Ask Stephen E. Sterrett what happened to the wave of consolidation predicted for real estate investment trusts a year ago, and the treasurer of Indianapolis-based Simon Property Group simply sighs.

Egos," he replies. "This is an ego-driven business, much like in the entertainment industry with Walt Disney or Ted Turner. Some egos will have to take a back seat if there is a consolidation, and you still have a lot of organizations where the founder's name is on the door or the founder's family holds a significant share in the business. It's hard to go into a consolidation knowing that your identity could be lost."

While it may spook some companies now, Sterrett and others note that REIT consolidation is probably inevitable in the future. "The market is going to force some of that," he says. "I don't think there needs to be 200 public real estate companies, and I believe there are some efficiencies to be gained from size. You have to question the longevity of a public company with small capitalization. It's similar to what we're seeing in other industries, like banking, where large scale organizations are being created."

Industry still growing and changing

While REIT mergers haven't occurred as predicted, the industry is in a state of flux. After nearly three whirlwind years of impressive growth, the dust seems to be settling for real estate investment trusts. The public is not seeing as many IPOs popping up, meaning that investors will be able to digest the REITs already out there and not be swamped with a parade of prospectuses.

"The boom of IPOS and secondary offerings is past, though what has past has left over 200 REITS with formidable balance sheets, strong managements, performing portfolios and almost all with a mission for growth," says Samuel H. Gruenhaum, partner in the securities department of Cox, Castle & Nicholson of Los Angeles. "Cheap capital is available to only a chosen few. In some cases, debt has become more expensive and in other cases, REITS have hit the borrowing limits that Wall Street will accept."

Chris Lucas, vice president of research at the National Association of Real Estate Investment Trusts (NAREIT) in Washington, D.C., says there is no question the REIT industry is changing as it continues to grow. REITs are maturing, having grown from small cap stocks to an industry with mid cap stocks and some relatively large cap stocks. Yet the REIT universe is still a small star in the Wall Street cosmos: more than 200 equity REITS don't even equal the value of Microsoft Corp.

"For most of last year, fundamentals were good, and the yield spread was historically wide, yet REITs were only up 2% vs. the rest of the market, which was up 32%," says Robert Frank, managing director and head of real estate securities at Battimore-based Alex. Brown & Sons. "There are two schools of thought. Investors sold REIT stocks in order to buy tech stocks such as Netscape, or investors were fearful that the record amount in offerings in 1993 and 1994 would be repeated."

That didn't happen. Only five new REITS went public last year, according to Alex. Brown & Sons. In terms of REIT IPOs, the 43 in 1993 generated $8.7 billion in new capital, while 39 in 1994 generated $6.4 billion. The five last year - three of them hotel related - raised $832 million. "There is continued interest in securitization of real estate assets," NAREIT's Lucas says. "Companies that have shown themselves to be good corporate managers continue to receive investors' confidence and raise capital, continue to grow their asset base and appeal to a wider audience of investors. Some good companies got squeezed out of the IPO door in 1994. If the capital markets improve, they may still go public. And there are a few incubator REITs, private REITs, that are looking to go public in the right markets, too."

Ric Campo, chairman of Camden Property Trust, a Houston-based apartment REIT, applauds the REIT rally. "The fundamentals are in place for REITs to do well," Campo says. "There is the right capital restraint to prevent overbuilding, and you have a format of ownership for institutions and individuals to make investments in real estate. All interests are aligned properly to 1996."

Campo notes that the REIT sector appeared to be asleep for most of last year, because shopping center and apartment REITs -- which account for some 60% of the REIT market -- suffered. "Shopping center REITs have been down because retail is bad, and people think everyone is going bankrupt, while on the apartment side, people are concerned there is going to be more development," says Campo. "But now there are good governors in place to make sure development doesn't get out of hand. Today, there is no reason to build unless your cashflows increase; the disincentives are so much greater."

The expansion game

Accordingly, REITs are attempting to expand through new development and acquisitions. Simon Property Group, for instance, opened three regional malls last year, adding 3 million sq. ft. in six weeks. The company will open another one in 1996 and is on the verge of announcing other projects. "We're still going to see the continued gradual shifting of privately held real estate to REITs," Sterrett says. "There have been some institutions holding individual properties, small properties, that have been sold, and public companies -- because of their need to grow -- are the logical buyers."

