Although debt is up and stock prices are down, this is not necessarily a dire time for REITs holding shopping centers and malls. In fact, there is some reason for hope. The market already seems to have factored in all of the negatives and is waiting for sure signal of a turnaround.

Three major factors account for the current condition of retail REITs:

* There is a flight to quality both externally and internally. Investors continue to shop for the best retail REITs, and REITs continue to reposition their portfolios to put themselves in the best light to investors.

* Repositioning of portfolios serves to overcome a second factor: a lack of new investment funds from the capital markets.

* And lastly, retail REITs are still struggling to come to terms with being overshadowed by the technology community, which has virtually usurped the term "shopping mall" and turned it into dot.com lingo.

If you look strictly at business fundamentals, 1999 might be described as one of the best years for retail REITs in terms of operational performance. Earnings growth was in double digits: 15% at strip centers and 12.8% at regional malls. Occupancies improved, empty spaces were leasing up quickly and rents continued to increase. Robust employment growth plus high levels of consumer confidence and household spending likely are the driving forces behind these results.

That said, retail REIT performance lagged the office and residential sectors, with the retail sector down 11.77% in total return in 1999. Regional malls posted a 14.58% decline and strip centers a 10.71% decline, according to statistics from the National Association of Real Estate Investment Trusts (NAREIT), based in Washington, D.C. (See chart below.)

The under-performance stemmed from concerns about consumer spending maxing out last year, as well as investor concerns about leverage levels in an environment of rising interest rates. In the mall sector, specifically, there were a number of asset trades last year - and some investors were questioning the pricing.

"There was the penchant of many retail REITs for continuing the consolidation game even as the cost of capital was climbing during the year," says Robert L. Levy, senior real estate analyst for San Francisco-based Robertson Stephens Real Estate Investment Banking Group.

"Simon Property Group, The Macerich Co., General Growth and The Rouse Co., to name a few, continued their buying binges at a time when we believe most investors were more enamored with other strategies," he says. "These included a focus on internal growth, asset redevelopment, development, reducing balance sheet risk, and stock repurchase programs. We believe those same themes are just as relevant today."

Another issue for retail REITs was the bearish investor sentiment on REITs overall last year, and on the retail sector specifically.

Throughout last year, most market observers attributed at least part of the relatively poor performance of REIT stocks, as well as other income and value stocks, to the overwhelmingly positive net investment flows into technology, reports Mike Grupe, vice president and director research for NAREIT.

Only growth stocks, aggressive growth stocks and sector funds registered increased investment flows. When combined, the net investment flows into these three sectors jumped by more than 75% from 1998 to 1999. Every other investment-objective category registered either a decline in net inflows or net outflows.

Says Levy, "The entire REIT market suffered due to the lack of equity capital flowing into the sector during the year ... creating a significant capital vacuum and creating the need by mutual fund portfolio managers to sell real estate equities even if they may not have believed it was a prudent investment decision. This factor of course impacted the entire REIT sector, not just retail REITs."

Without investment dollars earmarked for REITs and with total negative returns, die-hard REIT investors really whittled their pencils and worked to refine their investment strategies. Some mutual funds reduced their retail REIT exposure, such as Philadelphia-based Delaware Pooled Trust.

Others shifted their holdings around, such as San Mateo, Calif.-based Franklin Real Estate Securities Fund. Matt Avery and Douglas Barton, portfolio managers for the fund, reported in a letter to shareholders: "Due to our concern about their higher-risk operating strategies, we sold our positions in Burnham Pacific Properties Inc. and The Mills Corp., and initiated a new position in General Growth Properties (GGP). We believe that GGP has the potential to grow significantly through both internal rental increases and select development opportunities, and feel that its stock offers compelling value."

But other funds such as Boston-based John Hancock Series Trust tried to weigh retail REITs based on their real estate, not necessarily on whether they were in or out of favor with investors. Reports Jay McKelvey, assistant portfolio manager for the fund, "We continue to believe the market has overreacted, especially in the near term, since the quality retail space owned by REITs is increasing, which has caused a boost in retail sales per sq. ft. - an important measure of value."

The flight to quality It is toward die-hard investors such as these that retail REITs are directing their strategies. Retail REITs are having to dress themselves up to make themselves attractive to this steadfast community of investors. They are doing this in several ways.

One strategy is to ditch underperforming, older or smaller properties or properties in markets where the REIT has no market share. In this way, it can boost the quality of its portfolio without having to spend money, which REITs have scarce access to.

At the same time, REITs are raising cash in order to purchase better-performing properties or properties with the potential to be redeveloped. And in this search for underperformers, retail REITs haven't overlooked their own intrinsic values - many REITs have redirected some of their investment dollars into their own stock.

Buyers for these selloffs typically have been private investors with a single market presence. Bethesda, Md.-based First Washington Realty Trust used this method to sell Pheasant Hill Plaza, a 63,000 sq. ft. shopping center in the Chicago area. The purchaser, a private investment partnership, paid First Washington $9.2 million using a combination of cash and the assumption of the existing mortgage.

