Financial advisors preach the benefits of diversification to their investor clients when it comes to portfolio composition. The same theory can be applied to a real estate company's portfolio. The Rouse Company (NYSE: RSE) maintains a diverse portfolio spread across three unique sectors—a practice which has served it well in the turbulent economic climate.

The Rouse Company

Headquarters: 10275 Little Patuxent Parkway, Columbia, MD 21044 Phone: 410-992-6000 Web Site: www.therousecompany.com Chairman & CEO: Anthony W. Deering CFO: Thomas J. DeRosa Core Markets: Rouse has a strong presence in the Baltimore/Washington corridor with additional holdings in the East Coast, Midwest and Las Vegas markets. Founded: Founded in 1939, James W. Rouse and Hunter Moss created the Moss-Rouse Company, which became The Rouse Company in 1966 with the merger of Community Research and Development. Ticker Symbol: RSE (NYSE) 52-Week High: $35.30 52-Week Low: $27.47

"During stormy market conditions, our company's distinct combination of retail, master-planned communities and office assets provides a breadth and balance that keeps the company upright and steady," says Anthony Deering, Rouse's chairman and chief executive officer. "While our peers concentrate heavily on single segments and have only one leg on which to stand, we have three, which helps keep us stable."

Rouse's strategy was put to the test last year. "Being in diverse businesses paid off during 2002," he says. "We produced record results due to the strength of the retail center portfolio and community development operations, even though tenant sales were soft and the office environment across the U.S. was very difficult."

In fact, The Rouse Company, which operates about 200 properties in 21 states and employs more than 3,700 people, reported that revenue, net operating income (NOI) and funds from operations (FFO) from recurring activities all reached record levels in 2002. Revenues reached $1.2 billion in 2002, up from $1.1 billion in 2001. NOI increased 16.5 percent to $650.4 million. FFO from recurring activities was $357.3 million for the year compared to $283.8 million the year prior. On a per share basis, FFO from recurring activities was $3.86 for 2002, compared to $3.74 for 2001. Net earnings were $139.9 million ($1.47 per share), versus $110.7 million ($1.40 per share) in 2001.

The analyst community seems optimistic that the 2002 results were not an aberration. States Matthew Ostrower, a REIT analyst with Morgan Stanley, "We believe The Rouse Company's core results and overall outlook are quite healthy, and that its shares offer compelling valuation. FFO in 2003 should represent one of the strongest growth rates in the REIT (and mall REIT) sector. We believe this growth is dependent on continued strength from the retail portfolio and the land business [community development], given continued weakness in the office portfolio."

Mall Portfolio Moves Upstream

When looking at Rouse's three-sector approach, it makes sense to start with its largest income generator. Sixty five to 70 percent of Rouse's NOI comes from its retail segment, with roughly 87 percent of that NOI (opposed to 35 percent in 1993) generated by upscale, super-regional and regional malls with high-end department stores targeting affluent consumers in major markets. Over the past decade, the company has moved its mall properties upstream, selling off 40 lower-end mall assets while funneling acquisitions and ground-up development into premier sites and targeting higher-end retailers across the country.

The company owns and operates 52 retail centers anchored by 140 nationally known department stores that, together with 7,000 smaller merchants, encompass 45 million square feet of retail center space nationwide. Rouse's retail portfolio generated $469.6 million of NOI for 2002, with same-store NOI increasing 3.9 percent from 2001. In addition, Rouse ended 2002 with a 95.1 percent retail occupancy rate, one of the highest in the industry.

Acquisitions and dispositions have played a key part in the evolution of the company's retail portfolio. In May 2002, Rouse spent $1.5 billion to acquire 30 percent of Rodamco North America as part of the $5.6 billion mega-deal that included Simon Property Group (NYSE: SPG) and Westfield America Trust. The deal added eight premier regional retail centers to Rouse's mix, each with higher average sales per square foot than Rouse's existing portfolio average. Each Rodamco property acquired by Rouse fit the company's desired strategic profile of great locations in major markets with multiple high-quality department stores, Deering says.

