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Subject:  NAREIT Conference Date:  6/9/2002  9:12 PM
Author:  Reitnut Number:  13820 of 86793

I can provide only an incomplete view of the goings on at the NAREIT Institutional Investor conference in New York on June 3-5, as I spent lots of time in meetings with REIT executives (and had to leave early for a “marketing” trip) and thus didn't attend several of the industry-wide panel discussions. But, hopefully, the following will provide some flavor. And please forgive the length of this post; it turned out to be a lot longer than I anticipated when I began to draft it.

The first sessions were on the morning of June 3. Robert Arnott, of First Quadrant, led off. For want of a better description, he can be labeled a “bear” on equities. He provided, in a series of charts and graphs, information that leads one to believe that, historically, returns from stocks generally do not exceed the dividend yield plus growth in GDP. I didn't take notes, so cannot provide specifics, but recall that his view is that, particularly given today's skimpy dividend yields, investors will be fortunate to generate returns on equities that will exceed the mid-single digit range for the next several years.

Interestingly, and contrary to conventional wisdom, he provided data showing that returns on stocks with high dividend payout ratios tend to outperform stocks with low payout ratios. The reason? He guessed that having to focus scarce resources on a limited number of opportunities provides higher returns on investment capital, and thus adds the greatest amount of value for shareholders. (Music to my ears!) Mr. Arnott supports WEB's widely-discussed belief that equity returns of 7% annually over the next 5-10 years would be the best that investors could hope for. Mr. Arnott felt that real estate was one of the few asset classes that were not overvalued at the present time.

Mr. Arnott was followed by the widely acclaimed academic, Jeremy Siegel. Mr. Siegel provided a chart that showed that, commencing in 1871, stocks rotated around an average P/E multiple of 14.6x. Today that ratio exceeds 20x. Unlike some of the bears, however, Mr. Siegel does not believe that stocks will fall back to a level of 15-17x earnings. He noted that the bulls believe that today's very low interest rates and low inflation levels justify an average market multiple of 20x. While he agrees with this conclusion, he also noted that the low level of inflation “curtails” future revenue growth (and thus earnings growth). Mr. S also believes that several factors other than rapid earnings growth argue in favor of higher multiples, i.e., lower macroeconomic risk (avoiding depressions and high rates of inflation, and greater stability of “labor income”), a lower effective tax on capital gains and lower transaction costs. Thus he concluded that the new “long-term equilibrium” P/E ratio would be in the low 20s, about where it is today.

Nevertheless, Mr. Siegel stated that today's “secular” higher valuations translate into lower future stock returns, i.e., there is no “free lunch” in the investment world. Thus he forecasts that annual REAL stock market returns over the next 5-10 years will be in the neighborhood of 5-7%, putting him in the camp of WEB. He supported this with a chart showing that total real returns from stocks during most periods are in the 6-7% zone. Even in the “modern era” of 1946 to 2001, they were 7.1% (and this included a period during which dividend yields averaged 3.8%).

He then provided information to show that the “mean forward-looking, before tax, real return on stocks has been 6% annually (a real return of 5.5% after taxes, assuming no sale of any stocks held). He also showed that the mean REIT dividend yield going back to 1972 hasn't changed much at all (between 7-8%), while the mean yield on the S&P 500 has steadily declined during that period. He also believes that the current dividend yield on REITs, at about 6.3%, is a conservative estimate of “forward looking real returns.”

I've gone on much too long with Mr. Siegel. So, to conclude, he believes that “dissatisfaction with large stocks and bonds are leading many investors to search for asset classes with potential returns” in excess of 10%. He said that many of these, including small caps, hedge funds, venture capital, etc., are too small to absorb huge fund flows and may create an investment bubble. However, “real estate (and perhaps international stocks) is the only significant asset classes large enough to absorb significant fund flows.” Finally, he concludes, “REITs are an attractive asset class” under present market conditions.

I was asked to do a presentation to the NAREIT conference, which I delivered following Mr. Siegel's presentation. My topic was on “The REIT Industry Today, and How to Invest in REIT Stocks.” While those of you who come to the Board often are familiar with my views on this subject (and probably provides little new information to any of you), I will be happy to send you my PowerPoint presentation if you will send me an e-mail requesting such.

Another presentation followed, this consisting of a series of presentations on the various sectors that make up the REIT world. Speakers included James Kammert (Goldman Sachs), Matt Ostrower (Morgan Stanley), Lou Taylor (Deutche Banc), Larry Raiman (Credit Suisse) and one other guy whose name, unfortunately, escapes me. Each of them talked about a specific sector. Time doesn't permit me much elaboration, but here are a few quick notes:

Jim Kammert talked about apartments. Vacancy was 6% in '90, but fell to 3-4% for the period from '90 through '00, then rising to 6% now. Rents have also fallen, but Reis forecasts a return to 2-3% positive rent growth over the next few years as supply abates, falling to below 2% of existing stock. His firm expects apartment REIT FFO growth to return to 5-7%, beginning in '03.

