AEW analyzes the REIT market with a special look at the office, apartment, hotel and retail sectors.

As we move through 1997, REITs continue to draw increasing attention from Wall Street analysts, institutional investors, mutual fund managers and others who have noted the acceleration in market capitalization and stellar investment performance that has characterized the REIT industry over the past five years. One simple measure of this increased interest can be drawn from the increase in investment bank analyst coverage from 0.6 analysts per company in 1994 to 6.5 analysts per company in June of this year, completely leapfrogging past the average small cap company.

The REIT industry has experienced a complete transformation, from virtual dormancy to viable investment alternative, over a relatively short period of time. Prior to 1990, the entire equity REIT market was valued at less than $5 billion and consisted of fewer than 60 companies. At year-end 1996, according to the National Association of Real Estate Investment Trusts, the total publicly traded REIT market consisted of 200 companies with a market cap of $89 billion. During the first half of 1997, an additional $13.5 billion of new equity capital was raised, including approximately $2.3 billion in initial public offerings and $11.2 billion in follow-on offerings. Overall, the industry experienced a growth rate of 55% per year between 1991 and 1996 and, during 1997, the capitalization of the REIT market is on pace to increase by an additional 20% to 25%. If the REIT market continues this impressive rate of growth over the next five years (and we believe it will), total REIT market capitalization will top $250 billion by 2002.

There are a myriad of well-documented reasons for this phenomenal growth (e.g. the growth of institutional investment in REITs, the perceived diversification benefits for a multi-asset portfolio, the REIT industry's outperformance of the S&P 500 over five of the last six years and the Lehman Government/Corporate Bond index during each of the last six years). But perhaps more interesting than this growth itself is the impact that the new breed of "specialized" REITs are having and are expected to continue to have on the various sectors of the real estate market.

Compared to their predecessors, today's REITs are larger and better capitalized. They also enjoy the cost of capital advantage, primarily as a result of their ability to borrow on the basis of their credit ratings rather than on the quality of individual assets offered as collateral. Where there were once numerous "diversified" or "mixed property" REITs, today's companies are increasingly focused on one or two specific property types and are managed by some of the most renowned real estate operating franchises in the business. There is also a trend toward consolidation, as larger REITs rationalize public and private companies with competing (or complementary) portfolios. The end result is that, unlike their predecessors, the new REITs have become major players in property level transactions in virtually every major submarket in the country, and there appears to be no limits to the property types that REITs are actively acquiring -- from more traditional investments in office, retail and apartment properties to golf courses and even correctional facilities. The following is our review of some of the top-performing and largest specialized REITs in the office, apartment, retail and hotel sectors, many of which are currently involved in acquiring additional properties on a massive scale.

Office REITs are dominant After lagging the other property types during the first four years of the "new REIT era," five of the top 10 REITs in terms of increase in total market capitalization during 1996 were office REITs (Beacon Properties, Crescent Real Estate Equities, CarrAmerica Realty, Cali Realty Corp. and Highwoods Properties). All five rank among the top 20 of all 200 publicly traded REITs in terms of total market capitalization and, with the exception of Highwoods, the remaining four rank among the top 10 in terms of total capital raised through secondary equity offerings during 1996. (Beacon Properties ranked No. 1 in this category, with an increase in total market capitalization of 266.5%.) During the first half of 1997, the office sector dominated the new issuance calendar, garnering over 30% of the total equity raised. Indeed, three office initial public offerings (IPOs) accounted for 70% of the markets' IPO total, and the IPO of Boston Properties was the third largest IPO of any stock during the first half of the year.

There appears to be no end in sight for the accelerated growth of office REITs, many of which continue to report favorable operating results and an abundance of financing opportunities. Steady economic growth continues to generate new office jobs in many suburban and metropolitan office markets throughout the country. Office vacancy rates nationwide have declined to their lowest point since 1986, while rental rates (as measured by CB Commercial) are accelerating at their fastest rate since 1981. Demand for office space is outpacing supply in most cases, and the resulting increases in occupancy and rental rates have been driving the profitability of many office REITs.