A GLIMPSE AT ROUSE'S HISTORY In April 1939, James W. Rouse and Hunter Moss founded the Moss-Rouse Company to originate Federal Housing Administration loans for single-family housing, working from a small office in Baltimore with three full-time employees. When veterans returning from World War II created an increased housing demand, the Moss-Rouse Company was well positioned to benefit from the government-financed residential real estate boom of the late 1940s and early 1950s. The company changed its name to James W. Rouse & Company, Inc. in 1954 (when Moss left) and began arranging financing for commercial real estate projects, including groups of suburban retail stores that came to be known as strip shopping centers. It entered into the development business as the owner's representative for the formation of the Mondawmin Shopping Center in Baltimore, one of the country's first regional malls. In 1956, the company became publicly traded, and through an acquisition was renamed The Rouse Company. During the early 1960s, the firm broadened its scope of activities to include community development; through a joint venture, it purchased 14,100 acres of rural Maryland property and created the planned community of Columbia, today a thriving city of 95,000 residents. In the late 1970s and through the 1980s, Rouse developed a series of downtown retail centers and mixed-use urban marketplaces, pioneering the enclosed mall, specialty retailing, open storefronts, interior landscaping, cooperative advertising and merchandising programs, and food courts. Between 1985 and 1988, Rouse's office and community development business grew significantly. In the late 1980s, recognizing overbuilding in the marketplace, the company refrained from new development projects and instead focused resources on property renovation, expansion and leasing. During the real estate depression of the early 1990s, while many developers experienced financial problems, The Rouse Company remained strong and stable. At the end of 1997, occupancy levels at all retail and office properties were over 94 percent—well above industry averages. In 1996, the company acquired The Hughes Corporation and Howard Hughes Properties Limited Partnership, with assets primarily in Las Vegas. Through a 1998 joint venture, Rouse acquired a portfolio of retail centers from TrizecHahn Corporation (now Trizec Properties, Inc.). The company also purchased 67 office and industrial buildings (totaling 4.6 million square feet) and 107 acres of commercially zoned land, all in the Baltimore-Washington area. By 2000, the company's development pipeline was among the most active in the industry. Rouse's May 2002 acquisition of 30 percent of Rodamco North America added eight premier regional retail centers to Rouse's mix, each with higher average sales per square foot than Rouse's existing portfolio average.

In early March, the company completed its latest deal along this strategy. Rouse sold six lower-end shopping malls in the Philadelphia metropolitan area to Pennsylvania Real Estate Investment Trust (NYSE: PEI) for $548 million. Rouse used a portion of those proceeds to purchase a 50 percent interest in a higher-end property, Christiana Mall in Newark, DE, from New Castle Associates, a partnership that includes PEI executives.

"Retail is a relatively strong category in the real estate sector, which has been the best performing sector in a sagging stock market," Deering says. "Retail will continue to outperform the other real estate segments throughout 2003, giving investors a safe area in which to concentrate." While Rouse is constantly brought up in the context of other acquisitions or as a potential takeover target, Deering asserts, "We just can't talk about any deals until they happen."

Analysts have speculated that Rouse could be a suitor for Taubman Centers if the takeover bid by Simon and Westfield, which was being deliberated in court at press time, failed. In fact, Rouse made a bid for Taubman in 1998, according to documents released during Simon's suit against Taubman. Those desires were re-asserted at a March investor conference when the company said if Taubman were to decide to sell in the future it would want to be in a position to acquire its assets.

Village of Merrick Park Coral Gables, FL

On the mall development front, Rouse's major projects include the Village of Merrick Park in Coral Gables, FL, a 740,000-square foot project completed last fall; The Fashion Show in Las Vegas, NV, a high-profile, two-phase, $356 million expansion and renovation project producing one of the country's top 10 centers in terms of total size and sales volume; and The Shops at La Cantera in San Antonio, a 1.3 million square foot, single-level open air center, with an expected total cost of $189 million.

