FUNDAMENTALS

BERNARD WINOGRAD: Let's begin by talking about real estate fundamentals and how that's playing out in the real estate investment trust business. What's happening to the top and the bottom lines of real estate companies as a consequence of the state of the commercial real estate business?

GREGORY WHYTE: What you appear to be referring to is the great irony in the real estate business right now: no pricing power on the rental side, but huge pricing power on the asset side. In fact, there is especially little rental pricing power for industrial, office or multifamily companies.

"We consistently find that interest rates are among the most significant drivers of a variety of different metrics in the real estate business." LEE SCHALOP

The one positive note here is that many companies are successfully recycling capital. We have seen one or two companies dramatically reduce the size of their total portfolio, take advantage of high asset pricing, and to a certain extent, buoy, what would otherwise be weak operating characteristics.

We are also at an interesting fulcrum point-asset pricing may come under pressure if interest rates go up. Frankly, if the economy is starting to improve, we might start to see the operating side of the business begin to improve a little bit and see asset pricing coming down.

LOU TAYLOR: What strikes me about this environment is how different the outlooks are for the different property types. There is a broad REIT umbrella, but it's really six very different businesses from hotels, to warehouses, to offices, to apartments, and different kinds of shopping centers. For instance, the top line is under a great deal of pressure in the hotel sector. Yet, in office, the top line is not doing that bad, but the capital expenditures are just killing people.

At the same time, I think people have acquired a tremendous appreciation for regional malls and learned that leverage isn't necessarily that bad in that sector. In the apartment sector, the complete absence of any pricing power, as Greg has mentioned is notable. Coming into the recession, who would have thought that the competition from single-family homes would have been so unbelievably intense. There have been a handful of dividend cuts in the sector; it's really been quite a struggle.

So, we look at the REIT landscape as several very different businesses going in very different directions.

JAY LEUPP: Yes, five different businesses going in different directions, but the one thing all these businesses have in common is that the equities in each of these sectors are all up in 2003. I think that's the biggest disconnect. I do believe that we are about to enter a period of normalcy, perhaps in 2004, where share prices start to reflect what is going on in each of the individual sub-sectors. As the economy gets back to normal from an economic and job growth standpoint, we could continue to see areas like malls and shopping centers outperform, and maybe office and apartments pull back just a little bit.

LEE SCHALOP: I would echo the point about the differences in the different businesses. We all, as REIT people, tend to look at the group monolithically. But, we really do have many unique businesses with different drivers affecting those businesses. So, in businesses where there is difficulty in increasing the supply, like in the mall business, there has been pricing power on rent. In addition, there are situations like competition from single-family homes that is very detrimental to the apartment business, but really isn't affecting the other businesses. So, I think that the different drivers of the major categories of real estate have been very important.

The other related issue has been lease term. As we've gone through the last 12 months, we've seen a significant impact from lease terms. Companies that have very short lease terms, like hotels and apartments, have been impacted by weakness in the economy broadly, and in real estate specifically. Whereas, companies that have longer lease terms, like the CBD office companies and the mall companies, have managed to prosper because they haven't been as afflicted by the impact of rolling leases on their businesses.

THIERRY PERREIN: Perhaps this time around, the situation is somewhat different to the extent that REITs are better capitalized as real estate investment firms, which helps them survive this challenging environment. REITs have been forced to play defense, as compared to offense. Basically, they have to manage their occupancies and try to maintain the dividend coverage. That's been somewhat of a challenge.

This time around, when you look at the supply and demand, the supply is perhaps half the level of what we had back in the last cycle. What's missing this time around is the demand.

It's interesting because we are, perhaps, approaching the bottom. GDP is growing, but we haven't yet seen strong signs of real job growth. We need job growth to help the real estate sectors to recover, especially in the office, apartment and, to a lesser extent, industrial sectors. The key here is that we have an industry that is much better capitalized.

