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No. of Recommendations: 61
I feel bad not having been to the Board since January 3. In my defense, my wife and I took a 10-day vacation beginning Jan 5 (a cruise to Mexico), and got back Jan 15. Since then, it's been pretty much all catch-up... and now, my youngest son and his computer guru buddy are on their way here this morning to install a new computer in my office (my old one was bought in 2000). So, even if all goes well, I will be off-line for at least a day. Prayer to the computer gods: And, please, let all go well!

Anyway, in a lame effort to make amends, I am posting the next issue of The Essential REIT before it goes out to the public on Monday or Tuesday. So, should anyone care, you saw it here first. :-)


“The Essential REIT”
January 24, 2005

“Writing does for me what giving milk does for a cow.” -- H.L. Mencken

“Writing is not necessarily something to be ashamed of, but do it in private and wash your hands afterwards” -- Robert Heinlein

“Writing is like prostitution. First one writes for the love of doing it, then for a few friends, and, in the end, for the money.” – Moliere

1. Mugged on the Way to the Country Club.

Perhaps we can compare REITs' stock price performance during the first half of January to that of a confident company executive who's been making all the right moves, on her way to the country club early one morning – only to be painfully mugged by an ugly bloke hiding in the bushes. REITs could do no wrong last year, scoring a total return, per the NAREIT Equity REIT index, of +31.6%; and that's not a rebound from an oversold 2003. That year the total return was +37.1% (notice the “+” sign in front of both figures).

So it's natural that REIT investors might have been a bit careless as they waltzed into 2005 (although, thanks to David Shulman and others of a similar mind-set, I don't think “cocky” is a label that fits). And the stocks were certainly subject to early-year selling pressure, if for no other reason than all those huge paper profits were driving some investors nuts – and felt as they “had” to sell (or, more intelligently, lighten up). These guys might have included individual investors, but more likely consisted of non-REIT dedicated equity funds. And, of course, who can criticize investors for rebalancing their REIT allocations after two glorious years? Finally, we Reitsters are no longer in Kansas, and must deal with the increased volatility brought to our world by wider recognition of REIT stocks and by the new ETFs, which can telescope what might be a two-week sell-off into two trading days.

And that, indeed, is what I think has been happening. Since becoming a fan of Colombo, Sherlock Holmes and P.D. James many years ago, I tend not to believe in coincidences. And so, I submit, it was no coincidence that REIT stocks began to decline from the moment we flipped our calendars to January. Indeed, from the end of 2004 through January 5 (only three trading days), the RMS had been chopped by 6.2%. The stocks drifted even lower, hitting their nadir on January 12, at which point the RMS had been trashed by 7.4%; they then staged a modest comeback, rising for the next four trading days before running out of gas late last week. As of Friday's close (January 21), the RMS and NAREIT Equity REIT indices were down for the year by 5.26% and __%, disrespectively.

I learned years ago that watching week to week stock price movements can be as productive as trying to figure out how to stop Sammy from lifting his leg on neighborhood “No Parking” signs. However, my impression, as I write this paragraph on January 21, is that the early '05 REIT swoon consists of sound and fury, signifying not much of anything other than a lightening up by cautious REIT investors after two glorious years. This conclusion is bolstered by the fact that some of the best performers of last year, e.g., Avalon Bay, have been hit hardest early this year.

So, except for traders caught on the wrong side of the tracks, this year's mugging has been healthy and productive (though not particularly enjoyable); it has destroyed any incipient feelings of invincibility and hubris amongst us REITsters, provided us with better values and entry yields, and taken a lot of pressure off the “overvaluation” issue. It would be nice if REIT stocks would just back and fill for several weeks – but I suppose that's too much to ask for, huh?