"The sale underscores our commitment to refine our portfolio of neighborhood shopping centers and to reallocate our capital over time to those investments which we believe will provide the greatest return," says Stuart D. Halpert, chairman of First Washington.

First Washington is also one of those firms buying back its own stock. It is repurchasing up to 1 million shares of its common stock.

New Hyde Park, N.Y.-based Kimco Realty Corp., the country's largest owner of neighborhood and community shopping centers, was a buyer. It completed property acquisitions of $108.3 million for its core portfolio during the final quarter of last year. In addition, it acquired $99.1 million in shopping center properties for its strategic joint venture, the Kimco Income REIT (KIR).

During the fourth quarter, Kimco acquired 13 sites totaling 1.5 million sq. ft. Many of the properties acquired had tenants with below-market rents or expansion areas that would provide potential for future growth. For the year, Kimco acquired 34 properties totaling 3.4 million sq. ft. for an aggregate cost of $229.4 million.

Fourth quarter acquisitions for KIR included three shopping centers with GLA totaling 1 million sq. ft. KIR was formed in April 1999 to acquire, own and operate shopping centers that are leased to national tenants, At the end of the year, it had approximately $577 million in gross assets.

Kimco also reported that it purchased 160,000 shares of its common stock at a price of $31.75 from an institutional investor. Kimco does not have a share repurchase program but acquired the shares when it received an unsolicited offer to buy them.

Cary, N.C.-based Konover Property Trust sold two of its properties in the fourth quarter to two separate private owners for a total of $5.4 million.

"In an effort to further align the company's portfolio with our strategic plan of concentrating our portfolio of shopping centers in the Southeast, we sold Casa Grande, a held-for-sale asset, and Sulphur Springs," says C. Cammack Morton, president and CEO of Konover Property Trust.

"Not only are both centers non-core assets located in the central part of the nation," he continues, "but their limited growth potential was not consistent with the overall performance of our remaining centers. We believe the sale of these two properties will help us maintain an economically solid portfolio that is poised for continued growth."

Southfield, Mich.-based Ramco-Gershenson Properties sold Trinity Corners, a 50,000 sq. ft. shopping center in Pound Ridge, N.Y., for $2.8 million.

"The decision to sell this shopping center, as was the case with the recent sale of a freestanding Toys 'R' Us in Commack, N.Y., is part of our overall strategy to sell non-core assets that are not redevelopment candidates," says Dennis Gershenson, president and CEO. "The proceeds generated from the sale will be reallocated into future growth opportunities."

New Orleans-based Sizeler Property Investors Inc. converted Colonial Shopping Center in Harahan, La., to a multi-use center and signed on State Farm Mutual Auto Insurance as an office tenant for 27,000 sq. ft. of the center's total GLA of about 45,000 sq. ft.

Not all of these strategies work completely. Bingham Farms, Mich.-based Malan Realty Investors has tried a mix of them but ended up bringing in New York-based Prudential Securities as its financial adviser in the last quarter of the year.

Until this time, Malan has been pursuing opportunities to re-tenant and redevelop its properties and to increase occupancy. The company has been diversifying its tenant mix and negotiating for buyouts of existing leases and new leases to fill available space.

"We are exploring the full range of property and capital markets strategies available to Malan," says Anthony S. Gramer, the firm's president and CEO. "Drawing on the broad experience of our board of directors, as well as the professional assistance of Prudential Securities, we intend to look carefully at every viable strategic option. Then, we will identify the most appropriate, prudent and effective course of action to continue to build value for our shareholders."

The complete capital vacuum In terms of return potential, there are still some attractive strategies available to REITs. In general, share repurchases and development/redevelopment are the highest-yielding investments, says Lisa Kaufman, an investment analyst with Baltimore-based LaSalle Investment Management.

However, REITs are finding it difficult to raise common equity, and they can stretch their debt only so far. Thus they are having a hard time raising money for development and redevelopment.

So by selling property, REITs are raising needed capital to add new properties and improve those assets with the potential for immediate redevelopment.

Kaufman likes Indianapolis-based Simon Property Group, which in early 1999 upgraded its portfolio with the acquisition of CPI. Now, with money tight, Simon is looking to sell about 15 of its original lower-grade properties.

"Simon is a bellwether for the industry," she says.

She is not alone in her preference. "Simon Property Group is our favorite name in the mall sector for a number of reasons," says Levy of Robertson Stephens. "First, Simon has a very exciting development pipeline that we believe will produce solid returns for them over the next few years. Simon recently completed seven major development projects totaling close to $500 million in invested capital for the company. In addition, we estimate Simon has an additional $500 million in projects we expect to come on line in 2000. These projects vary from new developments to expansions and renovations of existing assets.

"Second," he adds, "we believe Simon's tremendous size and diverse portfolio creates certain economies of scale and efficiencies not available to many of its peers. Because of this, we believe Simon has been able to use its branding concept to drive revenues and improve operating margins through expense reductions." Levy notes that his firm considers Simon's access to capital superior to other REITs and its balance sheet very stable.

