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SECTOR SCOPE by James A. Anderson July 6, 1999

The End of the REIT Retreat?
A battered sector stirs anew, though the days of outsize growth seem past

It has been an action-packed three years for real estate investment trusts, or REITs. Pre-1998, it seemed that the landlords of such disparate properties as office buildings, shopping malls, and apartment complexes couldnít miss in the stock market thanks to a rip-roaring real estate market. The euphoria ended 18 months ago over fears that too much building would produce an oversupply of properties and sap rental income. REITs tumbled out of the penthouse, falling nearly 16% last year. Things got so bad that even contrarian Warren Buffett went shopping in the group last April.

REIT stocks have since bounced back a bit, and now the sector seems to have achieved a stability of sorts. "Thereís definitely less in the way of sex appeal, but if you can live with total returns [share gains plus dividends] in the mid-teens, this group will keep you happy," says David Sherman, a REIT analyst for Salomon Smith Barney.

That sounds pretty placid compared with a couple of years ago, when it was easy for the group to float new shares or tap into cheap debt to fund acquisitions and fuel earnings gains. Morgan Stanley's REIT index shows that the group rose 35% in 1996 and 18% the year after, and those figures understate the performance of some individual stocks. Vornado Realty Trust (VNO), for instance, posted total returns of 49% in 1996, and 87% in 1997. Crescent Real Estate Equities (CEI) delivered 65% total returns in each of those years. The overbuilding scare ended that with a thud, though. By April of this year, the sectorís stocks were trading at a discount of as much as 12% below the value of their assets.

That was good enough for Warren Buffet. The Omaha investment guru caused a stir by snatching a 5% stake in Tangay, a small operator of outlet malls. Investors mimicked the master, and pushed REIT shares up 10% in April, though the 132 companies tracked by the Morgan Stanley index have since backtracked to just 3% above where they opened in 1999. Indeed, for this year and next the group may be grounded by some basic lessons from Landlord 101. "At this stage of the real estate cycle, passive ownership of properties isnít going to produce earnings growth," says Frederick Carr, a principal with the Penobscot Group, a Boston real estate research firm. "REITs now will have to rely on raising rents and developing properties."

"AVOID THE BOOMTOWNS." In other words, buying REITs intelligently will involve ferreting out which ones have the biggest advantages when it comes to location, location, location. "Today, itís a market by market game," says Richard G. Brace, an analyst with Torto Wheaton Research in Boston. For example, Torto Wheaton projects that office vacancy rates in the Dallas and Phoenix metropolitan areas could climb from 16.9% to 21.7% and from 11.6% to 14.3%, respectively, over the next five years; in Atlanta, the vacancy rate could jump from 10.3% to 15.1% by 2003.

"Right now, itís best to avoid some of the big boomtowns where itís easy to develop," says Carr. "Weíre looking in markets that have supply constraints and where demand is healthy," says Ritson Ferguson, a portfolio manager with CRA Realty in suburban Philadelphia. "The West Coast, Mid-Atlantic, and Northeast are looking attractive right now," he adds. "In places like San Francisco and Washington, D.C., weíre seeing rental rates increase, in part because itís difficult or next to impossible to bring on new supply."

On balance, the Street is modestly bullish. "Youíre not going to get the 30% spikes investors in technology have come to love," says Ferguson. But you might get half that. The silver lining for investors is that since REITs, by law, distribute 95% of their taxable income to shareholders, so a large share of their total return right now comes in the form of a meaty dividend. And the sectorís weak showing over the last two years has pushed dividend yields up to an average 7.5%, well above the meager 1.3% for the Standard & Poorís 500.

TWO STRONG REITS. Yields are only half of the REIT return equation. The other compass point is funds from operations (FFO), a cash flow surrogate that tells investors how much rent money is coming in. Since most of the Street values REITs on FFO, knowing that figure can give you a pretty good idea of a stockís upside. "Right now, 10% cash flow growth seems reasonable, and certainly 8% is attainable without many bullish assumptions," says Ferguson.

One well-situated REIT is Spieker Properties (SPK), which rents office space and industrial properties in Silicon Valley, Los Angeles, and the Pacific Northwest, regions with rising demand and low vacancy rates. Better yet, a large percentage of Spiekerís leases expire within the next year. With its current rents running an average 20% below the going rate, Spieker is in line for an earnings spurt once it signs tenants to new terms, according to Standard & Poorís analyst Michael Schneider. Spieker currently yields 6.3% and with FFO growth of 11% will bag investors a total return in the mid- to high-teens. Currently, 10 of the 12 analysts who follow the stock on Wall Street rate it a strong buy or buy, according to Zacks.

Another intriguing, if unusual, play might be Public Storage (PSA). It runs the country's largest self-storage warehouse chain, with more than 1,300 facilities in 37 states. Its 3.2% yield seems a tad slight compared with those of its REIT peers. Still, Publicís attractive because of its nationwide exposure. And its current dividend payout is only 33% of FFO, vs. an industry average of 60%, says David W. Jellison, portfolio manager of the Columbia Real Estate Equity fund (CREEX). Jellison expects Public Storage to lift its dividend soon, and says its 12% cash flow growth has the stock on target for total returns in the low- to mid-teens. According to Zacks, 10 of the 11 analysts who cover Public Storage rate the company a strong buy or buy.

On the mutual funds front, you might check out Columbia Real Estate Equity, a no-load offering that as of the end of May led our Morningstar Principia screen of the sector with a three-year average annual total return of 14.63%. Year to date, the fund is up 5.68%.

James Anderson teaches journalism at the City University of New York

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