Rei Ts: Boom Today, Gloom Tomorrow?

Calling it a gold rush is an exaggeration. But not much of one. Although commercial real estate has been bouncing along the bottom of its worst slump in decades, yield-hungry investors haven't been able to get enough of real estate investment trusts, which are basically packages of actively managed commercial real estate. Some $7.2 billion in REIT initial public offerings has been gobbled up in 1993 through Nov. 12, vs. a mere $919 million for all of 1992. An additional $6 billion in REIT IPOs is currently in the pipeline. The market capitalization of equity REITs has jumped from $5.6 billion to $23 billion in just three years.

The euphoria rampant in the REIT industry for much of 1993 was reflected in a recent conference held by the National Association of Real Estate Investment Trusts in New Orleans. The lavish entertainment--a masked Mardi Gras gala featuring a parade by a local marching band--and rhetoric (one panel discussion: "U.S. Real Estate Markets: An Opportunity of a Lifetime") evoked nothing so much as the 1980s' Predators' Balls, where junk bonds were king.

If you think this party sounds too good to last, you may be right. The major problem: While REITs promise high and ever-increasing dividend growth, the real estate they own, such as shopping centers and apartment houses, even office buildings, probably won't rebound as fast as their growth stories may imply. "In the long run, REITs can only be as prosperous as the properties they contain," said Anthony Downs, a Brookings Institution senior fellow who was a voice of caution at the REIT conference. "Their dividends can only grow when the conditions in underlying property markets become prosperous. And that's going to take a while."

STRONG DYNAMICS. There are already serious signs of weakness, with the REIT market down close to 12% in the past three weeks. While supply soars, demand is easing as hot money moves away from REITs. Earlier in the year, numerous issues brought to market immediately jumped up in price. But recent REIT IPOs not only haven't had the hoped for big bump-up in price but have fallen below their IPO price. Case in point: Associated Estates Realty Corp., which debuted at 213 4 on Nov. 11 and closed at 20 7 8 on Nov. 17. Then there's Avalon Properties Inc., which was priced at 203 4 on Nov. 11 and has since slipped to 201 8. A somewhat earlier IPO, Mark Centers Trust, traded above its issue price of 181 2 at first, but had fallen to 153 8 as of Nov. 17.

As more private developers rush to go public, investors are becoming increasingly discriminating in their purchase of REITs. The market got a chance to give REITs a warning about living up to their projections when Mark Centers Trust announced on Oct. 26 that it wouldn't meet its expected numbers for its first quarter as a public company. The stock dropped 5.6% that day. By Nov. 17, it was trading more than 16% below its offering price. "We need to do deals that are straight, to sell income in place, to sell reality," said Chicago investor and REIT executive Samuel Zell at the REIT conference. "We don't need to, nor should we, sell futures. If we sell futures, we will end up fouling our own nest."

As in the junk market, the dynamics fueling REITs are powerful. Investors are eager for the 4%-to-8% annual yields typically forecast by prospectuses. Developers, many of whom are facing severe financial problems, see REITs as an almost heaven-sent way to cash out--and, in some cases, "mix their dog (properties) with their jewels" in the process, as Downs puts it. Investment bankers have been raking in luxurious fees by putting these two groups together.

Institutional and retail mutual funds have been among the biggest REIT buyers. According to Morningstar Inc., net assets in the seven real estate funds it tracks swelled almost 200%, from $259 million at the end of 1992 to $764 million in September. "These people are so eager to buy yield, they're creating excess demand, which is leading to a supply to meet that demand," says Brookings' Downs.

These dynamics are being undermined by the likely slow growth of REITs' underlying properties. Take apartment buildings, a popular REIT holding. Fewer consumers are entering the work force, which means fewer new households are being formed. With mortgage rates at historic lows, more apartment tenants can afford single-family homes. And while the low level of multifamily housing starts may lead to eventual rent increases, rent hikes are now the exception, notes David Kostin, Salomon Brothers Inc. REIT analyst.

A more immediate threat is the possibility of higher interest rates. "If interest rates rise sharply," says Downs, "this flood of mutual-fund money could change," leading to a substantial drop in REIT prices. "Mutual-fund managers are traders with a short-term horizon of 20 minutes, while real estate is a long-term horizon situation." When the Taubman Centers Inc. REIT announced that its cash flow would be slightly short of projections, the stock dipped as much as 13% in a single day, which Downs blames on selling by mutual funds.

"THIRD INNING." While predicting rough times ahead, many REIT-watchers say the recent shakeout is healthy and that they expect the overall market to grow dramatically. David G. Shulman, head of real estate research for Salomon Brothers, expects the industry to top $100 billion in market capitalization in the next six years. Zell says it could reach $150 billion in three years. But while agreeing with a mutual-fund manager's characterization of the REIT industry as being in the "third inning of a nine-inning baseball game," Shulman recently cautioned that the current REIT boom will be subject to a "two-hour rain delay. Make no mistake about it."

Sam Zell tells a story about a bumper sticker he saw in Houston in 1984 that reflects the sense of caution that is gradually permeating even the more euphoric segments of the REIT industry. The bumper sticker read: "Please, God, give us another oil boom and we promise not to screw it up."