Where Good Rei Ts May Be Lurking

Look for owners of full-service hotels and big-city offices and apartment complexes

To real estate's savviest investors, timing the cycle is simple. Just think baseball. "It is definitely the first inning," insists property and publishing magnate Mortimer B. Zuckerman, who just registered for a $903 million initial public offering of his vast real estate portfolio. "It is the sixth or seventh," declares vulture fund investor Thomas J. Barrack Jr., who has moved beyond buildings to buying operating businesses.

It all depends, it seems, on who's playing the game--and why. Most players, though, feel the easy wins are over. For the past four years, investors could score on almost every pitch in the distressed real estate market. By now, though, rents and occupancy rates have almost fully recovered from 1991 lows. Office occupancy levels, the last remaining laggard of the real estate turnaround, have rebounded so strongly that they drove the index of the National Association of Real Estate Investment Trusts up a huge 36% in 1996. But that won't soon be repeated. Indeed, the REIT index fell 2% from January to the end of April, thanks to a flood of new offerings and a cooling-off from last year.

But there still is a compelling case for REITs for investors who choose carefully. Real estate investment trusts, which are publicly traded pools of actively managed real estate, have a good record for delivering predictable returns in the low double digits. In exchange for their tax-free status, REITs are required by law to pay out 95% of what would be their taxable profits to shareholders in dividends. Thus, unlike stocks, they offer stable income, even in a time of uncertain valuations. And REITs are once again cheap relative to stocks, on a price-to-cash-flow basis. According to Green Street Advisors, REITs are selling at a price to operating cash flow multiple of 14 vs. the current Standard & Poor's price-earnings multiple of 21.

TRIPLE IN VALUE. Moreover, the ongoing rapid consolidation of private real estate will fuel REIT growth well beyond the cyclical recovery. Analysts expect their total market value to triple in the next 10 years.

The favored property classes in the real estate market are costly to build full-service hotels and metropolitan office space, and apartments in cities with strict zoning laws, all of which keep supply in check. The trick is to select REITs that are successfully buying out and repositioning private portfolios to increase cash flow. Keith R. Pauley, who manages $2.3 billion in real estate assets at ABKB/LaSalle Securities, likes Patriot American Hospitality Inc. and Bay Apartment Communities Inc. Patriot is buying out Wyndham Hotel Corp., bringing its portfolio of managed and owned hotels to 158. Bay Apartments is a play on the hot San Francisco-area rental market, where rents rose by more than 20% last year.

Both of these REITs are pricey, but they're unlikely to see their territory invaded anytime soon by new development. And there are next to no new development projects under way for metropolitan office space and full-service hotels. "The big news going forward is downtown office [space] will see a dramatic increase in rents as leases roll over," says G. Kenneth Heebner, manager of CGM Realty, last year's top-returning REIT fund that takes huge bets on individual sectors.

Heebner favors Vornado Realty Trust, even at a premium double net asset value. Vornado, a huge shopping mall REIT, grabbed one of the highest profiles in the rebounding New York City office market by buying out Bernard Mendik's portfolio of office towers. He will remain manager of the portfolio.

VALUE BUYS. There are a score of other high-profile REITs that are proven consolidators in the office sector, such as Menlo Park (Calif.)-based Spieker Properties and Richard E. Rainwater's Crescent Real Estate Equities Inc., but they, too, carry high premiums above net asset value. More value-conscious managers are picking up less richly priced office portfolios such as Highwoods Properties Inc. in the Southeast, Kilroy Realty Corp. in California, and Pennsylvania-based Liberty Property Trust.

Some managers are stepping into depressed sectors such as the apartment market in the Southeast. Andrew A. Davis, manager of top-performing Davis Real Estate Fund, recently bought Atlanta-based apartment companies Post Properties Inc. and Gables Residential Trust. "Atlanta is in a post-Olympic hangover," says Davis. "But long term, do people want to live there, will there be job growth? Unequivocally, yes."

Another contrarian pick is the retail sector, which is severely overdeveloped. Most analysts are very worried about the number of stores still going up across the country. One of the few plays Heebner feels comfortable with is Chelsea GCA Realty Inc. of Roseland, N.J., whose strong earnings and cash flow make it a diamond in the severely troubled outlet mall sector. Money managers also like Rouse Co. of Columbia, Md. With $832 million in sales, it is the nation's preeminent builder of planned communities and the new owner of the Fashion Show Mall in Las Vegas. Shares in the publicly traded company have fallen 12% this year.

Beyond the traditional choices, investors may select from several novel properties that are being securitized. Alexandria Real Estate Equity Inc., for instance, specializes in developing and leasing biotech lab space and just raised $135 million in a public offering. The first prison REIT should come to market this summer, and there are now two REITs specializing in developing and operating golf courses. In the past, niche REITs have done well. For example, self-storage REITs have grown from almost zero to $5.2 billion in market value in the past seven years.

But with managers seemingly turning everything into REITs, investors should be wary of gimmicks--and watch IPOs carefully. Stay away from REITs that outsource management, such as the controversial IPO Westfield America. And stick to self-managed REITs with a high percentage of insider ownership, median-level yields, and more than $100 million in market capitalization.

Perhaps the most useful rule of thumb is to watch out for overbuilding. This decade's dramatic transfer of property from private-deal-oriented entrepreneurs to the public markets may have added discipline and efficiency to the real estate market. Still, real estate remains a cyclical commodity business, and new supply usually comes on in waves, dragging down rents and REIT returns. When you see a lot of building cranes, it's time to take a breather.

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