We admit we are starting to be boring," notes the beginning paragraph in a Salomon Smith Barney research report on the subject of real estate investment trusts (REITs).

Frankly, all seems to be fairly quiet in the REIT world. Expansion is way down; mergers and acquisition (M&A) activity is almost non-existent; investor interest is nil; many REITs are net sellers not buyers of real estate; and as David Sherman, an analyst at New York-based Salomon Smith Barney points out, "REITs continue to trade flat to down."

How bad are things in the REIT world? After noting that same-store sales growth for most retailers in the second quarter was excellent (Gap, up 13%, Limited, up 11%, Kmart, up 9.2% and Federated, up 8.4%), Sherman looked at the mall and strip-center REITs which were still underperforming even when compared with other REITs. While the average REIT logged a total return of 1.72%, through the middle of September the retail sector was off -4.27%.

"The fundamentals of REIT operating companies are good," says Ray Milnes, national industry director of real estate in the Chicago office of New York-based KPMG LLP. "Occupancies are good, rents are good, all the basic fundamentals are good," he continues. "But REIT stocks have not recovered from the hit they took a year ago when the general market went down, in part because people thought they were waiting for the next real estate cycle. REITs just lost their pizzazz as a growth stock and are now viewed more as quality income stocks."

One of the big problems for REITs has been a lack of investor interest. According to Chicago-based LaSalle Investment Management (Securities), cash flow into real estate stock mutual funds were in redemption continuously from second-quarter 1998 to April 1999. In the spring, there was a brief rally in REIT stocks as famed investor Warren Buffet bought into several REIT companies, but it quickly dissipated. By August, Sherman again reported, "Inflow to REIT mutual funds was zero."

Some would argue that the silence in REITs is not necessarily a bad thing as it indicates the sector is settling down and operating more efficiently than in the mid-1990s when REITs acted more like growth stocks. "If you look at the data, you'll find that the market cap of the [REIT] industry from the end of 1992 to the end of 1997 experienced a compound annual rate of growth of 55%," says Michael Grupe, vice president of research at the Washington, D.C.-based National Association of Real Estate Investment Trusts (NAREIT).

"Part of that was the result of significant economic returns generated by a recovering real estate sector," he adds. "Not surprisingly, you can only recover once. Two years ago, it became evident that the real estate economy was entering a relative period of equilibrium." The result, Grupe says, was that the amount of investment that the market was willing to commit to additional real estate assets stabilized.

In the short term, industry observers don't see much of a change ahead which means a continued flat period for REIT stocks and subsequently of the REITs' ability to raise capital. If REITs continue to have trouble raising capital due to low stock prices (only 144 equity offerings in the first three quarters of 1999 as compared to the peak year of 1998 when 474 offerings were issued), M&A activity could stay down as well.

"I don't think you will see any dramatic shifts in stock price performance," observes Gary Boston, an analyst with PaineWebber in New York. "There won't be any dramatic shifts in real estate fundamentals. REITs are in a fairly steady state. If nothing else, REITs are trading down again."

Mergers & acquisitions The smart REITs are the ones that are realizing they should not be out there buying like it was 1999, says Boston. "It wouldn't make any sense today."

Dealmaking began to abate around September and October of 1998, as an end-of-year global credit crunch disturbed most major markets. REIT stock prices remained persistently weak, making it difficult to pull off an acquisition of another REIT. Just a handful of deals were done this year, the most prominent being the March merger of Duke Realty Investments and Weeks Corp. creating Indianapolis-based Duke-Weeks Realty Corp., with a capitalization of $5.2 billion. The most recently announced major deal involved Chicago-based Equity Residential Properties' $740 million bid for Lexford Residential Trust of Columbus, Ohio.

Outside of those two transactions, there have been a couple of casino gaming deals: Nashville, Tenn.-based Corrections Corp. of America merged with sister company CCA Prison Realty Trust; for $1.7 billion, Indianapolis-based Simon Properties bought as many as 14 malls from New England Development Co. of Newton, Mass.; and Los Angeles-based Starwood Financial Trust is set to take over TriNet Corporate Realty Trust of San Francisco. Meanwhile, in private-public deals, San Clemente, Calif.-based Sunstone Hotel Investors is being bought by SHP Acquisitions, a private group including some of Sunstone's management, and Columbus, Ohio-based Schottenstein Stores Corp. has made a bid for Burnham Pacific Properties Inc. of San Diego.

