The widely held belief among industry pundits was that when the stock market started to rebound, the extraordinary performance of publicly traded real estate investment trusts (REITs) would cool. Investors, the reasoning went, would see more upside in beaten-down equities than in real estate, where values had soared for two years.

Well, the overall market has done nicely for the first nine months of 2003 — the S&P 500 is up nearly 15%, including dividends. But REITs have done even better. Through the third quarter, REITs reported a 25.39% total return, according to the National Association of Real Estate Investment Trusts (NAREIT), compared with a return of 5.22% for the same period in 2002.

The performance of retail REITs in particular is off the charts; the sector generated a total return of 32.83% over the first three quarters. Chicago-based mall REIT General Growth Properties has performed even more impressively with a 43.25% total return over the time period. The unexpectedly high REIT returns fail to surprise John Bucksbaum, CEO of General Growth. “I think it's appropriate because real estate has shown its resiliency,” he says. “There is a track record now for a lot of investors to follow.”

True, but the tremendous momentum enjoyed by REITs will be hard to sustain, say many REIT experts, because of larger market forces at play. The broader equities market is expected to return to normalized annual returns of 8% to 10% over the next three years or so after the tremendous 20% to 40% annual returns of the technology binge. As part of that major shift, real estate investors can expect to pay higher prices in exchange for lower returns, experts say.

“I'm always hesitant when I hear that real estate is being priced under a new paradigm; those words scare me to death,” says Nancy Holland, portfolio manager of the ABN AMRO Real Estate Fund in Chicago, a $45 billion mutual fund that invests about 80% of its assets in REITs. “But it looks like the pricing of U.S. real estate may be taking on characteristics of the pricing of real estate in other parts of the world, which have lower capitalization rates.”

The Dividend Factor

In effect, investors will pay more for REITs to obtain lower but more stable returns than other equities. In fact, it's already happening. Investors, who increasingly view dividends as an important component of an investment's return, still consider equities too risky and bonds too lackluster.

Those factors continue to make REITs, which are paying a 6% dividend yield, an attractive investment. The yields are especially appealing to aging baby boomers — who want to supplement their income — and chastened technology investors, who in the late 1990s zeroed in on stock price appreciation, only to get burned.

The tax cut on dividends also has fueled the frenzy over dividend yields. The cut reduced dividend tax rates for shareholders in companies that pay corporate income tax on earnings before doling out the dividends. REITs don't pay corporate income tax, so REIT investors don't get the tax cut. Nevertheless, the law shifted attention to dividend-paying companies such as REITs.

Plus, argue analysts at Banc of America Securities, the 6% REIT yield gives investors higher after-tax dividend income compared with investors who received the tax cut. And despite weak fundamentals in several property sectors, in the third quarter only one REIT cut its dividend while 16 raised their dividends. Based on the first three quarters of 2003, Banc of America analysts predict REIT dividend growth of 1.6% this year. In 2004, they anticipate growth of 2.4%.

“A lot of naysayers warned that the new tax cut was going to be a disaster for REITs because everybody was going to switch to Phillip Morris and whoever else,” says Hamid Moghadam, CEO of San Francisco-based AMB Property Corp., an industrial REIT with 96.5 million sq. ft. of assets globally. “I didn't think that would happen because there was going to be an increased focus on yield-oriented investments in general — and so on REITs.”

Waterfall of Cash

Retail investors plowed nearly $3 billion into real estate mutual funds in the first three quarters of 2003 after dumping $3.4 billion into the funds for all of last year, according to Steve Sakwa, a REIT analyst with Merrill Lynch. By contrast, more than $2 billion flowed out of real estate mutual funds during the technology boom of 1998 and 1999. For the near term, at least, REIT analysts and executives fail to see any investment alternatives that would trigger a gusher of cash flowing out of REITs.

The question is, how long until the unexpected REIT rally ends? Analysts don't expect the REIT bull to turn tail in a full-blown retreat anytime soon, though their predictions for REITs range from a mild correction to a more modest 10% return over the next 12 months. “What is interesting to note is that real estate fundamentals remain soft, although it appears as though operating conditions are no longer deteriorating,” Sakwa wrote in his third-quarter REIT recap. “The real question is whether fundamentals will improve fast enough to justify the recent stock price gains.”

Most analysts don't think they will. As of the third quarter, REITs were trading as high as 15% of their estimated net asset value, according to analysts at Legg Mason Wood Walker.

Morgan Stanley analysts also say the growing number of common equity offerings by REITs is a signal they've hit the top of the market. Typically, companies want to take advantage of high stock prices to raise capital. In fact, REIT execs are failing to pinpoint uses for the newly raised cash, indicating they're raising money simply “because they can,” Morgan Stanley says.