INTEREST RATES AND JOB GROWTH

WINOGRAD: The general expectation is that real estate is a lagging sector of the economy. We've seen a huge rise in GDP reported at the end of the third quarter. But, we haven't seen any growth in employment. We've got a Fed that says that they expect to leave interest rates where they are for "a considerable period of time." Which of these things, if they change, makes the biggest difference? Which of them, if any, do you expect to see change?

TAYLOR: As I look at the different businesses, the macro environment isn't going to do a whole heck of a lot for retail. If you look at the supply that's been built in the last couple of years, it's very minimal. It's not that retail is immune to the economy, but if consumer spending picks up a little bit, it's really not going to move the needle for the mall companies or the retail companies, as far as I can tell.

"To address those who think that a rise in interest rates is going to hurt REITs, if interest rates are going up, perhaps it means that the economy is doing better." THIERRY PERREIN

The companies that need the job growth and the rise in interest rates are clearly apartment REITs. While supply is moderating, it isn't moderating that fast, which is just going to make the recovery that much slower and prolonged. The office companies need job growth, but in our view, even if you had rising employment rates, it's still not going to help them significantly. There is a lot of under-utilized office space to work through. That's just a hangover from overly aggressive corporate expansion in 1999 and 2000.

So, even though the economy may improve and rates may rise, the main short-term beneficiary is the apartment group.

WINOGRAD: Jay, do you agree with that?

LEUPP: Well, I would say that we talk mostly about job growth having the most effect going forward. But, I would argue that interest rates probably would have the most effect if they changed dramatically. The reality is that interest expense, or the cost of capital, is probably the biggest line item in any of the income statements of the companies that we follow. It only takes a 50 to 75 basis point move across the board in interest rates to have a very serious negative effect or positive effect on the bottom lines of the companies we follow. This is especially true for those companies that have more exposure to variable rate debt.

SCHALOP: We consistently find that interest rates are among the most significant drivers of a variety of different metrics in the real estate business. One of the issues that we've consistently had with the apartment business is that apartment CEOs argue that it's all about jobs. All the statistical work that we've done argues that it's all about interest rates.

If you look at the correlation between job growth and demand for apartments, it's significantly lower than the correlation between interest rates and demand for apartments. The single most important driver of demand for apartments is rates. If rates go up, people buy homes less and they rent more.

WINOGRAD: Thierry, you must have spent a lot of time studying the effect interest rates have on REITs?

PERREIN: Actually, interest rates have had a very beneficial impact on REITs' balance sheets. When you look at the net operating income (NOI), the NOI has been trending down for most of the sectors. But, when you look at earnings, a lot of companies were able to support needed coverage and leverage statistics because of a very low interest rate environment. If anything, many of the REITs have been out there refinancing their debt, mortgage debt and preferred instruments, at much lower rates, which have helped them in the capital marketplace.

To address those who think that a rise in interest rates are going to hurt REITs, if interest rates are going up, perhaps it means that the economy is doing better. If the economy is doing better, that means that there is going to be an increased demand for space, eventually. You have to look at it that way as well.

So, for the time being, low interest rates help the balance sheets. Down the road, they hurt the cost of capital, but could help the top-line revenue. That's something that would be a great positive for the sector.

WHYTE: The issue that I believe is most important centers on whether we're talking about operating fundamental improvements for these companies or the price performance of their stocks. And I'm not sure there's an exact correlation between the two. I believe reported job growth may not be the only thing necessary to get office REITs reporting better results. Yet, the mere hint of some job growth might start to drive the stocks, and this is particularly relevant when we consider the relative multiple valuation differentials between the different REIT asset classes right now. So, the improvement in the fundamentals is one thing, but actual stock appreciation is another.

WINOGRAD: Jay, you talked a little bit about what you thought the impact of rates would be on the fundamentals, the bottom line. What about the effect on the REIT market and the desirability of REITs as an investment and the flows of capital into the industry?

LEUPP: Yes, that is also a significant effect. We see it in the retail component in our investor base in particular. Over the last 24 to 36 months retail investors have been very hungry for yield and have been attracted to the relatively high and safe yields in the REIT sector.

