Rei Ts Come Of Age

The days of 20% returns are over, but there's more variety now--and some bargains, too

It took 30 years to catch on. But today, few investment vehicles are growing as fast as the real estate investment trust. Over the past two years alone, hungry investors have bought $58 billion of newly issued stock to help REITs buy everything from office complexes to car dealerships to prisons. Flush with cash and boasting ever-increasing stock prices, REITs also have gone big-game hunting: Samuel Zell's three largest REITs have made some $9 billion in acquisitions in 1997. And Starwood Lodging Trust floored the hotel industry with its recent, successful $13.3 billion bid for ITT Corp.

The deals should continue right through 1998. But the rapidly rebounding real estate market that pushed the National Association of Real Estate Investment Trusts (NAREIT) index of REITs up a cumulative 55% in the past two years is fast approaching maturity. Deals will offer smaller upsides for the 200 public REITs that dot the landscape. For investors, this means the years of returns greater than 20% may be over.

But in today's increasingly volatile stock market, REITs still offer a compelling alternative. In exchange for their tax-free status, REITs have to pay out 95% of their taxable income in dividends. That results in average yields of 5.8%. And while profit growth will slow in 1998 as competition drives up the price of real estate, rent increases are still expected to drive cash-flow growth up 9% in 1998, delivering total returns in the mid-teens. "Compared to the stock market, REITs are a better deal than they were a year ago," says Russell Platt, head of real estate funds at Morgan Stanley, Dean Witter, Discover & Co. "They should outperform the S&P."

SECTOR BETS. But the art of getting respectable returns relies on picking the right basket of REITs. Most major property sectors--including the favorites of the past two years, offices and hotels--are rapidly approaching equilibrium. So investors are plowing into narrower subsectors. Among the few obvious plays: downtown office space in cities such as New York, Boston, and Chicago. Kenneth G. Heebner, manager of the high-flying CGM Realty Fund, which has generated top returns by making huge sector bets, figures that S.L. Green Realty, a big player in New York's garment district, will do well. Heebner also likes Prime Realty, a company with a similar role in Chicago's second-class office districts.

As for last year's hottest sector, hotels, Heebner is among those who are starting to steer clear of it. He has dropped the hotel portion of his portfolio from 50% to 15%. Overdevelopment has already hit the limited mid-price sector. And costly luxury hotels may not be as protected as many believe, since old buildings in major cities are being converted into hotels. One investment still worth buying is Starwood, which has averaged 80% annual returns for the past three years. Its acquisition of Westin and ITT-Sheraton gives it the potential to expand internationally at a time when the U.S. market is slowing down. Uncertainty about the deal has driven down the price of Starwood shares, making the stock "extremely attractive," says American Funds' Kim Redding.

Investors also are becoming more selective about regions. California seems the best bet. The quality act in the office sector is Spieker Properties, based in Menlo Park. Spieker is selling at a 28% premium to the net value of its assets. It is one of the most experienced developers in California. Two Southern California favorites are land developer Donald Bren's Irvine Apartments and Kilroy Realty, a rising office REIT and likely takeover candidate.

With acquisition opportunities narrowing, several REIT mutual funds are looking beyond REITs and buying developers instead. In California, Catellus Development Co., a publicly traded real estate operating company, owns the biggest lots of undeveloped land in Silicon Valley, downtown L.A., and San Francisco. Cleveland-based Forest City Enterprises Inc., a closely held company, figures it owns $2.6 billion's worth of malls and office towers. "These companies are the owners of tomorrow's prize assets," says Stan Ross of real estate consultant E&Y Kenneth Leventhal Real Estate Group.

PRIME SPACE. With undervalued real estate becoming scarcer, the REITs to screen for have opportunities to boost rents by renovating and repositioning properties they already own. One with a high multiple that is still worth a look is Steven Roth's Vornado. It has delivered over 50% returns in the past two years. Vornado was the first REIT to plunge into the New York office sector by buying more than $1 billion's worth of properties in 1997, including the holdings of old-time New York developer Bernie Mendik. With a lock on over a third of the buildings surrounding Madison Square Garden, Roth plans to transform the entire area by upgrading the office spaces and adding entertainment and retail districts. Because he also holds all the old Alexander department-store sites, Roth is sitting on some of the best prime retail redevelopment space in the city.

For blue-chip players such as Vornado and Starwood, deals will keep flowing because private owners like Mendik are increasingly swapping their buildings for operating partnership units in REITs. More value-conscious managers are focusing instead on emerging leaders or weak companies that could be acquired. Morgan Stanley's Platt likes CarrAmerica Realty, an East Coast office-building owner that is trading at only a 15% premium to net asset value. Several analysts are betting that Atlanta will recover from its post-Olympic hangover, buying depressed apartment REITs such as Gables Residential and Post Properties.

Few are willing to plow through the paperwork needed to learn about REITs or have the stomach for the risk of picking them. With most REITs focused on a single region, it is essential to buy a score of them to get diversity. For many, the best way to invest might be a REIT mutual fund. As REITs have proliferated, so has the number of REIT mutual funds. There are now funds across the risk-reward spectrum that have provided consistently high returns for the past three years.

Still, too many investors may have come into the REIT market in recent years overlooking the fact that as REITs behave more like stocks, they will also carry risks more in line with stocks. The new breed of growth-oriented

REITs spawned during the bull market has yet to deal with the possibility of a real estate bear market.

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