These are hardly opinions that inspire confidence that REITs will maintain their price appreciation. Naturally, REIT executives take issue with the notion that their stocks are overvalued. In fact, most believe their companies are undervalued and that investors are recognizing REITs' stable returns. “I don't think the market is being stupid,” Moghadam says of the inflow of investment dollars. “Having said that, REITs will have corrections. But the long-term prospects are good.”

A True Growth Story

The debate over whether REITs are overvalued isn't new. Analysts have spent the better part of this year worrying about the run-up of REIT prices — a 10% REIT return forecast at the beginning of 2003 was considered lofty. But the worries have not stopped the stock price ascent.

One company that continually receives high marks from analysts is General Growth, whose 43.25% total return through three quarters ranks it among the top-performing REITs. “General Growth is doing just about everything right,” says Richard Moore, an analyst with McDonald Investments in Cleveland, who raised his target price earlier this fall to $83 from $74.

The company acquires the best properties, then pursues an aggressive leasing strategy, according to Moore, who also raised his estimated funds from operations (FFO) per share by 30 cents to $6.71 for 2003 and by 59 cents to $7.50 for 2004.

One of General Growth's major institutional shareholders, the Davis Real Estate Fund in Tucson, Ariz., echoes Moore's assessment. “General Growth continues to do what it does best, which is buying, rehabilitating, leasing and managing dominant regional enclosed malls,” say Andrew Davis and Chandler Spears, the fund's portfolio managers.

Moreover, General Growth is in the best-performing REIT sector, Moore adds, because new mall construction is non-existent while demand for mall space is growing. Healthy consumer spending numbers also fuel its success. Although retail sales dropped 0.2% in September, consumer spending jumped at an annualized rate of 12% in July and August.

Unlike so many companies that have been net sellers of assets, General Growth has expanded its mall portfolio to 145 million sq. ft., up from 116 million sq. ft. in 2001, primarily through acquisitions. Earnings have climbed an average of 15% a year over the last decade, and occupancy in the third quarter stood at 90%.

Through the first three quarters of this year, General Growth completed about $1 billion in mall acquisitions, including buy-outs of joint venture partners. In addition, the company paid $550 million in mid-October for three malls totaling 3 million sq. ft. in Maine, Texas and Indiana.

“I don't think there is a single center that we've bought where we haven't been able to increase the cash flows through our normal course of business,” says General Growth's Bucksbaum. “It's not just limited to trying to get more rent from somebody in the same space; there are redevelopment and temporary leasing opportunities.”

The endeavor General Growth is undertaking at its Northbrook Court Mall in Chicago is typical of the firm's strategy. The 27-year-old, 1 million sq. ft. mall, located in the tony Northshore community, is undergoing a re-merchandising effort to convince shoppers to visit more than just the high-end department stores such as Neiman Marcus. To accomplish that goal, the company is replacing mainstream retailers with more restaurants and luxury stores better suited to the affluent demographics.

In addition, General Growth is milking its relationship with blue-chip tenants to beef up its entire portfolio. In June, the company acquired the 1.16 million sq. ft. St. Louis Galleria in an $869 million deal that included a mall in New Mexico. General Growth will use the Galleria's sales of more than $500 per sq. ft. to attract new retailers to the mall.

Valuation Challenge

General Growth remains the darling of the REIT universe. As of early October, 10 of 12 analysts tracking the company rated General Growth a “strong buy” or “buy,” and the other two analysts rated it a “hold.” Morgan Stanley raised General Growth's target price to $77 from $70.

Still, concerns are mounting about the company's ability to keep increasing its share price, which was trading at approximately $74 in late October. Analysts point to the company's exposure to variable rate debt — which could weaken earnings if interest rates rise — its dependence on acquisitions to maintain its 15% annual earnings growth rate, and the possibility of retail bankruptcies and store closings.

Bucksbaum admits that maintaining 15% annual earnings growth is a challenge, but hopes to keep growth in the double digits. He also downplays concerns about debt and potential retail closings. Mostly, however, he takes issue with how analysts value REITs, and says General Growth is undervalued.

Bucksbaum's contention stems from the use of net asset value to determine a company's worth, which places what he describes as an artificial ceiling on a company's value. Instead, he says investors should employ the methods used to evaluate businesses in other industries — earnings growth, cash flow or the dividend discount model, which bases a company's stock price on the discounted value of projected future dividend payments.

“The question becomes, ‘Are we a collection of assets, or a company that owns and operates all of these assets?’” he says. “In any other industry, businesses aren't viewed as a collection of assets.”

REIT RETURNS VS. INVESTMENT ALTERNATIVES

Domestic returns are listed in annual percentage changes.

Figures for 2003 are year-to-date through Sept. 30.

