The stunning run of regional mall real estate investment trusts has finally shown signs of tiring. Between 2000 and 2006, mall REITs averaged annual returns of close to 32%, pummeling the S&P 500 Index's average of 4.6% over that same period.

But regional malls are no longer outpacing the field. During the first three quarters of 2006, mall REITs mustered a 12% total return — including stock price appreciation and reinvested dividends — while the REIT industry as a whole generated total returns of nearly 23%. Meanwhile, office and apartment REITs generated total returns of 29% and 35%, respectively, according to SNL Financial, a research firm based in Charlottesville, Va., that tracks the real estate industry.

“Regional malls have certainly been the high-flyers over the last several years,” says Keven Lindemann, director of the real estate group for SNL Financial. “But this might be the time they start slowing down and giving some [of those returns] back.”

Influential capital

Ultimately, private equity's invasion of publicly traded property portfolios has driven other commercial real estate sectors to the front of the pack heading into the last lengths of 2006. By avoiding mall companies but snapping up other REITs, private equity buyers have helped to convince real estate fund managers to cash out of malls and funnel their gains into other real estate asset classes, particularly the office and apartment sectors.

It's not as if portfolio managers needed the encouragement. They've been betting that job creation, rising demand and constraints on new supply would lead to accelerated rent growth in offices and apartments for months. Office properties nationwide, for example, are just now showing strong rent growth after years of declining and flat lease rates.

“Malls were a very good place to go and hide [early this decade] to seek returns — year in and year out, same-store growth never went negative,” says Joe Smith, managing director for New York-based ING Clarion Real Estate Securities. “But now we think there's better growth ahead in the apartment and office sectors.”

Indeed, over the last year, ING Clarion, which manages $14.2 billion in commercial real estate equities, has rebalanced its portfolio. Mall REITs now account for approximately 13% of its real estate holdings, down from a range of 17% to 20% a couple of years ago, according to Smith.

That rebalancing has occurred virtually throughout the REIT mutual fund industry. In the $9.6 billion Vanguard REIT Index Fund, which moves in tandem with the bellwether Morgan Stanley REIT Index, offices made up 21% of the portfolio at the end of the fund's fiscal second quarter on July 31, an increase of three percentage points from Jan. 31.

Vanguard's total investment in apartment REITs, meanwhile, grew one percentage point to comprise 19% of its portfolio over the same time period. And malls? They slid from 14.3% to 12.8%.

All the while, investors continue to plow money into REITs. According to AMG Data Services, more than $200 million flowed into real estate mutual funds between the end of September and early October, and inflows have been positive for 16 weeks.

Down, but not out

The rising fortune of office and apartment properties and the falling favor of malls mark a dramatic shift from the first half of the decade, when mall REITs reported annual total returns of less than 25% only twice. Moreover, mall REITs generated returns that blew by the rest of the non-retail REIT property classes between 2000 and 2005; depending on the year, the closest competitor lagged by a range of 21% to 200%.

But in their never-ending search for yield, investors may find a silver lining in the mall REIT sector's unspectacular performance this year. Analysts suggest that regional mall companies are now undervalued compared with other property sectors.

Fear of recession and a pullback in consumer spending, among other reasons, conspired to depress mall performance compared with other REIT sectors, wrote Citigroup Analyst Ambika Goel in a research note. “We believe the concerns have been overstated and have created a buying opportunity,” Goel stated.

Some fund managers are starting to share that opinion. “We were less bullish on the malls coming into the year,” says Lisa Lebow Kaufman, managing director at Chicago-based LaSalle Investment Management Securities, which manages some $7.3 billion in real estate assets. “But as they've underperformed [compared with other REIT sectors], they've looked more attractive to us, particularly in the last couple of months.”

So dubbing mall stocks as also-rans in the REIT sector this year may be a bit premature. Indeed, total returns of the beleaguered Mills Corp., based in Chevy Chase, Md., plummeted some 59% through three quarters this year after it announced it would have to restate earnings all the way back to 2000, which subsequently spurred a Securities and Exchange Commission investigation into the company.

The events have dragged down the entire mall sector: Sans Mills, mall REITs generated total returns of a none-too-shabby 15.6% through three quarters, according to SNL Financial. Like nearly all REIT property sectors, mall stocks as a group outperformed the S&P 500 Index, which posted a mediocre total return of 8.5% during the same period.