This accelerated growth has translated into fierce competition among office REITs to acquire new properties in what is perhaps one of the most notable national real estate trends we have identified. In the second quarter of 1997 alone, Beacon Properties invested $643 million in approximately 3.3 million sq. ft. of office properties, increasing the size of its portfolio by 22% to 18.6 million sq. ft. Similarly, CarrAmerica and Crescent invested $408 million and $1 billion, respectively, in new properties during the first two quarters of 1997. But when 1997 draws to a close, both Cali Realty Corp. and Equity Office Properties Trust will have eclipsed Beacon to become the new office sector leaders as measured by total market capitalization. Cali has completed $555million in acquisitions thus far in 1997, representing a 69% increase in its portfolio holdings since year-end 1996, and it recently announced plans to merge with the Mack Co. If the merger is successful, the new company will be one of the largest REITs in the country, with a total market capitalization of approximately $3.3 billion and a portfolio of over 21 million sq. ft. of office space located primarily in the Northeast and Southwest. July 1997 brought the much anticipated IPO of Sam Zell's latest powerhouse, Equity Office Properties Trust, which boasts a $5 billion portfolio of office buildings comprising 32 million sq. ft.

Office REITs posted a total return of 46% during the past year -- higher than the 37% return for all REITs and better than the 39% return of the S&P 500. Overall, investors seem to remain optimistic about prospects for the office sector in general and about REIT operators' ability to turn strong market fundamentals into strong returns.

Apartments set consolidation trend The apartment sector has been the leading edge of the REIT resurgence since the IPOs of 21 operators in 1993 and early 1994. As the first property type to reach equilibrium in this cycle, we believe the significant consolidation which is occurring in this sector presages a similar trend in other property types.

With a total market capitalization approaching $4 billion, Equity Residential Properties is nearly twice as large as its next largest competitor in the apartment sector. Between 1995 and 1996, Equity Residential was clearly the performance and growth leader in this sector, having increased its market capitalization by 38.5% and its share price by 35.2%. This accelerated growth and performance continued into 1997. During the second quarter, Equity Residential's earnings (FFO) per share rose by 20%, reflecting more than $2 billion in recent apartment property acquisitions and higher income from apartments owned at least one year. Unlike its next largest competitors in the apartment sector, which concentrate on acquiring and developing regionally, Equity Residential's holdings are truly national (spanning 31 states), making it one of the most geographically diversified REITs. Equity Residential's status as the unrivaled giant of the apartment sector may be in jeopardy, as one of its next largest competitors, Post Properties, is poised to merge with Columbus Realty Trust. If the merger is approved by shareholders in November, the "new" Post Properties will also boast a market capitalization in excess of $2 billion and will be positioned as the dominant developer and operator of upscale multifamily communities in the southern states. Another sizable leap in market capitalization was made at year-end 1996 by United Dominion Realty Trust, which merged with Southwest Property Trust to create a combined REIT with a market capitalization of $1.2 billion and a portfolio of 56,000 apartments in the Sun Belt.

On a smaller scale, REITs such as BRE Properties, Essex Property Trust, Bay Apartment Communities and Irvine Apartment Communities continue to reap the benefits of regional focus on West Coast properties. Each posted earnings increases (FFO) ranging from 9% to 16% at the close of the second quarter of 1997, when compared to the prior-year period. These favorable operating results reflect the continued strengthening of the San Francisco Bay, Seattle, San Diego and Orange County markets.