The combination of the newly acquired properties and the development projects should continue to spell positive results for Rouse's retail segment, says Stuart Axelrod, research analyst with Lehman Brothers. "Rouse's upgraded retail portfolio is anticipated to lead to more significant long-term rental growth and higher occupancies, with today's sales per square foot significantly above the REIT average."

Difficult Office Sector

The second-largest segment in the Rouse portfolio, though one that is waning, is the office sector. The company owns and manages 9.4 million square feet of space, primarily in the Baltimore-Washington corridor and in Las Vegas. Roughly 20 percent of Rouse's total NOI comes from these holdings. Rouse has seen its office performance continue to weaken (after outperforming in 2000), with analysts noting the segment's explicit drag on company performance.

For the full year 2002, Rouse's average office occupancy dropped to 89.6 percent from 93.5 percent, a slip that appears to be stabilizing, and same store NOI from "office/other properties" declined 2.3 percent for the year.

"We note that the percentage of NOI from the office portfolio has continued to decline during the past five years," Ostrower says. "We see slightly negative NOI growth from the office portfolio in 2003, and flat results here in 2004."

Lou Taylor, senior real estate analyst with Deutsche Bank Securities, agrees. "At year-end 2002, Rouse's office rents were up, but only 2 percent, well below our average outlook of 7.5 percent for the year," he says. "Going forward, for 2003 we expect the company to see rent declines of 10 percent."

Rouse is focused on trying to stabilize office occupancy levels, even at the likelihood of seeing flat, even lower rents, says Deering. But as some analysts question Rouse's long-term competitive advantage in the office segment, Deering admits that the company will continue to develop office space only on a selected basis, mainly in Columbia, MD and Summerlin, NV, while it reduces its overall activities in this segment in the coming years.

Hughes Center, Las Vegas

Master-Planned Communities, A Core Asset

The remaining 15 percent of Rouse's NOI is generated by its community development business, with record results driven by a very strong housing market in 2002. "During 2002, community development set record results by contributing $85 million of NOI," Taylor says. "Given anticipated strong results in 2003 and the continued outlook for low interest rates, we're increasing our 2003 estimate by $10 million to $85 million for the year."

In the fourth quarter of 2002, NOI from community land sales was $23.5 million, with profits from Summerlin eclipsing Columbia's for the first time. Summerlin has been the fastest growing master planned community for nine of the past 10 years, today representing a 12 percent share of all new homes sold in Las Vegas. Located in western Las Vegas on 36 square miles of land owned by the Howard Hughes Corporation, an affiliate of The Rouse Company, Summerlin is expected to encompass 60,000 dwelling units and a population of about 165,000 in 30 distinct villages when completed in another ten-plus years. In addition to its diverse residential properties, the 25-year project will include landmark office parks, major retail centers, recreational facilities, medical facilities, schools, and cultural and civic centers.

The more mature Columbia, MD project began development in the early 1960s. Today it is a city of 95,000 residents in a community offering social and cultural outlets, jobs, quality education (including 14 schools and 30 child care centers), a major shopping mall, eight village shopping centers, 120 restaurants, eight major supermarkets, two golf courses, 27 swimming pools and 5,300 acres of open space.