During 1995, most public REITs spent a great deal of time getting their houses in order -- looking at operations, people and strategy, says Gregory T. Mutz, chairman of Amli Residential Properties Trust of Chicago, with the goal of making themselves perform better, quicker, faster and more effectively. "Apartment real estate generally is very capital-intensive and margins are under a great deal of pressure, whether you're a fee manager, syndicator or whatever," says Mutz. "Those ingredients generate lots of consolidation. I think you'll see more public acquiring private by hitching up or consolidating with a public entity, but I don't think you'll see much public acquiring public."

Michael T. Tomasz, president and CEO of First Industrial Realty Trust of Chicago, says expansion is his mode of growth, proudly pointing out that the company began as a REIT with 226 industrial projects and now has 268. It originally boasted 17.4 million sq. ft. and has 22 million after a year and five months. "We're going to get bigger," predicts the head of the second-largest industrial REIT. "CB Commercial has identified 9 billion sq. ft. of industrial space in only 54 markets. As a percentage of all real estate owned, that's a really small percentage. So, you look at the long-term trend, and CB Commercial's national vacancy for all 54 industrial markets varied by 2% from 1991 to 1995. So there is more space out there for companies such as First Industrial. Why merge when you can go out and buy real estate?"

Adding to portfolios is on the minds of most REIT executives, agrees Douglas B. Nunnelley, senior vice president and CFO of Colonial Properties Trust, a diversified REIT based in Birmingham, Ala., with multifamily, retail and office properties in Alabama, Florida and Georgia. "In 1995, we acquired more than $70 million worth of properties, primarily retail," he says. "In 1994, we acquired $330 million of properties, the bulk of which were multifamily, and we're looking at acquisitions this year, too."

Like other REIT managers, Nunnelley has heard the talk about consolidation, but the gulf between discussion and action can be great. "We personally are looking at all sorts of alternatives to grow our company," he says. "If a merger opportunity comes along -- and we're talking hypothetically -- it's something we would look at. Obviously we'd go into such a situation assuming we'd be a survivor. But being an office, retail and multifamily REIT, the likelihood of a merger would be more difficult since most REITs concentrate in a single line of business."

Thomas J. Crocker, chairman of Crocker Realty Trust, a Boca Raton, Fla.-based REIT that owns office properties in 16 Southeastern cities from Virginia to Florida, adds that the economics of mergers aren't attractive for most REITs, yet there is still a lot of talk about them. "I think there are very few consolidations that will work really well," Crocker says. "There's not that much economies of scale to be realized. But the talk at every industry conference is about consolidation. It's like the banking industry. For the last 20 years, the talk was that there was going to be a lot of bank consolidations with only five dominant banks left. That hasn't happened."

Crocker acknowledges he is a realist, however. "Everything in our company is for sale at the right price, but that isn't always the case at other REITs," he explains. "A lot of people have vested interests in keeping their corporate structure, and one of the motivations to sell is economic. If you've already got a lot of money, I don't think the motivation is there."

Survival of the fittest

For many CEOs and CFOs in the REIT business, the motivation now is survival of the financially fittest. Many are busily remaking their balance sheets. Capital, not consolidation, is the watchword, and growth by new development or recent acquisition is at the forefront of management's thinking -- provided the cost of capital is attractive. For the industry as a whole, the real difference has been in terms of capital raised -- a shift from new companies to existing ones. In other words, given the high current yields on equity, companies felt they could obtain cheap debt without diluting shareholder equity. Analysts say some $3.9 billion was raised in 1993, $3.9 billion in '94, and $5.6 billion last year.

REITs are taking advantage of a wider range of financing, not just secondary offerings but also private placements as well as additional secured and unsecured debt lines to raise capital. "We have ample access to capital on an unsecured basis, and that's a great way to raise capital," says Stanford J. Alexander, CEO of Houston-based Weingarten Realty Investors, one of America's most successful REITs and and investment trust since 1985. "We've recently bought long-term capital at below 7%, and it's a unique experience for us. We just bought 12-year money at 6.7%. We still have a shelf registration with $85.5 million of unfunded capacity so that we can raise more money when we think it's attractive and needed. We can pick up a phone and complete an MTN (medium term note) transaction quickly. It's extremely efficient and effective."

Added to this is the fact that WRI has a 5-to-1 interest expense coverage, and an A+A2 rating. "Only two of us in the entire industry have that rating," he adds.