Victim of its own success

Still, the swoon in mall REIT performance is due in some measure to private equity's preference for offices, or at least any property but malls. Why not mall REITs? The portfolios are massive with largely stabilized operations, say experts, while private equity buyers are typically hunting for a value play — less stable properties with more upside. Plus, tenant relationships in the mall business are critical, which would require private equity buyers to keep management teams intact.

But fund managers are quick to point out that they'd hardly be surprised if the wave of private capital swept over a mall REIT or two, especially considering Mills' struggles and its apparent positioning for a sale. “To date — and I emphasize to date — we haven't seen a big mall privatization,” says Marc Halle, managing director of the Global Merchant Banking Group for Parsippany, N.J.-based Prudential Real Estate Investors, which has some $31.6 billion under management. “But you can't underestimate the strength of the capital that's coming into the market.”

Inevitable worries

But just how much longer will capital remain obsessed with real estate? Property experts and analysts certainly have mixed views. For years, they've seen estate investments as a defensive strategy against rising inflation, recession and ho-hum earnings in the broad market.

Yet many argue that a growing appetite for dividends and physical assets, particularly among persons headed into retirement, has transformed real estate into a more mainstream asset class.

Earlier this year, for example, it appeared that a recession was on the way. High energy prices, falling consumer spending and an uptick in interest rates through the spring and summer fueled those worries. Analysts feared that a slowing economy would ultimately hurt real estate fundamentals.

But perceptions abruptly changed. The cost of crude oil fell to less than $60 a barrel from $80 a barrel in only a few weeks in late summer and early fall. Even though many experts say job growth is slowing, some 6.6 million jobs have been created in the last three years. Moreover, in spite of the Federal Reserve Board's mixed messages regarding future interest rate hikes — or cuts — the 10-year Treasury yield has generally settled at around 4.8% since mid-August after floating above 5% in much of the spring and summer.

While real estate experts predict the healthy signs bode well for property investments, the worry now is that times might be too good. “Many are breathing a sigh of relief, as a recession appears less likely, and the slowdown now has the semblance of a pause that refreshes,” waxed Citigroup REIT Analyst Jonathan Litt in a recent report. “However, the sounding of an all-clear on the broad equity market could trigger a rally in large caps of another sector, resulting in an exodus of capital out of REITs.”

In fact, real estate experts acknowledge that the heady REIT performance must end. The question is when that will occur? “REITs are really into their seventh year of outperformance; it's staggering,” says SNL's Lindemann. “But I think everybody is a bit nervous about when the music stops. At some point, the broad market starts to outperform REITs, or REITs start to underperform the broad market.”

No let-up just yet

It's hard to fathom that the music will stop anytime soon, particularly as cash continues to flow into REIT funds. The rash of REIT privatizations also continues to drive REIT stock performance, says ING Clarion's Smith.

When private equity funds buy a REIT, they pay cash for the outstanding shares, including those owned by mutual funds. REIT fund managers take that cash and invest it right back into public property companies.

What's more, a lack of new real estate initial public offerings (IPOs) limits the pool of candidates for investment. Only three REITs have launched IPOs this year compared with 40 over the last two years, according to the National Association of Real Estate Investment Trusts in Washington, D.C.

Most recently, uber New York private equity fund Blackstone Group and New York-based Brookfield Properties, an office REIT, completed their $9 billion acquisition of Trizec Corp. The deal was priced at an 18% premium to Trizec's U.S. properties and a 30% premium to Trizec's Canadian real estate.

By paying such high prices, private buyers are essentially confirming the long-held argument that the public markets undervalue real estate. Thus, REIT fund managers are betting that there's more upside to come.

They believe REITs are trading at a discount to their net asset value, based upon the prices suitors are paying to merge and acquire portfolios. So while internal earnings growth remains one measure of valuation, REIT funds are placing more emphasis on NAV, Prudential's Halle says.

“We've seen significant privatizations of good quality office REITs, which has driven [stock price] performance in the sector,” Halle says. “There's a huge private market for office buildings.”

Acceleration at last

Much of the appeal of office properties stems from the anticipated accelerated occupancy and rent growth going forward. Smith says office REITs on average will fetch rent increases of about 3% annually for the next three to five years.

Those increases are comparable to the rent growth of malls and offices, depending on the market, but the office sector offers more upside, he adds. Why? Office landlords are experiencing positive rent growth for the first time in several years, and offices still have room for occupancy growth. Malls and apartments, however, have already experienced occupancy gains and are more dependent on rent increases alone for earnings growth.