2. REIT Portfolio Management: To Thyne Own Objective be True.

Many, perhaps even most, people who own REIT stocks might own only 2 or 3 of them. After all, there are still lots of unbenighted investors out there who have allocated a puny 5% of their assets to REIT stocks (my apologies to those of you who I've offended), and so a 2% position in each of three REITs gets them there. The following discussion, however, is addressed to the REIT diehards, i.e., those who have a significant allocation to REITs, perhaps owning 10, 20, or 30 REIT stocks, and have sometimes wondered about the strategies of REIT portfolio management.

First, a caveat. This is not a topic that one sees discussed regularly in Money magazine or the financial press; portfolio management tends to be the proprietary territory of the academic types, and most articles on the subject are apt to be filled with more arcane and incomprehensible formulae than what we might find on the blackboard at an M.I.T. post-graduate seminar on string theory. The good news is that I went to law school, not business school, so the following discussion will be notably devoid of higher mathematics (or even lower mathematics, for that matter). The bad news is that it offers no practical tips or 5-step programs for immediate weight loss (er, portfolio management).

All right, enough temporizing. First, let's clarify something. Not all REIT organizations are created equal, nor are they equal. They each own different assets in different locations, have very different business strategies, and the quality and depth of their management teams differ substantially. Some have strong and conservative balance sheets, while others don't mind “betting 'em high and (possibly) sleeping in the streets.” Some are very clean and are good corporate citizens, while others have so many conflicts of interest as to make the management of Krispy Kreme Donuts blush. Perhaps all classical music sounds the same to the uninitiated, but connoisseurs certainly know the difference between Schubert and Shoenberg.

These issues, as well as the relative valuations of REIT stocks (Centerpoint is a great company, but its stock trades at a rich price), make the risk profile of one REIT stock quite different from that of another. So, to think of REITs as one might think of regional bank stocks – “who cares which one you own?” – is a big mistake. Risk profiles do count in REIT investing and, over time, will certainly affect performance and volatility. Think of it this way: If you want to invest in the “energy” sector, how do you stock your portfolio? The integrated majors, e.g., Chevron, Exxon, et al? Small E&P companies? Drillers? Natural gas pipelines? MLPs? Do you look for oil, or gas? Do you focus on big reserves in “exciting” places such as Algeria, or are you more comfortable in the Williston Basin? Your answers will, of course, affect your porfolio performance and risk profile.

It's the same with REITs. REIT portfolio management, I believe, should be driven by one's investment objective. Is it getting the best possible performance, risk be damned? To just beat the benchmark by 100 bps annually? To be a closet indexer? How important is risk – not just volatility, but the prospects of a permanent decline in portfolio values due to some REIT stepping into something very unpleasant, or a management team blowing it? Is volatility important? High dividend yields? Maximizing after-tax returns? We have learned long ago that there is no free lunch in the wacky and wicked world of investing, and there's a price to be paid for everything, including safety. So let's take a closer look at some possible objectives.

a. Beating Benchmarks and Risk Management. We all want to beat the benchmarks, right? For those who get paid to manage portfolios, it's our raison d'etre – and justifies our fees. For those managing portfolios on their own, superior performance gratifies the ol' ego. But we often don't focus too much on what's required to beat the benchmark – especially if we want to smash it to bits, a la (at times) Ken Heebner. Let's admit it; while the REIT industry has expanded by over 20x since the end of 1992 (and had an equity market cap of $307.9 billion at the end of last year), it's still a somewhat small industry and our investment choices aren't wide and deep, particularly when liquidity is an issue. And there are lots of new investors grazing in Reitland, some of whom are surprisingly intelligent. Companies now regularly issue guidance, and most FFO/AFFO estimates out on the Street are very similar; beating, or failing to meet, consensus numbers by more than a few pennies is only a bit more common than seeing pigs fly.

So, it's very competitive out there. A select few may be able to beat the benchmark somewhat regularly by simply being skilled and conservative stock-pickers – but they won't beat the index by more than, say, 100 bps a year. On the other hand, trashing the benchmark by 300-400 basis points requires one to embrace risk as one would embrace a cold lager after a 10-mile hike. So, let's assume that a portfolio manager wants to kick some serious butt; how should he manage an all-REIT portfolio?