"We're one of the few companies that are in such a financial position regarding our equity-to-debt ratio. With our ready access to capital, our battle-tested development team and our internal capabilities, we're in a strong position to grow."

That will serve the company well in the coming months. "We'll continue to develop, provided we have tenants in place and are 50% to 60% preleased," Alexander says. "Right now, there are motivated sellers who desire cash, so we need to be in a position to respond quickly. And in the competition for acquisitions, the cost of capital will be crucial."

For those REITs seeking to conserve capital, some analysts say they may bow to the financial facts of life by setting their payouts lower. "The cheapest source of capital is retained earnings," points out Wayne Brandt, director of New York-based Nomura Securities International, real estate and mortgage finance. "You'll see the stronger REITs, over time, will attempt to drop the payout ratio. If it's in the 80s (percentage) today, maybe it'll be the 70s later. It's like getting on the freeway on-ramp. You can't go from 0 to 60 in six seconds. You need to do it gradually. The challenge is to reduce it while maintaining the growth of the company."

At the same time, Brandt says, a number of REITs are looking at creative ways to increase FFO by fee income, acquisition and asset management -- any way REITs can generate additional cash. "On the capital market side, REITs are seeking to promote self sufficiency, by creating common equity, preferred equity, large-term fixed-rate debt, secured or unsecured," he says. "We'll see the continued trend of the marketplace, long-term assets with long-term fixed-rate, but we'll also see a larger trend toward unsecured debt."

Niche REITs score high

Clearly, there has also been a trend toward niches in the REIT industry. One of the fastest growing segments has been self-storage REITs, which also have been one of the best performing sectors. Analysts point out that self storage is so diversified -- the top six or seven self-storage proprietors own a mere 4% of the industry's assets -- that there is opportunity for well-capitalized, well-run companies to exploit. REIT observers predict more assets will be purchased from smaller players as the mom-and-pop operators become more concerned about estate planning.

Initially, self storage was more of a land play, but now the self-storage product is being developed strategically next to high-traffic areas and highly transitional multifamily communities. In addition, self-storage REITs are also marketing ancillary products such as trailers and moving equipment.

"We are very bullish on the self-storage REIT product type for several reasons," says Clint McDonnough, national co-director of REITs for E&Y Kenneth Leventhal Real Estate Group, Los Angeles. "Rental rates are very high on this category, while maintenance of the facilities is very low by comparison. This segment has come a long way."

Unlike other REIT categories, which are having trouble finding products at the right price, self-storage REITs are positioned for acquisitions and growth, analysts say, with many opportunities. But because the industry is still fragmented and mostly dominated by mom-and-pop owners, single properties are considered the real play, not portfolio acquisitions. This means better pricing, but it also requires that operators "get in and roll up their sleeves."

Another niche player is Manufactured Home Communities Inc. of Chicago, a self-administered, self-managed equity REIT that is one of the country's largest owners and operators of manufactured housing communities. "We're a unique asset class; there are only four of us right now," explains Cindy McHugh, vice president of investor relations at the Sam Zell-led firm. "It's a fragmented industry with many individual owners, most family-owned. It's come to the situation where the mom and dad owners are in their 60s and saying, `I want to do something else.' That is providing opportunities."

Commercial Net Lease Realty of Orlando, a company that deals with 10,000 sq. ft. to 50,000 sq. ft. single-tenant, long-term retail leases, is another niche player. "We have not seen a significant influx into this particular real estate sector, so we've been kind of operating in a different environment with regard to competition," says Kevin Habicht, CFO. Like other REITs, CNL is in a growth mode. The company acquired about $50 million in assets in 1993, some $80 million in 1994 and a similar amount last year.

"Clearly, the headlines are not very good for the retail environment, but I think we've been inclined to believe that the total industry retail sales are going to be fairly stagnant," Habicht says. "But there will be shifts between retail players, retailers who are doing well taking sales from other retailers. We'd like to believe that's the case with some of our tenants such as Office Max and Computer who on a gross sales base are performing well. We think those sales are coming out of someone else's pocket."