Not every retail REIT has fared as well. Baltimore-based Prime Retail Inc. voted in January to suspend the regular quarterly distribution on its common stock and the common units of limited partnership interests in Prime Retail LP. The company expected to pay only enough to meet its minimum REIT requirements. The company's liquidity was being squeezed on several fronts:

* An anticipated decline in occupancy and property level net operating income at a limited number of the company's outlet centers in the bottom quartile of its portfolio;

* Increased interest expense due to recent increases in floating interest rates and increased borrowing costs; and

* Higher marketing allowances to subsidize marketing budgets at the company's centers.

"In light of the company's various short-term obligations, our board of directors felt it prudent todiscontinue distributions on our common stock in order to preserve cash resources and enhance the company's fiscal integrity and financial flexibility," says Abraham Rosenthal, CEO of Prime Retail.

"The cash retained in our company this year will be used to fund these short-term obligations and to repay our outstanding corporate lines of credit," he continues. "The company also will use retained cash to fund various leasing and capital expenditures on certain of our centers to enhance their income potential in the future. We expect to re-evaluate the payment of a quarterly dividend on our common stock and common units in the year 2001 based on the company's forecasted cash available for distribution at that time."

Among most retail REITs across the board, the scarcity of funding showed itself in the scaling back of acquisitions throughout the first three quarters of last year.

Shopping center consolidation took several steps backward toward the end of the year. For example, Rockville, Md.-based Federal Realty Investment Trust terminated discussions with a third party regarding the sale of its shopping center assets, and New York-based New Plan Excel Realty Trust took an $800,000 charge for a failed acquisition.

More high profile was San Diego-based Burnham Pacific's rejection of Columbus, Ohio-based Schottenstein Stores' revised offer and its own modification of a joint venture with the California Public Employees' Retirement System (CalPERS). These curtailments came late in a year in which Burnham Pacific had acquired 25 shopping centers totaling $560 million from San Francisco-based AMB Property Corp., which bailed out of retail in favor of industrial properties.

As of this writing, Schottenstein hadn't given up acquiring Burnham. Schottenstein filed documents with the U.S. Securities & Exchange Commission opposing any further actions that Burnham might take that would preclude or limit Schottenstein's ability to make a bid to acquire the company. The opposed actions included a "fire sale" of Burnham's assets or an agreement with a third party that would it give it a leg up in acquiring Burnham.

As part of its modification with CalPERS, Burnham opted out of some acquisitions as a way to reduce debt. It exchanged substantially all of its equity interest in the joint venture for $39.4 million. It also sold two properties to the joint venture for approximately $18.9 million. Cash proceeds were used to reduce debt.

The Internet scare Real or perceived, REITs also have to deal with the issue of e-commerce and what it means for brick-and-mortar shopping centers. In 1999, retail REITs gradually, reluctantly moved from a defensive position that online shopping will never replace shopping centers. Now, conceding that the threat from dot.coms is real, they're taking a proactive approach to the Internet by integrating e-tailing with shopping centers, notes Kaufman of LaSalle Investment Management.

Says Levy of Robertson Stephens, "The fear that e-tailing is going to destroy brick-and-mortar retail businesses had a negative impact on retail REIT stock prices. Even if investors did not believe this annihilation was actually going to happen, there was a significant negative overhang on the retail sector that we believe created downward pressure on the stocks."

A Simon Property Group fan already, Levy cites its Internet strategy as another reason for liking Simon. "We view Simon as a leader in the battle for the consumer between brick-and-mortar companies and e-tailers," he says. "Simon has been on the forefront of creating Internet strategies for retail REITs - not only to help defend their business against new technologies but also to potentially drive new customers to their properties and reduce operating expenses, thereby boosting profits."

Other retail REITs are also moving to the front line of the battle. BarPoint.com and Konover Property Trust teamed up to bring its shopping centers to the web. The Mills Corp., Arlington, Va., created an Internet site for its Franklin Mills mall. And separately, Mills teamed up withCenterseat to create exclusive entertainment programs for its malls to enhance t he in-person shopping experience.

Now that REITs are confronting the situation, the Internet scare that plagued REIT stocks last year should be less pronounced this year, says Kaufman of LaSalle. Moreover, investors are realizing that pure e-tailing without a brick-and-mortar presence is not a viable business model, given the huge volume required to reap profits. All in all, the horizon looks good for shopping centers. "Operations have never been better at malls, occupancies are climbing and rents are increasing," she says.

This optimism is supported by independent statistics. RCT Systems Inc., developer of the National Retail Traffic Index, estimates that 1.2 billion people shopped at the nation's enclosed malls this holiday season.

"Malls beat the Internet hands-down this holiday season. At the mall, shoppers experience a total holiday environment where they can see and sample gifts, and leave with packages in hand," said Krista DiBerardino, vice president of marketing for the Chicago-based firm.

Notes John Bucksbaum, CEO of General Growth Properties, "The strong sales growth is a clear indication that traditional brick-and-mortar retailers can peacefully coexist with their Internet peers."