It had to happen.

After nearly two years of non-stop -- some would say frenzied -- growth, the Real Estate Investment Trust (REIT) industry is pausing, albeit briefly, to catch its collective breath. "We started 1993 with only $18 billion in REITs and now the industry is valued at more than $45 billion," says Martin Debrovner, president of Houston-based Weingarten Realty Investors, which has been a REIT for nearly a decade. "Some 120 new companies have blossomed over the last year alone. Now there are a number of new players in the industry and that's having an effect on the marketplace."

In three short years, the REIT market has grown from a $10 billion industry capitalization to just under $50 billion. Jonathan Litt, vice president and real estate securities analyst at Salomon Brothers Inc. in New York, expects that REITs will reach the $100 billion mark by the end of the century.

"We're still small, but we're very much a leading sector of the overall real estate industry and I think we're going to continue to be a strong sector of the industry," adds Mark Decker, president of the National Association of Real Estate Investment Trusts (NAREIT). He believes the real estate industry is undergoing a secular transition in which the REITs are playing and will continue to play a significant role. "This is not a fad that is going to fade," he says.

Decker reports that during 1993, 141 REIT offerings of securities were completed, raising more than $18 billion, almost triple that of the previous year and significantly higher than in any of the previous 30 years. Over $13 billion has been raised with 127 offerings through November 1994, reflecting the continuing strong interest in the REIT from of investment.

Kent Clark, director of marketing at Bock & Clark, an Akron, Ohio-based company that coordinates land title surveys for parties in the real estate community, does not foresee a slowing down of REIT activity in the next couple of years. Bock & Clark has had a significant work increase because of the REIT activity. "There is still a lot of money in the REIT industry for acquisitions," states Clark. "We have doubled our staff in the last six months simply in anticipation of the growth we see for 1995 and 1996."

Even so, most people in the industry like to say it's still early in the game for REITs. Kenneth B. Roath, chairman, president and CEO of Health Care Property Investors, sees only further growth. "REITs and Wall Street have a happy marriage and I think the industry is still in the embryonic stages; there is a great deal of opportunity for further expansion," he continues. "The fact that newly formed REITs are coming to the table with proven track records and management plus substantial investment in their own companies is a major advantage to the industry as a whole as well as to the investing public."

But that doesn't mean the industry will remain the same. REITs are expected to undergo significant changes in the coming 12 months, including a marked interest from pension and other funds, an increase in various types of REITs offered including the hotel, industrial and office sectors as well as an anticipated industry consolidation. In addition, many are predicting the industry, battered by rising interest rates in the fall of 1994, will continue to recover and will benefit from an infusion of new capital.

"With a plethora of new large REITs, the industry is no longer just a handful of survivors but a growing body with a wide variety of choices for the small investor and the size and liquidity that appeals to the large institutional investors," emphasizes William Newman, chairman of New Plan Realty Trust. Thomas Lavin, who heads the Real Estate Group at Smith, Barney Inc., adds that the institutional investors are already participating. "You've already seen them coming in 1994, not in a huge way but in a meaningful way," he continues. "A number of big state pension funds invested in companies who are in their state. We have seen that the Ohio funds in particular have been active in the Ohio deals.

The fact that many of the REITs that have gone public in recent years are among the country's top companies has fueled pension fund interest. In EMERGING TRENDS IN REAL ESTATE, a report sponsored by Equitable Real Estate Investment Management, pension accounts were asked where they planned to make new real estate investments in 1995. The results were encouraging: 46% of the funds surveyed said they planned to invest in REITs. That's a large increase from the previous year, when a mere 19% mentioned REITs.

San Francisco-based RREEF, one of the country's largest real estate advisory firms, has formed a separate division to invest in REITs.

"The pension funds market is becoming a significant force now that government regulations have been changed and pension funds will target up to 6% of their assets in real estate," adds Debrovner of Weingarten Realty. "Initially they were reluctant to try real estate again after the experiences they had in the 1980s, but now they are putting money in better quality REITs. Large institutional investors such as pension funds add growth and stability to the market."

Pension funds have already opted to participate in the REIT market by contributing properties in exchange for cash and stock, according to Arthur Andersen & Co. The IBM Retirement Plan sold its interest in retail properties to General Growth Properties Inc. -- an Iowa-based REIT that owns 40 shopping malls -- in exchange for stock, notes and cash at the time of General Growth's IPO. Pension funds also provide equity and debt financing to fund REIT development or acquisition activities. The IBM Retirement Plan and Wells Fargo Realty Advisors formed a joint venture with General Growth to develop a regional mall; some $150 million in financing was pledged for this and other projects.

Diversified portfolios are desired

While retail and residential REITs have been dominant in the early rush to REITs, investment trusts are expected to represent an increasingly larger portion of the market as the REIT marketplace shows a willingness to embrace more diversified portfolios. Health-care REITs, for example, are relative newcomers to the market, investing in highly specialized properties such as nursing homes, acute-care hospitals and rehabilitation centers. All but one of the health-care REITs have been in existence since 1986.