If we move into a period where we have significantly higher rates, or higher yields with similar attractiveness can be found in other sectors, we may see some capital flow away from the sector. That could hurt share prices, both the common and the preferreds.

WINOGRAD: Lee, your study about the relative importance of interest rates is about the fundamentals. But, is it also true of the market?

SCHALOP: There's a perception that REITs are unusually inversely correlated with interest rates, and that REITs will really suffer disproportionately—the way people think insurance companies or banks will suffer disproportionately—if rates rise. We found that it's not true. There is an impact on REITs, just as there's an impact on all stocks. However, the impact on real estate stocks is no worse than the average stock and less than other financials.

WINOGRAD: Thierry, your worst-case scenario for REITs, in terms of an economic environment, seems to be a situation where growth improves, rates rise, but employment lags. Do you think that's the worst that we can see?

PERREIN: From a credit point of view, it could be the worst. We've run some stress test scenarios whereby, for example, REITs could take a 35 percent dive in their revenue base and, given their capital structure, could still meet a one and a half EBITDA coverage. We haven't seen any of that, even given this challenging environment, which is very interesting. But, this is a testament to the strength of the balance sheet.

Back to the interest rates, what's also interesting to note is the fact that financial services industries, e.g., banks and insurance companies, are much more vulnerable to low interest rates and we can see what's going on now in terms of the M&A activity. When you look at a REIT's balance sheet, you find that less than 20 percent of debt is floating. When you look further down the capital structure, you find out that roughly less than 50 percent of the capital structure is comprised of debt. And if you examine the debt profile a bit closer, you'll find out that capital structures are in good shape because, on average, less than 10 percent of that debt is coming due in any given year. So, you have to look at a real doomsday type of scenario to really be concerned about the REIT sector.

WHYTE: Maybe this is a little retrospective, but I believe one of the reasons that the REIT sector has performed so well over the last few years is because the companies really got the balance sheets right this time.

Years ago, we saw many real estate owners operate with 90 percent debt and this time around we're seeing roughly 50 percent. That's really what's kept REITs in such great shape this time around, and I believe is part of the reason why we've seen so few dividend cuts and serious corporate failures within the REIT sector.

WINOGRAD: Lou, you're not afraid of a productivity-led recovery?

TAYLOR: No. What I worry most about is the relative value of all the alternatives, either fixed income or equities. I worry a lot about the calendar, not just the REIT calendar but also the market's overall calendar. If you think back, the thing that drove these stocks down in 1999 was the attitude from clients that, "I need to sell something to buy something." They were looking at that IPO or secondary offering that was coming down the pike.

Fortunately, the supply and demand for money is very favorable now with a lot of money chasing very few deals. Over $100 billion has come into general equity funds in the last six months or so. But, the IPOs and secondaries have only been a total of around $55 billion. So, there's not a lot of pressure to sell REITs. If that dynamic changes, REITs could easily be a source of cash for that calendar.

We also look at the relative value of the alternatives. I think Lee and Jay touched on the interest rate component, but we also look at the equity component. Think back to the change in the composition of the S&P in 1998, when the telecomm and Internet companies were added. It really increased the forward growth rate of the S&P 500. People said, "Gee, I can get a better return in another part of the market than I can in real estate so the rotation began in earnest."

I think those capital market influences are going to have a greater impact on the stock performance than whether we get job growth, higher rates, lower rates, productivity or not.

ACCOUNTING AND FINANCIAL STANDARDS

WINOGRAD: There are a number of industry related accounting and financial standards pronouncements pending. Do you expect any of them to have a significant impact on either company behavior or investor perception?

SCHALOP: So far we have found that most of these accounting pronouncements have been rather bone headed.

"There’s no question that as a diversification tool and as a legitimate equity investment, REITs are here to stay." JAY LEUPP

WINOGRAD: Tell us how you really feel.

SCHALOP: The investment community, to its credit, has recognized that and there really hasn't been much of an impact. We've consistently heard from managements that they don't run their businesses based on accounting pronouncements, that they run their businesses based on what they think is a good deal and what will provide a good economic return for investors. We expect that they will continue to do that.