There are lots of ways, including (a) active trading, seeking to scrape or claw an extra 2% here and 3% there, albeit at the cost of high portfolio turnover; (b) heavily overweighting or underweighting specific real estate sectors – REIT industry performance can vary widely by sector from year to year (even quarter to quarter), and finding oneself greatly overweighted in a strongly-performing sector can do wonders for performance; (c) ditto for specific companies, particularly if they are not heavily represented in the benchmark, e.g., taking 6% positions in, say, Cedar Shopping Centers, Feldman Mall Properties and Mission West can put us well ahead of – or way behind – the benchmark. Heck, we can even “cheat” a bit by owning non-REIT stocks such as Brookfield, St. Joe and Starwood. Or perhaps IHOP?

Risk comes in various shapes and sizes, and can be increased or decreased in ways other than overweighting or underweighting sectors or stocks, or indulging in heavy trading. Some sectors are inherently more risky than others; the cash flows of hotel REITs, for example, are only slightly more predictable than the same-store performance of Wet Seal or Hot Topic. And, of course, risk differs substantially by company. While nobody can say whether there is more exposure to a short-term stock price decline in Crescent Real Estate or in Boston Properties, there is little doubt that the former is simply a riskier company to own – and not just because of stock price volatility.

Differences in company-specific risk are due to a number of factors, including management strategies (how risky is the strategy, and how much capital is being devoted to it?), stability and predictability of cash flow streams from real estate (and real estate-related businesses), and the extent of development risk and overseas investment risk. How reliable has management – and its forecasts – been in prior quarters? Are they likely to foul something up? And, of course, some balance sheets are simply riskier than others – due to high amounts of debt leverage, substantial variable-rate debt and/or near-term debt maturities. Liquidity in REIT shares can also become an issue, particularly if the company disappoints. The bottom line here is that one might generate better near-term performance from a portfolio chock full of Mission West, Crescent, and Meristar Hospitality, but it's going to be a riskier portfolio than one filled with Kimco, Equity Residential and Boston Properties. So let's not kid ourselves: Performance is wonderful, but it comes at a price.

b. Reducing Volatility. If low volatility is our objective, there are some things we can do. One obvious approach is to focus heavily upon low-beta stocks; these beta figures are available from various sources, although I confess to paying little attention to them. Yesterdays' high-beta equity may become tomorrow's sleeping dog, and vice-versa. Several other tools can perhaps be more important and effective than beta in reducing portfolio volatility. Let's look at a few of them:

One obvious tactic is increasing cash levels. Nobody's going to call you a wimp for keeping cash at 5-8%, and doing so will certainly reduce volatility (though it will, of course, punish you in a bull market). Another is to make sure that positions aren't concentrated, i.e., don't put more than 3% of your assets into any single position. Again, this may entail a cost in performance if you are right about your stock picks, but volatility will be reduced. It will also be advisable to spread one's investments out over many sectors of real estate, as this will tend to even out daily and weekly performance.

I would be remiss if I didn't suggest that risk and volatility tend to be joined at the hip, and that riskier stocks will usually be more volatile. If this is so, focus on the safer companies in Reitdom – from the perspectives of management quality, business strategies, development risk, cash flow predictability and stability, balance sheet strength, share liquidity, dividend coverage, and other issues that can affect a REIT's stock price level 12 months later. Shares of companies like Kimco, Simon and, again, Boston Properties are likely to be less volatile due to their company characteristics and the ability of mangement to deliver on their forecasts and promises. So, if low volatility is your game, load up on the stalwarts.

c. Maximizing After-tax Returns. Many smart financial planners continue to remind us that what we keep, after tithing to Uncle Sam and our state government coffers, is what really counts. We may make $10,000 on a successful short-term trade, but in California and many other states we're lucky to keep $6,000 of that and will need to earn a 66.6% return on any new substitute investment just to get back to where we were in terms of net worth. Of course, many investors own REITs in IRAs and 401k plans, so their mantra will be, “We don't need no stinkin' tax planning.” Fine. But others do need to think about their taxes, perhaps even more in REIT investing than elsewhere.

