Real Estate
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By Reitnut
April 8, 2002

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This past week I met with a number of financial planners and investment advisors in Dallas and Houston. Perhaps a review of some of our discussions might be interesting to many of you. I did this rather quickly, so I apologize in advance for grammatical and/or mis-spelling errors.

The knowledge of REITs among the group was quite varied. Some of them already used REITs in their clients' portfolios, while others were almost embarrassingly ignorant of them. But even those that used REITs were generally hesitant in their allocations, e.g., 3-5%, with a few going to (gulp!) 10%. The reasons for this can be summarized as (a) lack of knowledge of REITs and their investment characteristics, (b) being scared by REITs' poor investment performance in '98 and '99 (and sometimes by the horrors of the old real estate limited partnerships of the '70s) and (c) inertia from the Great Bull Markets in equities of the '90s, resulting in their desire not to admit their mistake in not having been well-diversified among asset classes. Many of the FPs and Advisors continued to pigeon-hole REITs as an "alternative asset class," which almost by definition makes it difficult to allocate more than 5% of client assets to REIT stocks.

I received lots of questions regarding the "priciness" of REIT stocks today. Those that owned them for their clients wondered whether they should "take something off the table" after their "glittering" performance of the past two years, while those who didn't yet own them wondered whether it was "too late" to jump in. I responded by politely suggesting that these were perhaps the wrong questions, and the "right" questions should be REITs' long-term performance potential and their other investment attributes. REIT stocks should be owned by those with a 5-10 year investment horizon and, over such a time period, there is no reason to believe that REITs would be incapable of delivering total returns in line with long time periods of the past, i.e., 10-12%. This is due to current dividend yields of approximately 6.5%, coupled with growth in free cash flow (i.e., AFFO) of 5-6% (assuming no long-term compression in P/AFFO multiples).

REITs can achieve this kind of AFFO growth merely by generating same-store NOI growth of 2.5% to 3%, levering that up (with 50% debt at fixed rates) to 4.5% and adding another 1-2% through the deployment of retained earnings (the typical REIT today retains about 20-25% of its free cash flow).

The issue then becomes multiple compression. I stated that I did not believe that REIT prices today are so expensive that multiple compressionitis should be expected, which would eliminate that 5-6% capital appreciation for a number of years. I provided statistics, courtesy of Merrill Lynch, that showed that, at worst, REITs were trading at the high end of their historical valuation bands, i.e., (a) NAV premiums, at 5-10%, are just a bit higher than they've been historically, (b) P/AFFO ratios, at just short of 12x, are not much higher than the average of about 11x, (c) AFFO yields of REITs (the inverse of the P/AFFO multiple) are in line with historical averages vs. other equities and bonds, and (d) that REIT dividend yield spreads are in line with what they've been vis-�-vis utilities and bonds. Furthermore, I noted, other asset classes are not exactly cheap today � especially if WEB and other experienced investors are correct in their contention that equity returns for the balance of the decade may not rise above 7%.

I concluded this part of the discussion by noting that no one can forecast the near-term price direction of any asset class, including REITs � which tend to march to their own drummer � but that I believe that, over a long time period, REITs have the wind at their backs due to the new (and hopefully long-lasting) appreciation for yield within diversified portfolios, coupled with stable cash flows and low price correlation with other asset classes. Eventually, as the Boomers retire, having REITs well-represented within broadly diversified investment portfolios will increase the portfolio yield and reduce the need for other portions of the portfolio to work hard to generate the kinds of returns that the Boomers need while withdrawing funds to meet retirement expenses. If one wants to withdraw 6% of his/her assets annually, not much price appreciation is required if the entire portfolio yields 4%.

We also talked a lot about the "disconnect" between today's difficult RE markets and the performance of REIT shares. I readily acknowledged that real estate occupancy and rental rates were declining in the office, industrial and apartment sectors, and that even retail is facing some serious challenges. These factors are making for a very low AFFO growth rate this year. However, I suggested that, assuming we DO get an economic recovery, some time next year (or early the following year), a declining supply of new space will intersect with rising demand, returning most real estate markets to equilibrium. This will cause REITs' growth rates to recover back to a long-term secular growth rate of 5-6% (and higher for some of them), an event which investors now seem to be discounting.

There is also the possibility that real estate may be re-priced upwards vis-�-vis other equities, particularly if interest rates remain low and EPS growth rates delivered by Corporate America remain stuck in the 6-8% range, and that the REIT market may be discounting that. In any event, REIT stocks declined in '98 and '99 despite very strong real estate fundamentals; now they are rising during a period of real estate weakness. As REITs are still equities, we should expect this apparent contradiction to occur frequently.

My general thoughts as my flight on America West returned me to California? Perhaps I'm misleading myself, but I detected substantial interest among the persons I spoke with in increasing their clients' allocations to REIT shares. They will, hopefully, learn a lot more about REITs, including their strengths and weakness. And, also hopefully, they will act deliberately, not in haste. It is only when we understand the investment characteristics of an asset class that we will have the confidence to buy when prices decline, and to take all such price declines in stride as part of the investment process.

What I want most is for the financial planners and investment advisors NOT to buy shares because of (a) high dividend yields, i.e., as a "parking place," or shelter against low yields on CDs or short-term bonds, or (b) they've been acting well, but rather to make a long-term commitment to REITs as part of their clients' diversified portfolios for all the reasons that REITs make good financial sense: current yield, stable cash flows, excellent long-term total returns, low correlation with other asset classes and, perhaps, a hedge against inflation. While the direction of REIT prices will ebb and flow over the short term, I know of no reason why they won't ultimately perform in line with their double-digit historical averages � as long as businesses need space in which to house their employees and to store produce, and as individuals need a place to live, shop and play.


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