With the niche REITs performing well, hotel REITs continue to be in the investor spotlight. Three of the IPOs last year were hotel related -- Sunstone Hotel Investors in San Clemente, Calif., Newton, Mass.-based Hospitality Property Trust, and Patriot American Hospitality Inc. in Dallas -- together which raised more than $638 million. A repeat of that isn't predicted in the months ahead. In fact, a number of hotel companies are now looking at C-corporations instead, says Dr. Bjorn Hanson, national industry chairman of hospitality at Coopers & Lybrand in New York. "Bristol, Wyndham and one or two other companies are very far along in the selection process of going the C-corp. route," he adds. "It's not that the REIT model has fallen out, it's just that others see investor interest in hotels."

The future of REITs

Hanson says the public market will remain active for REITs with large, secondary offerings. "We've seen a number of market phenomena that give us some predictive quality about where the REIT issue is going to price," notes Hanson. "If they are multitenant models, pricing will be between 7.8% and 8%; if single-tenant models, pricing will be between 8% and 10%. REIT secondary offerings will be close to 7%."

Still, economic conditions have already slowed down formation of hotel REITs. "The hurdle rates for a hotel company to become a REIT are difficult to achieve," says Bob Winston, CEO, president and director of Raleigh, N.C.-based Winston Hotels Inc. "You need a good size to go public, and it can be difficult to reach that critical mass. But the future looks good for hotel REITs; 1996 is going to be a good year, with increases in average daily rates. Overall, we're going to see revpar increase, (occupancy and ADR) and REITs will continue to show earnings gains."

Jon Litt, vice president and real estate securities analyst/REITs Salomon Brothers Inc., New York, agrees. Salomon expects hotel REITs will continue to outperform, he thinks, and apartments will recover. "I don't think you'll see many more hotel REITs, maybe one or two office or industrial," he continues. "I'm not so sure about the self storage, though, but I know in the hotel business it takes several years to build a property, but you can build new self storage anytime. That's the difference."

Thus, the REIT industry has one common thread among its more than 200 members: growth, and companies now are preparing for that future expansion.

1. Reckson Associate Realty Corp. (RA) $148.4 million at 9.53 yield 2. Sovran Self Storage Inc. (SSS) raised $135.5 million at 8.61 yield 3. Sunstone Hotel Investors (SSHI) raised $56.1 million at 0.68 yield 4. Hospitality Property Trust (HPT) raised $187.5 million at 8.80 yield. 5. Patriot American Hospitality Inc. (PAH) raised $304.8 million at 9.08 yield

Your balance sheet looks great. You've made a number of great acquisitions. You've set the company on a terrific course for the future. Yet your stock price is declining. What should you do?

Spread your good news.

"An integral part of being a REIT nowadays is communication - communication that is instigated by the company," explains Martin Debrovner, president and COO of Weingarten Realty Investors (WRI), the Houston-based REIT. "Your company might be accomplishing great things, but if only you know about them, it's not going to help your stock - or your reputation on the Street."

When WRI first went public in 1985, it was one of the few REITs and enjoyed an abundance of coverage from analysts and the press. Today, with the REIT industry having more than 200 players, it's different story.

Thus, WRI has implemented a strategic program beginning with its major institutional shareholders. Dubbed "Adopt an Institution," the plan calls for WRI's five senior managers to strive to keep open lines of communications - written, verbal and personal - by "adopting" several institutions that currently have significant holdings of WRI stock.

"The goal is to make these institutional holders feel comfortable with calling an officer of WRI if there is a question," says Debrovner. "They must feel comfortable and secure with who's running the company."

WRI also installed a toll-free number to invite large and small shareholders to call with questions or concerns. "We have one story to tell, and it's the same for everyone," notes Debrovner. "No one shareholder, large or small, gets priority information."

WRI also encourages analysts and shareholders to visit its headquarters in Houston, where 55% of the company's properties are located. Once Property Trust, an apartment REIT in Houston, to host an "Analyst Tour & Visit.'

The most recent event, in November, was attended by 48 analyst and portfolio managers who spent two days talking with WRI management and viewing WRI properties.

"We try to use all the tools at our disposal, whether they have been around for years - personal contact with shareholders and the media - or newly found ones like having your own Web site on the Internet," Debrovner notes "We're currently in the process of designing our Home Page and will be on the Information Superhighway this month. It's an economic and instant means of communications, so why not offer it to those who have access?"

Others agree.

"Doing such things shows you have a commitment to your shareholders," explains Cindy McHugh, vice president of investor relations at Chicago-based Equity Residential Properties Trust. "It shows a commitment to increasing values, and that's great."