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In the past two years, real estate investment trusts, or REITs, have been on an unprecedented tear. The equity REIT index of the National Association of Real Estate Investment Trusts has soared 55.8% since August, 1995, largely thanks to a flurry of REIT takeovers. ''This is an anomaly,'' says Thomas Barrack, head of Colony Capital, a private opportunity fund focusing on real estate-related investments. ''REITs are being priced on acquisition potential--not on the underlying property value.''

Given the high prices of many REIT stocks, investors must move carefully. Finding undervalued property classes is getting increasingly difficult. The game now is consolidation. Investors can play it two ways: buy the aggressively acquisitive marquee names that aim to be the Coca-Cola or Federal Express of this new world of real estate, or buy the weaker players that will be swallowed up by consolidators.

RICH MULTIPLES. The big national REITs have powerful advantages. Real estate is a capital-intensive industry, and these REITs have immediate access to cheap capital. If rents stop rising, most also have renovation plans to boost occupancy. But some caution is in order. To keep the rich multiples Wall Street gives them, they have to grow rapidly through huge purchases. With prices across the country approaching the cost it would take to replace buildings, some REITs will surely overpay.

Analyst Kevin Comer of BT Securities Corp. has several picks among the high-profile national consolidators: Vornado Realty Trust, Equity Residential Properties Trust, Starwood Lodging Trust, and Crescent Real Estate Equities. Vornado looks pricey, at 69 5/16, trading at about 25 times 1997 cash flow, but cash flow is expected to double by 1998, says Comer. ''Every transaction they've done has added to earnings.''

Marty Cohen, manager of Cohen & Steers Realty Fund, also prefers investing in larger REITs. He's buying Cali Realty Corp. and Reckson Associates Realty Corp., two East Coast regional office powerhouses. Kenneth Heebner, CRA Realty fund manager, is a fan of office REITs also, but he likes a smaller one, SL Green Realty, which owns B-class Manhattan office space. And he sees value in the far larger Boston Properties. Heebner expects the stocks to return at least 25% over the next year.

Mega-REIT Starwood Lodging Trust is attracting a lot of investor attention. But PaineWebber Inc. analyst John Litt recommends a cheaper option in the hotel sector: Patriot American Hospitality. It, like Starwood, has a ''paired share'' structure, which allows them to both own and manage hotels. All other hotel REITs have to contract out management. But Starwood trades at a multiple that is 30% higher. ''Starwood may be slightly better,'' says Litt. ''But not 30% better.'' His one-year price target for Patriot is 33, about a 30% jump from its current 25 1/2.

A less glamorous pick: Public Storage Inc., the nation's largest owner of storage space. Now at 28 9/16, it has corrected about 8% since July. Says Lawrence Raiman of Donaldson, Lufkin & Jenrette Securities Corp.: ''The stock has been asleep because a new pickup and delivery service has been off to a bumpy start.'' Raiman expects a 20%-plus return on the stock over the next year.

''ADAPT OR DIE.'' Given the appetite of the mega-REITs, plenty of weaker ones will be gobbled up. Back in 1993, when private entrepreneurs became overleveraged, an entire class of REITs came public--largely out of a desire to evade bankruptcy. ''Now is the time for these guys to adapt or die,'' says Comer. Ambassador Apartments Inc., an underperforming Southwest apartment company, ''is a classic Equity Residential Properties Trust acquisition waiting to happen,'' he says. In fact a Sam Zell affiliate already owns 9.5% of the company. Other potential targets, according to Keith Pauley of ABKB LaSalle Partners, are Las Vegas' Oasis Residential Inc. and Summit Properties Inc. in Charlotte, N.C. Both are apartment companies in weak markets with languishing stocks. Pauley thinks an acquirer would pay up to 25% above current stock prices.

All of which gives the investor a clear choice: a short-term bet on a target or a long-term play on the next Microsoft of the REIT world.

By Kathleen Morris in Los Angeles

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Updated Sept. 11, 1997 by bwwebmaster
Copyright 1997, Bloomberg L.P.
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