These new rules will create more a little more work for everybody and might increase the G&A line a bit. But, I think to a large extent, the accounting pronouncements have been a non-event as far as impacting the businesses. I expect that will continue to be the same going forward.

WINOGRAD: Thierry, is the same true in terms of credit analysis? The pronouncements are a non-event?

PERREIN: It is all rather disruptive and it could be confusing. In particular, I look at three pronouncements, FAS 150, FIN 46 and EITF D-42. At the end of the day, if you've got to bring a lot of debt on your balance sheet along with the associated interest expense, it will pressure your coverages. Actually, it may put you in jeopardy of some of your covenants that you have in place with your bankers. You may have to go back to the table and renegotiate.

Given what's understood of these pronouncements and this disruption, it shouldn't be an issue for a REIT to go back to the drawing table, perhaps for a fee. REITs have not been very active in joint ventures, except for maybe a handful of companies. So, it's not a major issue from a credit point of view.

WHYTE: I think this industry has mastered the art of creating its own valuation matrix. Just because accountants suggest things that have to be changed and accounted for differently, doesn't mean that analysts and investors won't go back and make more adjustments again.

LEUPP: Ultimately, real estate performance is measured down to the cash-on-cash return on investment. We're fortunate in this sector in that 12 to 15 analysts that follow this sector have been doing this for five or more years. We're all used to cutting through a lot of accounting issues to get down to what the company is returning to investors quarterly, annually, and on a cash flow basis. So, I don't think any of these accounting issues will have a major effect, long term.

MERGERS AND ACQUISITIONS

WINOGRAD: Now let's talk about M&A activity. It's been a remarkably slow period in terms of transactions in the real estate market. The number of properties changing hands is way down, and the amount of companies doing deals is not setting any records either. Do you see any change in that outlook?

LEUPP: We're actually a little more bullish about M&A activity in 2004. We think we'll see an acceleration in REIT M&A activity. We look for 2004 to be a return to normalcy in terms of equity performance. I think there'll be less of an emphasis on investors searching for yield and more on equity performance. Investors will be looking for REITs that can generate earnings growth and can measure up, to some extent, with other industries. Those that can will be awarded premium valuations, while those that can't will be awarded discounted valuations.

"If we really do start to see job growth pick up in the middle of 2004 into a strong 2005, the office REITs could be the sector to beat." GREGORY WHYTE

We think that creates an environment for accelerated M&A activity like we saw in 1998, 1999, and part of 2000, where you had wide disparities in valuations even within sectors.

WINOGRAD: Lou, would you expect that to happen?

TAYLOR: No. I don't think so. I think that analysts would like this industry to consolidate so they wouldn't have so many companies to look at.

But in reality, the buyers are looking for a very good price, and the seller has got to get fair market value because of its fiduciary responsibility to shareholders. That is just not conducive to M&A. Companies paying top dollars, whether it's for companies or assets, get punished. They have got to go find something that they can add value.

I think there are going to be five to eight companies acquired a year. Although we all would like the industry to get bigger faster and have fewer companies, I think that we're not going to see a materially different pace than we've seen in 10 years.

WHYTE: Let's not forget that we've had one example this year of a proposed hostile takeover, which didn't work. In this industry, I believe that M&A activity needs to be on a friendly basis. Many of the management teams have a slightly inflated opinion of what the true value of their assets are, and that would argue against there being an increase in M&A activity.

SCHALOP: In addition to the potential that management teams have an inflated view of what their assets are worth, there are, I'll call it, the social issues. There are a lot of managements out there that love the idea of M&A as long as they're the buyer, not the seller. When the opportunity is presented to them to sell, they suddenly think it's not a terrific idea. So, the social issues, especially given the number of companies that are still being run by the founding entrepreneur who views the company as one of his children, makes it extremely difficult to have a high level of M&A activity.