"While office/industrial REITs represent only approximately 10% of total capitalizations, new offerings [of this type] accounted for more than 20% of REIT IPOs in the first six months of 1994," points out Robert Davis, managing director of Arthur Andersen & Co.'s Real Estate Capital Markets Group. "In addition, as vacancies drop and rental rates stabilize in office markets, further offerings should surface as underwriting becomes more feasible."

With the financial markets hankering for something new, real estate companies have responded, reaping rewards. Hotels and office/industrial REITs were the only property asset classes that had all their offerings priced within or above their targeted filing range during 1994, Davis adds.

Clint McDonnough, national director of REITs at Ernst & Young Real Estate Advisory Services, says suburban office and industrial REITs will likely see increasing growth in the coming months followed by hotel REITs. "These sectors saw but a few IPOs in 1994 and the industry sees plenty of room for growth in these areas," he continues.

As of late 1994, the hotel market includes six public hotel REITs, with an equity market capitalization of $721 million and 106 hotels, according to Salomon Brothers. Two of the nine companies which were in registration have been postponed in part because of investors' concerns regarding structure. "The remaining several companies will own 236 properties and have a proposed equity market capitalization totaling $1.2 billion when they become public," says Litt of Salomon Brothers. "The combined equity market capitalization of the existing and proposed hotel REITs will amount to $1.9 billion, compared with the apartment sector which comprises 31 companies with a total equity market capitalization of $9.1 billion."

Asset growth emphasized

With new investors being drawn to the REIT industry and different products being offered, the established REITs themselves are not standing still. Growth has become their mantra. Typical of this crowd is Camden Property Trust, which completed $350 million in transactions, including the acquisition of 7,500 units and the development of an additional 2,500 units over the past 18 months. The Texas company reports a 242% growth in assets during the period and has expanded to surrounding states such as Arizona and Colorado. "We're in a growth mode," agrees chairman Ric Campo. "REITs nowadays need to grow and we're doing it through acquisition and new development."

United Dominion Realty Trust of Richmond, Va., is also in an acquisition mode as are companies such as Prime Retail, Colonial Properties Trust, and Kimco Realty Corp. Because of this need to grow, many in the REIT industry are predicting a consolidation in the months ahead. Already, Southeast Realty Corp., a privately owned affiliate of Leon Black's Apollo Realty Investors, is taking over Crocker Realty. Crocker, a Southeast office REIT that went public in 1993 with a $10 million IPO, owns three properties in Boca Raton, Fla. while Southeast has a portfolio of 47 properties in seven states. "This is a business where economies of scale matter," says David Simon, president of Indianapolis-based Simon Property Group. "Certain mergers will be beneficial."

Previously, Wellsford Residential Property acquired Holly Residential Properties and other transactions involving different partners are said to be in the works. "It is widely believed that many of today's REITs could realize substantial scale benefits from mergers and acquisitions into larger entities," says Jeffrey Rutishauser, managing director of Price Waterhouse's Real Estate Industry Services' New York office. "These scale benefits are expected to level off as the entity reaches the size threshold of $1 billion in assets. As a few firms begin to approach these sizes, they will exert competitive pressure on the smaller REITs, which will be competitively disadvantaged in future markets."

Even so, Keith Guericke, president of Essex Property Trust, a newly formed REIT, says good, qualified companies can make it whether they are large or small. "Obviously, there is a bias to bigger REITs. We went public to grow."

"In 1995, all multifamily REITs will have to look to internal growth rather than external growth," states Michael H. Rosen, executive vice president and COO of Baltimore-based Town & Country Trust, a 15-year-old, exclusively multifamily REIT. "Because the opportunity for acquisition will be slim, the key to success will be property management. You can be the most aggressive acquisitions company in the world, but once you're done acquiring the property, you have to run it. The strength of a REIT is its management's ability to handle, operate and oversee its assets."

"Management is becoming a key component of a REIT, more than just the underlying assets." affirms Allen Sweet, president of Amli Residential Properties Trust, a Chicago-based multifamily REIT. "In the past, as REITs became public, most were a collection of assets. From 1995 onward, the better REITs will transform themselves from a collection of assets to an operating company. The quality and quantity of their internal growth will be a function of their success in becoming an operating company."

"There are two ways for a REIT to grow," says Jay Shidler of The Shidler Group, San Francisco. He is also chairman of First Industrial Realty Trust, Chicago, and co-chairman of TriNet Corporate Realty Trust, San Francisco. "It can grow internally by working with its existing portfolio; or it can grow externally by developing, expanding existing buildings or buying new property. It is important for a REIT to be able to grow internally, and to rely on good property management if there is no capital for external growth. I believe a REIT must have a good blend of the two."

Increasing numbers of REITs are also expanding their market niche. TriNet Corporate Realty Trust takes an unusual approach to the real estate market, specializing in corporate sale/leasebacks. The company works with corporations that want to raise money but still want to use their properties; TriNet's protfolio includes 71 properties in 19 states.

