BUSINESSWEEK ONLINE : JUNE 14, 1999 ISSUE
COVER STORY

Real Estate: REITs on the Rise
After a long slump, they're back on solid footing

No one is sure of the exact catalyst--but a wave of optimism has returned to real estate investment trusts. Some say it was the $50 million Warren E. Buffett threw at a few REITs in April. Others point to the $500 million funneled into REITs that same week by a big state pension fund. In any case, REITs, which own, operate, and develop portfolios of buildings ranging from hotels to self-storage centers, have appreciated 14% since mid-April. That puts REITs, which underperformed early in the year, well ahead of the Standard & Poor's 500-stock index, with a 7% gain year to date.

It's about time. After hitting a record high at the end of 1997, REITs slumped, despite their reputation as a defensive investment. But investors feared a recession that never came. Now, REITs are expected to increase cash flow by 11% in 1999.

The current rebound will not necessarily deliver a knockout performance for the rest of 1999. But REITs still offer unique charms. These stocks are for those who want security, not excitement. Property leasing is a slow but predictable growth business. And in good times or bad, REITs shell out 95% of their taxable earnings in dividends in return for their corporate tax-free status. The average REIT dividend yield is currently 7%, compared with 3.7% for utilities and 1.3% for the S&P 500.

Most important, real estate stocks offer low volatility and less correlation to the movement of the S&P 500 than almost any other asset class. Combine that with their rich dividend flow, and you have a value that's hard to beat. Currently, REITs, which are valued on cash flow because they pay out most of their earnings in dividends, are trading at 9 times 1999 cash flow. Compare that with the S&P 500, which is trading at 25 times future earnings, still a near-record valuation gap.

LOCATION, LOCATION... The trick, of course, is picking the best prospects for internal growth from new development projects or by raising rents on existing properties. The most upside in rentals is in the office sector. But stick to REITs concentrated in the downtowns of major cities with high barriers to entry like New York, Boston, San Francisco, Washington, and Chicago.

Look to REITs such as SL Green, a small company with a concentrated portfolio of second-tier properties in Manhattan. There's also Canada's Trizec/Hahn Corp., which is not a REIT but an operating company. It owns a huge portfolio of office towers across North America. But unlike its peers, Trizec/Hahn is trading at a discount to its breakup value.

In California, Arden Realty Inc.(ARI) is a good pick, says Ken Statz, strategist at the top-performing Security Capital Real Estate Fund. Arden has two major benefits: It's a pure play on the robust Southern California office market. And Arden is considered a prime acquisition target for big national REITs such as Samuel Zell's Equity Office Properties Trust(EOP).

Apartment REITs offer interesting opportunities. Any increases in inflation can be passed on quickly to apartment renters, who generally lease by the year. Favorite picks include Avalon Bay Communities(AVB), which has a $4.3 billion portfolio of top-quality apartments in the two strongest markets, Northern California and the Northeast. Another choice is Charles E. Smith Residential Realty Inc.(SRW), which owns high-rise apartment buildings in Washington, Chicago, and Boston.

Many real estate executives are worried about E-commerce. But Carl B. Tash, who runs a Los Angeles REIT fund, is scooping up shares of high-end mall companies such as Taubman Centers Inc.(TCO) and Urban Shopping Centers Inc(URB). ''These are destinations--places you go for indulgence,'' claims Tash.

Scrutinizing mall stocks seems like a yawner when you can be the proud owner of such sizzling virtual retailers as Amazon.com Inc.(AMZN) or Etoys Inc(ETYS). But as we head into the ninth year of the bull market, a little brick and mortar could be the perfect stabilizer.

BY KATHLEEN MORRIS

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