UPSIDE-DOWNSIDE Samplings from analyst reports on The Rouse Company: Banc of America Securities Rating: BUY (3/7/03) "The Rouse Company provides investors with a unique combination of stability and growth. The company owns a portfolio of high-quality malls that are likely to generate reasonable growth with a low level of volatility over the next few years, in our view. In addition, the company has a development pipeline that should deliver solid growth, in our opinion. As a result of this combination we rate Rouse a buy with a 12-month price target of $40." Deutsche Bank Securities Inc. Rating: BUY (2/19/03) "Despite the restructuring charge and low initial development yields (from Fashion Show and Merrick Park), it's very difficult to ignore Rouse's $175 million of retained cash flow each year. It equates to nearly $2 per share or 6.2 percent NAV growth to go along with 4.8 percent yield. We believe the yields at Fashion Show and Merrick Park will ultimately improve to 9 percent by 2005, which should make these assets reasonable contributors to earnings. As a result we're keeping our $36 target and buy rating." Green Street Advisors Rating: HOLD (3/20/03) "It is hard to find fault with Rouse's current strategic thinking, and the early grade is positive on the recent management restructuring. To boot, the wind continues to be at the back of retail landlords for the remainder of 2003. These positives are offset somewhat by weak results in Rouse's office portfolio, risk associated with development, and longer term risks in the retail arena and community development arenas. The solid performance of Rouse's shares in the last couple of years suggest that the positives have not gone unnoticed, while the fact that the shares have underperformed other mall REITs is likely appropriate considering the fact that the company is not a pure-play mall owner. We continue to rate the shares a hold." Legg Mason Wood Walker Rating: HOLD (2/21/03) "We have upgraded our rating to hold. Rouse shares have consistently underperformed the returns of its peer group, including Simon Property Group, Taubman Centers, CBL & Associates, General Growth, Macerich, and even Crown America and Pennsylvania REIT. It significantly underperformed each of these peer companies and the group overall for the one, three, five and seven-year periods ended Feb. 14, 2003, the last date we ran the relevant charts. We believe that there are fundamental real estate and management reasons for this underperformance, but point out that Rouse's below-average 5.1 percent dividend yield is the major differentiating financial return factor."

Sales commenced in the fourth quarter of 2002 at a third Rouse community, Fairwood in Prince George's County, MD. A fourth project in the works, Emerson, in Howard County, MD, will create a planned community on 570 acres, and include single and multifamily houses and town homes, and 215 acres of permanent open space.

Rouse's leadership in the master-planned space is seen as a strength by many analysts. "Rouse has demonstrated a consistent skill set in master planned community development and clearly views it as a core asset," Axelrod says. "We would not be surprised to see additional projects added to the pipeline over the next few years."

Indeed, the firm plans to purchase additional parcels of undeveloped land with the goal of transforming them into villages similar to Columbia and Summerlin, universally recognized as two of the most successful master-planned communities ever undertaken. "Our goal for the future is to expand our community development capacity. We hope to announce other new community initiatives in the months and years ahead," Deering says.

Restructuring Prepares for Future

To better position itself for future growth and execute its corporate plan at lower cost levels, The Rouse Company revised its organizational structure in October 2002, according to Deering. Rouse appointed eight new senior vice presidents (all previously vice presidents at Rouse) and merged its development and operations division into one new asset management group.

"The recent succession to the next generation of managers at Rouse appears to pave the way for continued growth in years ahead. Rouse's management team reflects seasoned experience, strategic depth and a unique team culture, with many of the senior executives having been with the company for 20 to 30 years," Taylor says.

Prior to those moves, long-time Rouse executive vice president and chief financial officer James Donahue retired in August 2002. Thomas DeRosa, previously global co-head of health care investment banking for Deutsche Bank AG, succeeded him.

Also on the corporate governance front, Rouse has taken steps to ensure that its board is up to the standards being set forth by the SEC. "Rouse's board reflects a true independent structure, with only one member of management [Deering] on the 12-seat board," Taylor says. "In addition, all six audit committee members are independent."

"The advantage to shareholders of our diverse board is a better transparency for understanding what goes on at this company," Deering says.

As for the future, Deering says it is fairly easy to say where the company will be, say, five years from now, since its projects take so long to build. He says that Rouse likely will reduce its investment in the office area as it expands its community and retail developments, including the Summerlin Town Center, "which I believe will be incredibly successful when it opens in Spring 2005. I have confidence that retailing will be strong going forward. So about Rouse's future, I say more and better of the same."