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EOP? A no Brainer?

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By Reitnut
August 19, 2002

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Jeez, I didn't think it had been THAT long since I'd been here, but I found that it's taken me almost 4 hours this morning just to try to catch up, and I haven't written a single post yet. What a great place -- and magnificent forum for REIT education -- this Board is!

First, just a brief comment from my point of view, having just left the battles of Earnings Season. It's a very tough world out there in commercial real estate, which certainly comes as no surprise to any of you -- although the magnitude of the decline in demand for space has been surprising to just about everyone. To use a rather graphic remark, we are still "groping for a bottom" in most real estate sectors other than retail, which continues to hold up well (though some worry a lot about the slide in the consumer confidence figures and what they might portend). About the only good news from Q2 is that the rate of negative change seems to be abating. We really could use more capital spending by businesses and, even more important, a pick-up in job growth.

Apartment and office owners are in particularly tough shape; the signs of damage are more VISIBLE in the former sector, as leases are priced every 6 or 12 months, and occupancy rates are more fluid, but there's a lot of damage going on in the office sector that's not yet reflected in operating results due to long-term leases (but even now we are seeing signs of rent roll-downs). Concessions are oozing out of every pore, and Jim Luckett is right that there's a lot of "shadow" office space that's available and will discourage users from taking on more space for quite some time.

We won't be building much new office space for a long while (though they said that in '92, and the excess space then was absorbed a lot faster than anyone expected). The apartment owners' plight is particularly troubling, as single-family housing has remained very strong (driven by low interest rates and "momentum home investing") and low cap rates that are encouraging merchant builders to build even during these very, very weak market conditions. And, of course, poor job growth is a direct negative for apartment owners.

So why are REIT stock prices holding up pretty well? While way off their peaks in April, they're up substantially from the lows of late July. The possible reasons for this are suggested in REITWEEK, though of course this is merely a guess. Yield is still very, very attractive to today's investors, and REITs remain the only equity team playing in that league these days (along with a few odd-looking creatures such as master limited partnerships, etc).

Too, at the moment equity investors appear to be looking for an economic recovery next year (remember that equities markets look 6-8 months ahead), and such would very much benefit real estate owners as well as growth stock investors. Finally, I also believe that the REIT Story continues to unfold, and the attractiveness of adding REITs to a diversified investment portfolio continues to gain adherents -- despite the flat earnings growth for REITs this year and even into next.

Of course, there are risks that REIT investors face, and I think the largest is the nature of the economy; another recession wouldn't be pretty for REIT share prices, and could touch off a wave of dividend cuts (though that depends upon the depth of a second recession, if any). Also, a STRONG economic rebound could cause a large sell-off in REIT shares, even as REIT earnings growth accelerates; I have no empirical data, but I am quite sure that a lot of money has been tossed at REITs by momentum investors or others just looking for a "port in a storm," and they have shown us last month that they are not shy about pulling out in a big hurry, w/o so much as a "by your leave" (to use a great Klingon quotation). I personally think we will see a MODEST economic recovery which, I would argue, helps REIT shares the most -- but of course I am no better at forecasting the economy than anyone else.

Before I end this overly long post (even by my verbose standards), let me respond quickly to a Jim Luckett comment:

<<EOP is one of my largest holdings. As of the last time Ralph's fund updated its list of top-10 holdings, EOP was #2 on that list.>>

Today it still is in our top-10 holdings list, with a 5% weighting (though this is below EOP's weighting in the RMS index). But it is no longer #2; it is currently our 7th largest position. To put it simply, we still like this REIT and its long-term total return prospects (I agree with tjberk's excellent post on the importance of total return REIT investing), but we think it's only mildly cheap at the moment, given the current uncertainties and risks in the office sector (and EOP's substantial holdings in the Bay Area and the NW) and other factors (its strengths, of course, are well-known and well-summarized by Jim in his post). The stock sells at around Green Street's estimated NAV of $27, whereas our current valuation models come up with a warranted valuation that approximates a 3% NAV premium.

Ralph


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