Total Returns 2003 2002 2001
NAREIT Composite* 25.39% 5.22% 15.50%
Russell 2000 28.58% -20.48% 2.49%
S&P 500 14.72% -22.10% -11.89%
Nasdaq Composite** 33.80% -31.53% -21.05%
*The NAREIT Composite is an index of all publicly traded REITs (equity, hybrid and mortgage). Total return is share price appreciation/depreciation plus reinvested dividends.
**Price-Only Return
Source: NAREIT


Joe Gose is a Kansas City-based writer.

Retail REITs Aren't the Only High-Fliers

Office, industrial and apartment standouts post robust returns.

REIT investors follow a curious game plan. In 1998 and 1999 — when property fundamentals were strong — money poured out of real estate. Over the last two years, with fundamentals generally deteriorating, the money has been rolling back into REITs.

According to the National Association of Real Estate Investment Trusts (NAREIT), total returns through the first three quarters of 2003 were in excess of 20% for the industrial, office and apartment sectors (see chart). Not a shabby performance for fundamentally soft sectors.

How soft are they? Nationally, the office, apartment and industrial sectors are experiencing the highest vacancies in a decade. In the third quarter, office vacancies stood at 16.8% and apartment vacancies were 6.6%, according to research firm Reis Inc. Meanwhile, industrial vacancies registered 9.9%, reports Grubb & Ellis.

Despite the gloom, investors tend to bet on the future. It appears shareholders are optimistic that fundamentals will improve, and investors are taking heart in the 57,000 new jobs created in September, according to the U.S. Department of Labor, as well as other positive economic signs.

Preparing for the Next Cycle

The apparent ease with which these sectors are posting double-digit returns masks the ambitious disposition, acquisition and leasing strategies companies are undertaking to position themselves for business and revenue expansion when a full-blown recovery materializes. San Francisco-based AMB Property Corp., an industrial REIT, has accelerated its rate of dispositions over the past two years to take advantage of the heavy investment demand for real estate.

Since 2000, AMB has sold $835 million of non-core assets, reducing the company's disposition portfolio by 75%. The sales are part of a strategy to increase holdings of distribution facilities at major trade ports around the world, says Hamid Moghadam, CEO of AMB, which generated a total return of about 16% for the year through the third quarter.

Now AMB plans to be a net property investor for the next several quarters. In early October, AMB agreed to buy 37 air freight buildings adjacent to seven U.S. international airports — a total of 3.4 million sq. ft. — from International Airport Center for $481 million, including $119 million of assumed debt. AMB already has completed the purchase of 25 of the buildings in Los Angeles, Seattle, Miami and Charlotte, N.C., for $167 million and will close on the balance at the end of this year and early in 2004.

“We are very focused in what we do, and investors like companies to have a very focused and consistent strategy,” Moghadam says.

Cash Flow is King

Camden Property Trust, a Houston-based apartment REIT that owns 50,790 units from Florida to California, is focusing on leasing up its properties rather than shedding assets because finding replacement properties at a reasonable price is so challenging. Camden, which produced a total return of almost 23% through the third quarter, has laid out a four-pronged plan to generate an additional $47 million in incremental cash flow and reach a $50 share price by 2005 — all without raising rents. It plans to accomplish that goal via increased occupancy, reduced concessions and refinancing opportunities.

Richard Campo, CEO of Camden, admits much of the company's strategy relative to occupancy and concessions depends largely on job growth, something it can't control. Refinancing and development opportunities, on the other hand, are something it can control. “We have a fair amount of pent-up demand for our product,” he says, “but it's sitting at home right now with the parents or with roommates.”

In the office sector, some companies have clearly weathered the storm better than others. Mack-Cali Realty Corp. of Cranford, N.J., produced a total return of 37% through the third quarter of 2003. Company executives began initiating lease extension talks with tenants in anticipation of the downturn three years ago. The efforts have paid off. At the end of the third quarter, the company's occupancy rate was at 92.2%, nearly 10 percentage points above the national rate.

Mack-Cali also is disposing of assets. In September, it sold a 577,575 sq. ft., 19-story building in Jersey City for $194 million. “We've been sticking to our knitting,” says Mitchell Hersh, CEO of Mack-Cali, which owns 28.5 million sq. ft. of office and office/flex space in the Northeast. “And we're being rewarded for that. We have a huge amount of liquidity and a very flexible balance sheet.”
Joe Gose

EQUITY REIT RETURNS BY PROPERTY SECTOR
(PERCENTAGE CHANGE IN TOTAL RETURNS)*

YTD (Oct. 16, 2003) One-Year Totals (Oct.2002-Sept.30, 2003)
Retail 37.61% 35.66%
Shopping Centers 33.93% 36.29%
Regional Malls 42.77% 35.95%
Free-Standing 28.88% 29.13%
Diversified 30.48% 24.91%
Office 27.57% 19.86%
Industrial 27.46% 22.67%
Apartments 24.70% 21.97%
Lodging/Resorts 23.53% 15.82%
*Total return is share price appreciation/depreciation, plus reinvested dividends.
Source: NAREIT