Why? Think about it this way. Even long-term capital gains are often taxed at 30% (not 15%), when state taxes and AMT phase-outs are tossed into the equation. Can another REIT bought with the proceeds of a REIT we sold generate enough capital appreciation to make us whole within a year or two? Not likely – not when we should expect only 4-6% in capital appreciation annually on the typical REIT stock. So, those of us who invest in REIT stocks with personal funds need to think seriously about taxes and tax bills resulting from taking profits.

Fortunately, REITs are not as inclined to self-destruct as, say, a tech or Internet stock (“children, can you say E-Bay?”). It's highly unusual for a REIT to miss consensus estimates badly, and REIT assets seldom melt away like obsolete semiconductor inventory. Most REITs' cash flows are protected by long-term leases. So, it's not going to kill us to hold onto a REIT that has a big built-in capital gain that we would otherwise like to sell to take advantage of some other “screaming” bargain in Reitville. The best strategy, therefore, for those who want to keep capital gain taxes to a minimum is to resist the temptation to sell or pare back every time a stock looks expensive or the risk profile increases modestly. Own only those REIT stocks you'd be happy to own three years from now. And be careful of REIT mutual funds; most of them are driven by performance pressures, and their portfolio managers care as much about taxes as Sammy cares about Brad Pitt's divorce.

d. Investing for Yield. Many believe that Yield is the name of the game in REIT investing. And who can blame 'em? Historically 2/3 of the total returns from REIT investing have come from the dividend yield alone (although this percentage has been drifting lower in recent years, and my own assumption is that about half of REITs' total returns will come from the yield in future). There are many Reitsters who profess, “Hey, capital appreciation is nice, but I'll be perfectly content if my REITs provide me with a steady dividend, with occasional increases as circumstances warrant.”

And let's be honest. Even if Yield isn't one's only criteria in selecting REIT stocks, it remains an important consideration for most investors. Should a REIT investor focus only on yield? Of course not. But should he or she pay attention to yield? You betcha. Yield is certainly one of the distinguishing factors setting REIT stocks apart from their cousins in the broader world of equities, and a Chevron Texaco, clad in a 3% dividend yield taxed at lower rates, will be a formidable competitor to REITs with a similar yield.

But how should Mr. Yield Hog structure his portfolio? As I noted some time ago in a different context, “Here there be dragons.” As many investors have learned to their eternal sorrow, a yield that looks too good to be true usually isn't. But just as it's a truism that even though you may be paranoid doesn't mean that others aren't out to get you, even though you may have a jones for yield doesn't mean that you cannot invest in REITs successfully. Some of my best friends in Reitdom bear higher than average dividend yields, and I cheerfully own them, e.g., Nationwide Health and Prentiss Properties.

Of course, the “no free lunch” principle means that we must make certain sacrifices when we focus heavily on yield. Growth rates of higher-yielding REITs are apt to be lower; this is for at least two reasons. First, a higher dividend yield resulting from a REIT paying out close to, or more than, 100% of free cash flow means that less retained earnings can be invested for future cash flow growth (and companies that pay more in dividends than provided by free cash flows are liquidating themselves unless then can continually sell assets at great prices and replace them with new developments at positive spreads). Second, generally a higher yield is an indication that “the market” is less than impressed with prospective future growth prospects, and so demands that the current yield be high enough to offset this perceived sluggish growth, e.g., Prentiss Properties.

Another trade-off is higher risk. If a REIT is perceived as having sharp teeth and being unpredictable, e.g., Crescent Real Estate, investors will often price its shares to bear a higher current dividend yield so that they will be compensated for the heightened risk. Other examples include a number of mortgage REITs. Historically, some of the highest yields in Reitdom have been attached to shares that you would neither buy for your grandmother, nor take home to Mother. I won't name names; you know who they are, and some of these lounge lizards can be unusually slimy and untrustworthy.

