Return Of The Rei Ts

Yes, they've lost some luster, but the property market should smooth out in '99

This was no mere correction. For real estate investors, 1998 was an all-out disaster. That supposedly stable, predictable group of stocks called real estate investment trusts is down 18% for the year--including dividends. That's a 39% relative underperformance to the Standard & Poor's 500-stock index. "REITs haven't been this cheap since the gulf war," grumbles Cydney Donnell, manager of $2 billion in real estate investments for European Investors Inc.

The good news is that no underlying real estate crisis is on the radar. REITs should finish the year with cash-flow growth of 15%, according to Green Street Advisers, a research firm. In 1999, growth is expected to slow to a still-solid 9%. Even if the cash-flow multiples of REITs stay at the current historically low level of 8.7, their stock prices should climb 9%, says analyst Steven Hash of Lehman Brothers. On top of that, investors should pick up an average 7% dividend. "It is not high-five time, but it's easy to look out and see 10% returns," says Russell C. Platt, manager of the well-regarded Morgan Stanley Dean Witter real estate mutual funds.

PANIC ATTACK. What went wrong in 1998? It's pretty simple: an upward surge of REIT prices--56% during 1996 and 1997. By 1998, though, the opportunity to make profitable acquisitions was ending while new developments were increasing. Nervous investors proceeded to dump REIT stocks.

High-profile missteps compounded the nervousness. Prime examples were Richard E. Rainwater's Crescent Real Estate Equities Co. and former hotel highflier Paul A. Nussbaum's Patriot America Hospitality Inc. They acquired more than they could manage, then financed their growth with short-term debt. Not only was the equity faucet shut off for public REITs but also this summer's global economic jitters practically shut down the commercial mortgage-backed security market, a main source of financing for private developers.

Fortunately for investors, many of the better companies have been brought down as hard as their mediocre peers. The best place to look for values is the battered office sector. With unemployment hitting record lows, rents are still growing by 6%. But office stocks have been brought down an average 20% to date. Sam Zell's giant Equity Office Properties Trust, with $13 billion in assets and is now selling at a 6% discount to its estimated breakup value, is a favorite pick. So is Mack-Cali Realty Corp. The company's holdings are concentrated in the attractive Northeast markets. But its stock has still been hammered, 25% year to date.

For those willing to forego REIT dividends, go for Canada-based TrizecHahn Corp., whose fleet of trophy office properties includes Chicago's Sears Tower. Because it is not a REIT, Trizec can store up more earnings. It also made the deal of the year selling a portfolio of malls last spring for $2.5 billion. That gives it a war chest when its peers are hungry for capital.

Retail REITs held up well in the sell-off. But Simon Property Group, the dominant mall operator, can still be bought at a 6% discount to its underlying assets, according to Merrill Lynch analyst Eric Hemel. And while strip-mall giant Kimco Realty Corp. is not cheap, it has been buying up bankrupt retail space and is expected to record cash-flow growth of 19% in 1999. In apartments, money managers like David Jellison of this year's top-performing Columbia Real Estate Equity Fund advise sticking with big diversified players like Denver-based Apartment Investment & Management Co. and Archstone Communities Trust.

For those with guts, there is always the hotel sector, down 45% year to date. Hotels are most susceptible to economic slowdowns. Still, Host Marriott Corp., a big blue-chip name, is worth a look. The company, which is converting to a REIT in January, is trading at only six times 1999 cash flow.

Across the board, real estate stocks have been repriced from growth companies to slow-growth income vehicles. But at least, REIT's reduced expectations are now reasonable.