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Real Estate Inv. Trusts: REITs
Re: Somewhat bothered and bewildered am I

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By RDonohue
December 3, 2004

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Norm:

I think that you are exactly correct, when you say, "no one is going to be able to give us the answer to the big question--when to lighten and heavy up (long term), or when to leave (short term.)"

There are several reasons for that, including the fact that there are different answers for different investors. There is always some kind of Pareto-optimal world in which one exits at the top, re-enters at the bottom and figures out a way to do these things that minimizes taxes. I do not think that world exists. For most people, the relevant question is "given my circumstances, what should I do?"

I also do not have a ton of confidence in efficient markets, particularly in terms of the capital market. The space market is a competitive market, and probably comes a lot closer to a perfect market that does the capital market. I posted earlier this year about my decision (and that of my firm) to lighten our portfolio. We did so prior to the temporary correction in the spring, and we bought our REITs back at lower prices. We did not sell at the top, and we did not buy at the bottom, but we did sell at levels that provided a good return, better than we would have had barring our actions. Note that I work for a foundation, so the tax issue was largely moot. I do not delude myself into thinking that we did so through any particular skill or market knowledge. I looked at that decision as a combination of a calculated bet and luck, particularly as to timing. We rolled the dice, and it worked out.

In the intervening months, I have changed our approach to REIT investing, at least short term. We still only invest in REITs that we would be comfortable holding for a very long time at their current dividend. However, we have seen increased volatility in pricing for most of the REITs we follow. As a result, we have bought on dips and sold on spikes. We are not trading daily, but certainly more frequently than we had historically (long term buy and hold types). This is not a strategy that works for everyone. It really only works if you are willing to hold onto the stocks you buy for a long time (assuming current dividend) or if you are willing to take the risk of missing out on some dividends. The big risk for us is not on the downside, as we are in a position where we do not have to sell in a down market. The big risk is that we unload our REITs, take our gains, and prices continue to rise, making it difficult for us to re-deploy our capital. We typically look for a year or two worth of dividends in gains prior to making a trade in our long-term holdings. This gives us a cushion for the REIT to return to a level that we believe to be sustainable over a long period of time.

The result is that we miss out on some very fine companies that have traditionally traded at a substantial premium to what we believe to be an appropriate long-term price. Many of these companies will continue to trade at these premiums for an extended period of time and may result in greater total returns. However, this is a function of the particular investment goal for our portfolio, which is focused on current income and realized gains. In my personal portfolio, I have positions in some of these companies, and I have no intention of reducing those positions unless those companies change the way they do business, such that I am no longer comfortable with the investment.

So, we are now at the point where I am considering lightening up the Institute portfolio in anticipation of a price drop. I do not feel as strongly about doing so as I did earlier in the year, largely because I feel that space market conditions are improving, reducing the risk in current pricing. My guess is that we will end up selectively pruning our holdings, reducing our positions in lesser quality companies (we own a few) and upgrading on a price drop. If the price drop does not come, then I have to make sure that we can operate our business on the gains taken through the pruning process. So, it is a delicate balance that many of you are experiencing as well.

I do not know where rates are going to go. I suspect up, and have taken steps in other aspects of my professional work (Real estate asset management) that reflect that expectation (locking in rates long-term). I am perfectly content to hold on to what I own personally, because I bought those stocks for a different reason than my company bought its positions. I suspect that REIT pricing will be impacted more by capital market issues in the short term, and more by real estate space market issues in the long term.

We are going to make the bet on price drops, but we intend to do so selectively, and spread the bet over time. I am in no rush, because I do not see any impetus to drive prices dramatically one way or the other. I expect REIT pricing to move sideways for the most part, with modest downturns and up ticks. There is no heroism in this projection; it reflects what REITs have done through most of the Modern REIT Era.

I keep hearing about fund flows, which are fun to talk about conceptually, but very hard to measure. In my confused little world, I think of fund flows as the result of investment decisions made by investors based on their judgment about the future. That judgment, whether drawn from technical analysis, real estate analysis or reading tea leaves, can be referred to in the collective sense as investor sentiment. I do not think we have a good handle on investor sentiment, but many secretly (or perhaps openly) think it tells a more convincing story than the Efficient Market Hypothesis.

So, my guess is that the short-term price volatility for REITs is going to be larger than we have experienced for some time. But, with volatility, there are opportunities. So, the big question is one that each person will need to answer for their own portfolio and circumstance.

The one thing I can promise is that nobody, not me, not Ralph, not the analysts can tell any other investor what is right for them. All we can do is share information about how we see the world, and how we think the world might act in the future based on what we see as a logical chain of events. As you well know, the question becomes which story you find most convincing and what investment decisions you need to make based on your individual circumstances. For many of you, I think the answer is a function of comfort, and which decision will let you sleep at night. If you can live off the dividends and do so happily, let it go and enjoy the season. If you are not wired that way, then change your portfolio in a way that works for you.

FWIW,

Ron


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