "But I think we'll get past it.".

The former senior management team of RD Capital, a private real estate operating company with a strong institutional following, heads Acadia Realty Trust. According to Bernstein, RD Capital was a vertically integrated organization with superior operating and control systems, and an acquisition group with complex transaction-structuring and underwriting capabilities. He says those talents have been passed on to Acadia.

Playing the right hand Archstone Communities Trust, an Engelwood, Colo.-based REIT with 224 multifamily communities in 33 metropolitan markets, is driving up its value with a three-pronged strategy focused on investments, operations and finances.

Archstone maintains a strong balance sheet, with investment ratings and more than 75% of its assets unencumbered. "Our investment philosophy is that investment returns must exceed the cost of capital," says Patricia Schmid, vice president of Archstone. "This has worked for us in spades."

"We're creating a new kind of real estate company," says Schmid. "The industry is in transformation. The leaders who are at the top aren't afraid of innovation."

Other top-notch picks such as Liberty Property Trust acknowledge that success is due to consistency. "Consistency of earnings is our number one growth asset," says Willard G. Rouse, chairman and CEO of the Philadelphia-based REIT. Multiple quarters of double digit growth in earnings have earned this REIT a spot at the top.

"We're developers by nature, and we've developed yields that are extremely high relative to the averages of most companies," says Rouse. "Wall Street is starting to look at return on investment more closely, and we're at the top 10% as far as that's concerned."

Rouse expects the national economy to guide the future of REITs, but for now, the markets are in equilibrium. "The markets are more competitive and there's more demand," says Rouse. "That bodes well for the industry today."

The overbuilding of the late 1980s is not being repeated. As long as supply recognizes demand, REITs such as his can maintain earnings growth and continue to move forward.

REITs are a top-notch stock choice, Rouse says. "REITs once were sold as growth stocks, but that wasn't such a good characterization," he says. "A hyperventilation in the market has people taking their money off the craps table and putting it where the success is.

"Now we're under-leveraged, our dividends are secure and there are ample shock absorbers in place to handle a meaner market than were presently experiencing," Rouse continues. "That's growing our company and our dividends are going up by an equal amount. The earnings are not superficial. This is not a one-time shot."

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