There is some difference of opinion as to whether REIT dealmaking will pick up in the short term. No one, however, is optimistic. According to a LaSalle Investment Management report, "Consolidation will continue, with the largest companies essentially buying assets when acquiring other REITs. Combinations between equals will produce limited stock market profits in the short term. Smaller companies not open to this possibility will be left behind."

NAREIT's Grupe is hesitant to predict more consolidation in the REIT market. "Market factors will drive the economics of the REIT business," says Grupe. "If there should be additional consolidation, then it will take place but the market does not feel strongly that it needs additional consolidation. You don't have strong incentives to move in that direction."

A few trends in regards to M&As are developing, suggests John Moody, chairman and chief executive officer of New York-based Cornerstone Properties Inc. The first is that good companies such as Duke Realty and Weeks Corp., are getting together. Second, large companies will eschew smaller companies that are available and cheap because the assets are not right.

Public vs. private Another debate in the REIT world continues to be whether a REIT should remain a public entity. According to Moody, "There are a whole lot of REITs out there that shouldn't be public companies and they should go private, and if they continue to trade at huge discounts that is what will happen."

There has been a lot of talk this year of publicly traded REITs going private and that just may happen as the inability of public REITs to raise capital has put a crimp on acquisition activity. However, the trend has been slow to develop with just a handful deals.

One of the biggest public-to-private transaction occurred in April, when New York-based Blackstone Real Estate Advisors joined with Whitehall Street Real Estate Ltd. Partnership XI and Douglas Krupp, chairman of Boston-based Berkshire Realty Co., to essentially merge Berkshire Realty into a private company. The transaction was valued at $1.3 billion.

"Clearly there is an advantage to being private in that if you look at where we are today, there is still a lot of private capital available for real estate where there doesn't appear to be a lot of public capital available," says Thomas August, president and CEO of Dallas-based Prentiss Properties Trust.

This is not to say Prentiss will be heading in that direction. "We like the REIT format," August says. "We feel comfortable especially having started as a public company in running a group of assets. What we are looking to do is stay in the format we are in and continue to work as hard as we can to improve our value and our share price."

The most successful REITs do work well as public companies, says Salomon's Sherman, who adds there are a minority of REIT companies that are "basically a collection of assets by honest people without much of a corporate strategy. There is demand for those stocks, only not enough to support all of them. For those, the private market will be a better alternative," he says.

PaineWebber's Boston agrees. "Different REIT managements probably operate better in a private environment than a public," he says. "A lot of management is not cut out to be the management of a public company."

There were economic reasons for going private as well. First, a lot of private money was available and some REITs turned to the private markets to finance growth. Second, some managers realized their stocks were so cheap compared to underlying value, thus they were able to buy their company relatively inexpensively and capture a lot of value.

Operating efficiency Cornerstone Properties grew from a $500 million capitalization to $4.5 billion in about three years. Now, says Moody, it's time to concentrate on operating fundamentals. The quiet market of REITs "has given us a chance to get out of this rapid acquisition environment, take stock and batten down the hatches," he says. "You do the things you have to do after a period of rapid growth. There are a lot of things we have been doing this year that are not as glamorous as some of the things we did in past years, but they are essential for building the future."

A great percentage of REITs have taken the same route as Cornerstone. They have stepped back from the acquisition game to work on operating efficiencies, showing investors that they not only are aggregators of properties, but can manage them as well. REITs are also taking this time to weed out their portfolios, ridding themselves of non-core assets or assets that have little upside potential. As Moody observes, in this environment, "We would rather be selling assets than buying."