EQUITY AND DEBT ISSUANCE

WINOGRAD: Thierry, talk about equity and debt issuance levels. Even as REIT shares have performed very well, we have not seen a flood of equity issuance. At the same time, interest rates have been so low that credit and debt have held up very well. What is it that tips the balance one way or another? What would lead you to expect, based upon your view of the capacity of the balance sheets of this industry, that there would be a lot of issuance of either equity or debt in 2004?

PERREIN: What has prompted issuance in the first place is a REIT's use of funds-either the REIT buys or builds an asset. That was during the boom years. Most of that, early on, was funded with equity. All of these balance sheets were less than 20 percent leveraged and some of them had no debt.

"With the equity issuance and the reinvestment of cash flow, you could see the [industry] market cap getting to $300 billion in five years." LOU TAYLOR

Then the debt market and the preferred stock market came into place. But, associated with that, we had a fair amount of growth. REITs were active acquiring assets, often more than they could manage. What's interesting to see in this environment is that REITs are more focused on retaining their tenants than building or acquiring properties because the returns are not attractive.

If anything, what we're seeing is a massive debt refinancing effort without an increase in leverage. REITs are lowering their funding costs because interest rates are much lower and are substituting high-cost financing for lower-cost financing.

Having said that, in terms of capacity, it appears that we have reached capacity in terms of additional leverage. One has to remember that the REIT sector, in terms of leverage, has been through the cleansing cycle. I think there's a fair amount of scrutiny from both the Street and the lenders. However, there is also a fair amount of constraints placed upon the REITs via the capital markets where you have covenants in place limiting the amount of overall indebtedness on the books. If a REIT were to go beyond that, there would be an event of default and a call on the assets.

WHYTE: Let's not overlook the fact that we've seen a significant volume of equity offerings this year-volumes that are well in excess of 2003, and probably greater than 2001 as well. The methodology for raising new equity has just changed a little. Instead of the typically fully marketed, add-on financings, we're seeing a proliferation of "over night" or "bought" transactions.

What's most important though, is that many of these deals have been relative under-performers recently. In fact, if you track over the last 18 months, you will see a steady deterioration in after-market performance. And I believe some of this poor relative performance may, anecdotally, explain a diminishing investor appetite as well as overly aggressive pricing by bankers. Remember, there's a reason why stocks typically fall in price when a to-be-marketed deal is announced. If the discount of an overnight deal is not great enough, the stock will trade off.

WINOGRAD: So, you'd expect that to continue in 2004?

WHYTE: Yes. If we have an over-banked sector then you've got banks that are prepared to make aggressive commitments to the companies. If you're a REIT executive today, I assume you just call up five or six investment banks in the middle of the day and say, "I'm going to issue X amount of equity tonight, bid me for it." There appear to be few instances when at least one of the banks is not prepared to step up to the plate.

TAYLOR: The level of equity activity is definitely up over 2002. But, going back historically, it's at much lower levels. I think it reflects the maturation of the industry and the education of the management teams, which have been public for five or 10 years now. They recognize the value of the strong business property markets to really fund their activities. I think that's really lessened the need for capital.

But, the other factor is the human element. These companies that have been around for five or 10 years have the scars to show what happens when you have an ill-conceived equity offering or transaction. Also, there are no shortage of critics among the analysts and the investor community. The companies are sensitive to it. Many don't want the grief and abuse that happens when you do something that's not particularly well conceived. I think it just shows the growth and maturation of the industry.

WINOGRAD: Do you disagree with Thierry that we're at the limit of leverage? Or, do you think that the companies are just not using enough cash to force them into the financing markets?

TAYLOR: I think we are roughly at the limit of leverage. I don't think it's going to go much higher because we are constrained by use of proceeds. The bid in the property markets from private investors is simply stronger than the REITs right now. If that were to change, then I think your level of equity issuance, either preferred or common, would ramp up.

WINOGRAD: Jay, do you think that the analysts are the reason the companies aren't issuing equity?