Matt Ostrower discussed the retail sector. He explained why mall REITs have outperformed over the past 2 years: They were ignored for a couple of years, and are now becoming more appreciated; the lifting of the threat of e-commerce; more stable FFOs than other real estate sectors; and the fundamentals are better than most investors expected, i.e., unlike other sectors, estimates have not been revised downward. And occupancy trends are stable, unlike other sectors, while they have less exposure to tenant problems than other retail owners. Finally, malls REITs tend to use more variable rate debt, which has boosted FFO growth. However, the firm is less bullish on strip center REITs, due to tenant credit issues, i.e., K-Mart, Service Merchandise, et al. Also, they feel that there may be a surplus of “big box” space. Finally, there is more of a risk from “super-center” competitors such as Wal-Mart and Target.

Lou Taylor covered the office and industrial sectors. He says tenants took 2x the space they actually needed in the late '90s, and the late recession has really hurt office owners. Negative absorption has continued for 5 straight quarters, and vacancy rates have been rising by one basis point per day. But new supply is abating; it's now 2.9% of existing stock (vs. 4% in Q3 of '02). He expects vacancy rates to peak at 17% in mid-2003, and thus no improvement for office owners until late '03. DC and NY are holding up best, while Dallas, Austin and the Bay Area are among the hardest hit. He recommends that investors look for office REITs with low lease expirations and good tenant credits, e.g., BXP and SLG. He expects little in the way of acquisition activity due to stubbornly low cap rates. His firm is most worried about falling rents, which will continue thru '02 and may put '03 FFO estimates in jeopardy. He expects the next 18 months to remain tough, but likes BXP, SLG, RA and the Southern California office REITs, e.g., ARI and KRC.

Finally, Taylor stated that industrial REITs were better situated to weather the storm. They are not in as good a shape as mall REITs, but not as bad off as the office sector. Vacancy was 10.7% at the end of last year, but doesn't expect a lot more deterioration. New supply has been cut back to just 0.9% of existing stock. Rents have fallen, but not by much, i.e., 2.7% last year and 1.1% so far this year. Same-store NOI growth is holding up OK, at 1.1%. But, he says, we need better job growth to get conditions to improve meaningfully.

Arggh…I really am trying your patience with this very long post. So I'll try to be briefer in describing a panel discussion later in the day, hosted by Anthony Manno of Security Capital Group, and attended by Bruce Duncan (EOP), Jon Litt (SSB), Jon Fosheim (Green Street), John Olert (Fitch), Michael Pralle (GE Capital RE) and Mark Streeter (JP Morgan Chase). A few quotes follow:

Litt: RE markets are tough, but probably won't get worse. Investors are seeking yield, stability and shelter; yet, ironically, Wall Street is negative on the REIT industry. REITs are fairly valued today, and he won't get concerned unless/until REIT stocks trade at NAV premiums above 10%.

Fosheim: Paraphrasing Churchill, he suggest, perhaps tongue only partially in cheek, that “REITs and real estate are the world's worst investment – except for everything else.” Since real estate cap rates remain at 8.5%, they have a real leg up on the broader world of equities which is expected to deliver returns of just 7% if WEB is right. Real estate has been mis-priced, but now is correcting itself. On another topic, Fosheim stated that NAVs are forward-looking as they reflect investors' fears, expectations and desires… companies who cannot create extra shareholder value should trade at discounts, and vice-versa. He worries that if today's low cap rates persist, or get lower, it could spur additional real estate development (this is a worry that I share, but it probably would be most pronounced mainly in the apartment sector where development lead times are short, and new product fills rather quickly – with enough concessions).

Olert: There was a massive outflow of capital from real estate, but is now coming back. People are looking for things they can understand. RE markets aren't rosy, but they look good vs. other sectors.

Streeter: The debt market for RE is hot right now. If earnings bottom out near present levels, market conditions are manageable. Bond spreads on RE and REITs are tight, particularly given what's going on in the non-investment grade sectors of the bond market. Camden recently priced a sub-6% bond deal on a 5-yr maturity. RE provides a core level of earnings where cash flow is almost locked in due to long-term leases. On management: Is it a one-man shop, or is the REIT an organization? This is important [to the bond rating agencies]. We also, of course, look at cash flows when looking at bond ratings, including income from non-real estate businesses. We look for cash flow stability.

Pralle: REIT NAVs are definitely relevant, but at GE Capital we look at other issues as well, including the nature of the business, cash flows and cash flow growth. NAV is significant for us, but doesn't drive our investment decisions.

Well, I've gone on for far too long, but hope that a bit of this is useful, and maybe provides a brief flavor for some of what went on in NY last week. Perhaps others who were there can share their thoughts as well. A final point: Yes, it is possible that all this optimism is a “sign of a top” in the REIT and RE markets; however, sometimes trends last a lot longer than we expect, and thus more funds may flow into these asset classes if investors continue to be fearful that they won't generate their required returns on a broad assortment of equities in the years ahead. A huge number of pension funds are using actuarial assumptions that require 9%+ returns; if they are afraid of not getting them on equities, they may decide to allocate more of their assets to real estate (and, perhaps, even REIT stocks). We live in interesting times.


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