It is difficult to tap the public markets for equity and it is less difficult but still a challenge to go to the public markets for debt, says Dale Reiss, national industry leader for real estate at E&Y Kenneth Leventhal in New York. "So, what we are seeing is that REITs, which would previously have liquidated one property and acquired another through a tax-free exchange, are now selling the properties outright and deploying the cash for other purposes."

AvalonBay Communities Inc., of Wilton, Conn., boasts a capitalization of $4.2 billion and ownership of 140 apartment communities with 45,000 units. So far in 1999, it has sold 12 apartment projects. The reasons for the sales are purely economic. Richard Michaux, CEO of AvalonBay explains, "In the past 12 months we sold about $350 million worth of properties at an average cap rate of 8.2%. That money is used to develop new properties which, once they are stabilized, get a better cap rate. On 27 deals in the past four years, the average cap rate is 11.3%.

"So, that first year you stabilize you are at 11.3% against a cap rate of selling at 8.2%," he adds. "That's making 300 basis points on those dollars." Now is a good time to be a seller, not a buyer, Michaux stresses.

"Lack of investor confidence and interest in this sector had had a tremendous effect on the way REITs handle their expansion plans," observes Ken Bernstein, president of New York-based Acadia Realty Trust. About a year ago, Acadia took over Mark Centers Trust, a retail REIT, and that has been its last acquisition. "As a result of our taking over Mark Centers, we have been able to successfully grow our earnings," says Bernstein. "We have another 12 to 24 months of significant turn-around opportunities."

As for the industry in general, Bernstein suggests, "REITs have to focus more on blocking and tackling and creating the value internally."

There is a new tax reform act on the horizon, and the REIT industry is hoping part of that will be the creation of a taxable REIT subsidiary. This would allow REITs to take 25% of their assets and do things other than just hold real estate, perhaps have an operating business. E&Y's Reiss says, "A lot of REITs are keeping their powder dry waiting for that event."

Funds from operations REITs are one of the few publicly traded sectors that use an alternative form of performance measurement. With REITs, financial performance is universally determined by Funds From Operations (FFO) - a calculation which adds back depreciation when calculating cash flow.

The obvious difficulty when using an alternative financial measurement is that it is hard to compare REIT stocks with those of other companies.

For that reason, there has been a push in the REIT industry to do something about FFO.

"A small sector that decided to create its own measure has confused people who are not familiar with REITs," Milnes says. "To limit or change the way FFO is computed would be very positive and hopefully what emerges will be simpler. It would add more credibility to the marketplace."

Archstone Communities Trust, an Englewood, Colo.-based apartment REIT, decided to address the problem in its second-quarter earnings report with a new performance measure called earnings before structural depreciation. The move was an attempt to get closer to generally accepted accounting principles reporting, help investors better understand the company's performance and provide better information to compare Archstone's performance to that of companies in other industries.

"The big reason why GAAP net earnings is not adequate to fully understand the value of a real estate company relates to depreciation," comments Charles Mueller, Archstone's CFO.

One other problem that bothers analysts and investors about FFO, is that REITs have had the ability to make adjustments to FFO for non-recurring items and that has been fairly subjective.

However, there is a difference of opinion in the industry itself on the matter of FFO. LaSalle Hotel's Bortz finds the FFO "pretty accurate" and is not so inclined to replace it. "Part of the jobs of analysts is to dig into the number that companies generate and look at the quality of earnings," he says. "So, it's only a question of where you start, and in most industries you start with earnings per share and there are other industries that use other methods. Our industry uses FFO which is a pretty good proxy for operating cash flow per share."

On the other hand, PaineWebber's Boston believes that, "Anything that gets you closer to GAAP net income is probably a move in the right direction." No supplemental performance measure can be a substitute for GAAP net income, notes Jonathan Litt an analyst at PaineWebber in New York. "As we poured through various valuation benchmarks, we found surprising uniformity among P/E multiples for REITs," he says. "We also found that variations between companies were no more or less pronounced than for other industries. We believe the primary earnings measure for REITs should be GAAP net income and earnings per share."

There are a lot of proposals being floated to replace FFO, observes Cornerstone's Moody. "There are some better ways to report financial performance other than FFO, and I think some modification will be adopted."