Indeed, real estate research firm Reis reports that in the second quarter the office vacancy rate in the 80 markets it covers registered 13.2%. The apartment vacancy rate, meanwhile, registered 5.6% in the second quarter. Reis projects an increase of 6.3% in effective rents in the office sector this year, almost double the growth last year.

But recent merger and acquisition activity suggests that some property sectors are fully valued. At $70 a share, New Hyde Park, N.Y.-based retail REIT Kimco Realty Corp. isn't paying a premium to buy Pan Pacific Retail Properties, a San Diego-based shopping center REIT.

Australia's Centro Properties Group's $3.2 billion offer for Boston-based Heritage Property Investment Trust, another shopping center REIT, represents only a 3.3% premium.

“Pricing has gotten very high,” acknowledges Jahn Brodwin, a partner with the Schonbraun McCann Group, a New York-based real estate advisor. “Most retail REITs have done a very good job of squeezing out all of the cash flow they can.”

Mall rebound?

Now retail REITs are exploiting unconventional opportunities to drive growth, Brodwin adds. Among other strategies, they're buying distressed operating businesses simply for the real estate. Mall REITs are no exception. They've been acquiring department store locations from failed retailers adjacent to their malls, for example.

Subsequently, mall REITs such as Indianapolis-based Simon Property Group and Chicago-based General Growth Properties are adding lifestyle center-like additions to generate double-digit returns, says LaSalle Investment Management's Kaufman, who primarily studies mall and shopping center REITs.

In fact, REIT analysts maintain that mall stocks are a relatively cheap buy and have some upside. Merrill Lynch analysts, for example, suggest that mall REITs are trading at four percentage points below both the current and forward REIT industry NAV of 108% and 112%, respectively. Plus, an increase in consumer spending and consumer confidence in September indicate that shoppers aren't going to cancel mall trips.

It's no surprise, then, that fund managers are once again intrigued with malls after focusing more heavily on other property sectors for much of the year. Who knows, in the final furlongs of the 2006 REIT race, mall companies could once again find themselves in the money, neck and neck with the current leaders.

“We've participated in the office rally, and by no means is the play in office over,” says Prudential's Halle. “But the malls are becoming a lot more interesting.”

Joe Gose is a Kansas City-based writer.

REITs enjoy growing acceptance globally

The success of REITs in the U.S. is spreading abroad, driven by a hearty appetite among institutional investors for international properties. The market capitalization of international real estate stocks has doubled to $566 billion over the last two years, reports LaSalle Investment Management.

While Australia, Japan, France, and other Asian and European countries already have established REIT laws, U.S. investors are now focused on two of the biggest property markets in Europe: the United Kingdom and Germany. Competition and demand for real estate are driving a push to enact REIT laws, says Steve Burton, a managing director with ING Clarion Real Estate Securities.

“In Europe, if you want to invest in a public real estate company, there are only about five to choose from,” he says. The potential for a European REIT boom is enormous. Less than 4% of all institutional-quality properties are securitized on the continent, reports the Royal Institution of Chartered Surveyors in London, a U.K.-based international property consultancy.

U.K.'s new REIT law will go into effect Jan. 1, 2007, and some publicly traded real estate operating companies in the country have already announced their intention to convert to the trust structure. Among the converts are Hammerson, which owns 1.5 million square meters of office and retail space in Europe, and Slough Estates, which owns 4 million square meters of industrial, office and retail space.

U.K. real estate analysts predict the legislation will kick off a spate of mergers and acquisitions as large companies such as Land Securities, British Land and others buy up small public companies.

Meanwhile, Germany could pass new REIT legislation next year. Open-ended funds constitute the country's primary real estate ownership vehicle. But bribery scandals and declining real estate values in 2004 and 2005 led to a liquidity crisis within the industry and have helped expedite the creation of REIT laws.

In fact, Germany presents the biggest potential European property plum, investors say. The country makes up about one-third of continental Europe's economy, and open-ended funds own some $101 billion of commercial real estate. But the market has $158 billion in potential property securitizations, Burton says.

Germany's real estate climate is similar to the U.S. in the early 1990s on the eve of the modern REIT expansion, adds Marc Halle, managing director of the Global Merchant Banking Group at Prudential Real Estate Investors.

“Real estate in Germany today trades at a discount to net asset value and replacement cost,” Halle says. “We think that market can grow pretty dramatically.”
Joe Gose