The bottom line here is that there are good reasons why SL Green yields 3.9% and Crescent yields 8.6%. But those who work hard, study management teams and balance sheets, and have a firm handle on the risks presented by some higher-yielding REIT stocks can build a pretty good portfolio with them. And, of course, they will probably want to add a component consisting of fairly safe, higher-yielding REIT preferreds – although with these one normally gives up all opportunity for capital appreciation.

e. Personal REIT Investment Strategy. What's my personal REIT investment strategy? I try to blend several of the foregoing styles. However, my primary emphasis is risk avoidance; most investors, including your humble author, buy REIT stocks not for the purpose of shooting the lights out and bragging to their brother-in-law about their most recent coup but, rather, to preserve their capital, earn a good and predictable return on it and to avoid disasters – and even potholes. As a result, I tend to focus on those companies in which I have a high level of comfort that they aren't going to do something that “seemed like a good idea at the time.” They have superb management teams, own good quality properties in good locations, and ….

Hmmm…I can see that this is going to be a rather long discussion, particularly if I get into naming names and providing explanations. So I hope you'll approve if I defer this discussion until the next issue of The Essential REIT. And if you don't, well, tell Sammy about it. So, this discussion will be labeled, “To be continued…”

I'll leave you, for now, with a final thought. There is no “right way” to invest in REIT stocks; various strategies can work well if intelligently executed. That old saw claims that “bulls make money, bears make money, but pigs get slaughtered.” Similarly, only those investors who flip-flop from one style to another, perhaps chasing short-term performance, will get hurt owning REIT stocks.

The key, of course, is knowing one's financial objectives, performance requirements, risk and volatility tolerances, yield requirements and willingness to pay capital gains taxes. But every strategy requires knowing the REIT being bought or sold, including its management team, business strategy, assets and geographic locations, balance sheet and related considerations, as well as having a pretty good conception of relative valuations and risks. Those who don't want to play that game can always buy a REIT mutual fund or ETF, perhaps often with little loss of performance (but with the risk of being mailed big tax bills at the end of each year).

P.S. Still Thirsty. On Wednesday, Sheila Muto, in her regular real estate column in the Wall Street Journal, took note of the most recent Plan Sponsor Survey of tax-exempt real estate investors, conducted annually by Kingsley Associates in association with Instituional Real Estate, Inc. Ms. Muto reports that, according to the most recent survey, institutional investors “plan to devote 5.8% of their new funds to REITs, up from a planned 3.3% in 2004. That would boost new capital going to REITs to $2.98 billion from $1.44 billion last year [2004].”

We should, of course, take this note of intention with several grains of salt. These institutioinal investors don't always do what they say they'll do in surveys; furthermore, even $3 billion, as large as that seems to mortals like you and me, is but a very small portion of REITs' total equity market capitalization these days, and may easily be offset with selling by myopic investors who believe that “now's the time to get out of REIT stocks.” Nevertheless, these intentions are encouraging, as they support my thesis that (a) institutional investors are still increasing their allocations to commercial real estate, and (b) they see REIT stocks as an effective proxy for directly-owned real estate. We're still only in the 3rd or 4th inning of a splendid ballgame.

So, until next time, I remain,

Your humble servant,
Ralph (Block)

Disclosure: I and/or the firm(s) to which I provide services may from time to time have long or short positions in some or all of the stocks (if any) mentioned above. Further, this “newsletter” is not intended as a recommendation for the purchase or sale of any particular security and is not intended to be investment advice – or any other advice for that matter. The statements made in this newsletter are my own personal opinions, and do not represent the views of any other person, real or fictitious, or even the views of Sammy, my Golden Retriever. © 2005 Ralph L. Block
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