Commercial Net Lease Realty of Orlando invests in freestanding retail properties leased to major corporate tenants such as Pizza Hut and Blockbuster Video. While most REITs have focused on bigger investments, such as shopping centers and office buildings, CNL has concentrated on smaller, one-tenant properties with an average investment of $1 million to $5 million, allowing the company to spread its risk over a broader base. "We've been very successful sticking to what we do best," adds Gary M. Ralston, executive vice president and chief operating officer.

Financial climate may warm up

While growth and market niche are important, so is the climate in the financial market, which has been cool during the last half of 1994. After the hammering many REITs endured last fall, many investment trusts are expecting a warmer time ahead. Raymond Falci, an analyst with Natwest Securities Corp. in New York, notes that there are signs that the bottom of the REIT market may have been reached since the oversupply of new offerings appears to be slowing. "We remain convinced of the overall strength within the industry and we are confident that long-term investors will sort out the winners from the losers, eventually leading to a rebound," he reports. "We believe that the high yields on REIT stocks will be too attractive to ignore for many investors, especially those looking for alternatives to utility stocks, given the instability in that sector."

Increasingly, REITs are being recognized as a major way for institutions and investors to participate in the real estate upswing. Arthur J. Pergament, vice president of Cramer Rosenthal McGlynn Inc., a New York-based money manager, notes: "REITs are viewed as safe harbor investments, providing downside protection because of their yield, while having real upside potential. REITs are in both equity and fixed-income portfolios. On the fixedincome side, the focus is on quality of cash flow, which gives inflation protection to the investor."

Decker of NAREIT adds that there are now at least 15 actively managed mutual funds that specialize in the investment of real estate securities, something that had not been seen in years past. "Clearly the securitization of real estate is a broad conceptual change and it is opening up the real estate market to a lot of people that couldn't invest in real estate before," he says.

At the same time, REITs must be vigilant. "Operating public companies is dramatically different than operating private entrepreneurial companies," states Samuel Zell, chairman of the board of Equity Financial and Management Co. "High levels of sensitivity to conflicts of interest and consistent themes are what builds confidence and expands marketing demand for REIT securities."

The REIT industry is expected to continue to be a major factor in the years ahead. As Robert A. Frank of Alex. Brown & Sons Real Estate Securities notes, "The real estate investment trust is emerging as the 'new real estate paradigm,' the vehicle of choice for real estate ownership, operation, development and finance."

But REITs can't rest on their laurels. Martin Bucksbaum, chairman and chief executive officer of General Growth Properties, urges REITs to redouble their efforts to obtain investors. "We have to sell the public on the benefits of the REIT," he emphasizes.

Climbing Interest Rates, Innovative Measures

What was one major reason cited by newly formed REITs for entering the marketplace? Raising capital. But with interest rates on the rise, that could prove to be a problem in the months ahead.

Climbing interest rates are translating into higher equity requirements, meaning that companies without a strong balance sheet may not have the ability to expand as much as investors would like them to.

"Without capital, a company can't grow, and if you can't grow, you can't produce the results that Wall Street expects," says Joseph W. Robertson, Jr., executive vice president and chief financial officer of Weingarten Relaty Investors. "Two years ago, there was no more compelling reason to be a REIT than access to public capital. But that source is drying up. That means REITs can do two things: They can stop growing and wait for the market to change or they can realize the market is not going to change and plan accordingly."

Traditionally, companies have had a place to hide in the short-term rates, but observers are sensing the possibility of an inverted yield curve this year, when short-term rates could be higher than long-term rates. Analysts say such a scenario is forcing some sellers to come to grips with reality: Higher rates are going to result in higher equity requirements. If a firm was going to purchase a piece of property for $1 million at a 10% cap rate last year, the lender would value the deal at about $11.5 million and the company could borrow 85% to 90% of the cost. But one year later, interest rates are up 200 basis points, the deal is only worth $9 million and the company can only borrow 60% of the cost.

"What it means is a whole new world," Robertson adds. "The lack of equity means there are going to be more sellers and fewer buyers, and prices are going to have to go down to make sense as an investment."

So what's a REIT to do? Innovate. WRI significantly strengthened its balance sheet late last year by entering into a new $150 million revolving credit agreement provide through a bank syndicate with Texas Commerce Bank and First Interstate Bank taking major positions. The new agreement, which is unsecured and has an initial three-year term, replaces a secured, $80 million revolving credit agreement with Texas Commerce and provides about $100 million of funds available for acquisitions and new development. How did WRI do it? By following the response of a New Yorker who was asked by a man with a violin, "How do I get to Carnegie Hall" -- "Practice."

"We've had to work at it. Our credit has been rated A + by Standard and Poor's, and we're one of two REITs with that high a rating," Robertson adds. "Most other REITs are Triple-B+ or Triple-B. Nowadays, investors are demanding strong balance sheets and those with more equity are being rewarded."