Hotel REITs are active buyers Hotel REITs have been very active buyers over the past year, typically seeking opportunities not only to acquire the underlying real estate but also as strategic buyers to take over or control management. Premium pricing is being driven by just a handful of players that target upscale and business hotels. The largest of these REITs include Patriot American Hospitality, Felcor Suite Hotels Inc. and Starwood Lodging Trust. All three are "paired-share REITs," which essentially means that their individual shares represent ownership in two companies: the hotel REIT, which owns the assets and pays no taxes, and the hotel management company, which does pay taxes but does not have restrictions on its sources of income. From a taxation standpoint, this structure essentially allows shareholders to realize more of the value created by the underlying hotel investments. Patriot American recently acquired paired-share status as a result of its July 1997 merger with the California Jockey Club. Its pending acquisition of Wyndham Hotels, which is scheduled to occur in November 1997, will essentially provide Patriot with a management company to take full advantage of the paired-share structure.

During the second quarter of 1997, Patriot American Hospitality posted a 12% year-over-year increase in FFO per share. Felcor's earnings per share increased by nearly three times this amount over the same period, and Starwood's results were nothing short of astounding -- a 53% increase in earnings per share over the prior-year period. The notable surge in the earnings of these three REITs is attributable to increased demand for upscale hotel rooms, which continues to far outpace the level of supply in most major markets. Revenue per available room (REVPAR) gains are being disproportionately experienced by first-class, full-service hotels, as occupancy levels in the economy and midmarket segments are relatively flat due to increased supply. Ultimately, we believe competition from the economy and midmarket segments will begin to infringe on the first-class hotel segment beginning in 1998, impacting the earnings growth of the aforementioned REITs. We anticipate that the first-class hotel segment, as well as REITs that are invested in first-class hotels, can continue to post positive overall operating results through 1999, assuming sustained economic growth.

Business conditions ripe for retail Of all the sectors of the REIT market, the retail sector (regional malls in particular) showed the greatest improvement in overall returns between 1995 and 1996, rising from a total of 5.1% (3% for malls) in 1995 to 33.9% (44.8% for malls) in 1996. After years of sluggish retail sales and declining occupancy rates in many retail markets throughout the country, more and more retailers are beginning to report favorable operating results, which in turn has translated into favorable returns for the major shopping center and regional mall REITs, including Simon DeBartolo, Taubman Centers, General Growth Properties, KIMCo and Vornado Realty Trust. All of these REITs reported increased earnings and profitable operations during the first six months of 1997, which they attributed to increased occupancy, consumer sales and rental rates.

Business conditions are currently ripe for retail REITs, many of which have adopted aggressive development, redevelopment and acquisition strategies in an effort to take advantage of the improving retail climate. The improved economy also has more traditional shopping center retailers looking to open new stores for the first time in years. The retail market was stressed by continued supply growth in excess of demand throughout the first half of the 1990s. While all other property types benefited from complete or substantial shutdowns in construction, stand alone and power center big box construction paced total retail starts to a new record high in 1995. With strong selling competition from new formats, traditional mall and shopping center tenants struggled to maintain sales growth despite the economic recovery.

In this environment, the few retail REITs with strong acquisition and repositioning programs have paced the sector. General Growth Properties has used aggressive acquisitions to surge to the top of the mall pack, doubling in size while posting above average FFO growth. Among shopping center companies, Vornado Realty Trust stands out as by far the most aggressive, transforming itself from an average regional shopping center operator into an opportunistic growth powerhouse with major office holdings.

Relative to other types of publicly traded stocks, REITs are now priced to generate a much higher current yield, with the current yield spread between the NAREIT Equity Index and the S&P 500 hovering around 400 basis points. REIT yields have more or less tracked the yield on 10-year Treasury bonds over most of the past decade, staying well above utility stock yields over this same period. As the nation's property markets have improved, many REITs in various sectors have enjoyed substantial earnings growth and now trade at higher multiples. The most significant question for REIT investors for 1997 and 1998 is the degree to which the new breed of specialized REITs can continue to show earnings growth in excess of that already priced into the market. With current consensus earnings growth estimates roughly equal to the S&P 500, the cushion provided by the continued high yield spread and lower multiples should produce strong relative performance for the rest of this year and into 1998.

Douglas M. Poutasse is a managing director with AEW Capital Management L.P., Boston, and directs the activities of AEW Research.