LEUPP: One of the reasons is that the balance sheets are in much better shape. But, management teams in general also did a lot of the right things through the tougher years-buying back stock, taking good care of corporate governance, and behaving themselves regarding accounting disclosure. We've got a lot of capital dressed up right now, with no place to go. If we do see an upward movement in cap rates and development yields to the tune of 100 to 150 basis points, I think you're likely to see a continuance of equity issuance. If not, you'd probably see equity issuance slow down and become dependent on either an opportunistic development or an M&A opportunity or a portfolio acquisition.

WINOGRAD: Lee, early on you were a big critic of the sophistication of the balance sheet management practices of the industry. Do you think it's matured?

SCHALOP: There's no question that managements today value their equity a lot more than they have in the past. The concept of issuing equity to do deals, which I'd say was rampant in the late 1990s, is relatively unusual today. We've seen that slip a little bit over the past few months, where we've seen management say, "I thought the cap rates were too low to buy deals. Now, they don't seem to be going back up. So, this must be the new market. I'll issue equity and buy some properties."

But, to a large extent, most management teams have avoided that temptation. That's been very important to the strong performance of the stocks. The few companies that have succumbed to that temptation and effectively overpaid for real estate, have been punished by the market.

INVESTOR BASE: RETAIL AND INSTITUTIONAL

WINOGRAD: Many students of the industry thought that it was originally sold as a growth vehicle back many years ago. And that we are now are in the ideal environment, one where the industry can attract its natural constituency, the yield-oriented investor. Do you see that happening? Do you see a real change in who's investing in REITs?

TAYLOR: We have. We have done a pretty extensive analysis of the shareholder base over the last two years. What we have seen is the ownership of the general equity investor has grown. It grew by about 300 basis points from 41 percent to 44 percent, from 2001 to 2002. The ownership of the dedicated funds has dropped by about 200 basis points, from 27 percent to 25 percent. The real surprise has been the retail investor. Depending on whether you do it on a market cap weighted basis or an equal weight, their ownership has dropped by about 500 basis points.

We definitely see a broadening of the base in the general equity category, especially from the small cap value guys who were very under-weighted in the group two years ago and now realize they have to have some presence. Certainly, the presence of the index funds has had an impact as more REITs have gotten into the S&P 500. But I haven't seen a lot of hedge fund interest. They've tended to avoid the sector.

We have a pretty healthy mix of investors right now. If there's going to be more broadening, it's probably going to be on the institutional side and on the income-oriented side, as opposed to individual investors.

WHYTE: This is an interesting debate because there are two sets of dynamics at work here. On one side it is interesting to consider what's going on in terms of general investor themes and thesis in the broad market. The second issue relates to what's going on in the REIT market. When you referred earlier to REITs being growth stocks in the early 1990s, they truly were. The companies were coming out of a real estate depression in the late 1980s and early 1990s, and so their internal growth as they leased up vacant space and marked-to-market rent rates was far greater than the long-term average. In addition they were able to pick up acquisitions at 60 cents on the dollar of replacement cost.

So, when you put both the internal and external growth components together, it wasn't unusual to see a REIT post 30 percent FFO per share growth. In the mid 1990s, the general stock market also happened to be in a growth stock investment environment. So, as a consequence, REITs satisfied the generalist growth investors and you had the birth of a new industry.

When REITs fell off so sharply in late 1997, early 1998, I believe that was because REIT FFO per share growth rates were starting to deteriorate and we were still in an investor environment where growth mattered. Remember, growth fund managers typically don't buy stocks that have slowing growth, even if the stocks are still growing at 25 percent or 30 percent.

The next time REITs really rallied was in late 1999, early 2000, when the general investor was becoming more and more skeptical about growth rates and technology stocks. Investors wanted hard assets and they wanted yields. Well, enter REITs again. This was their natural forte. They had both value and yield attributes and so the stocks worked well.

Going forward, we have to ask ourselves whether or not we are starting to see a drift back by investors toward more of a growth environment within the general stock market? Clearly, we've seen the risk aversion of the general investor wane as they have returned to the market in general. If we are in fact drifting toward more of a growth environment, on a relative basis, where do REITs fit versus the broader market? I would argue that the operating leverage at most S&P companies, as well as the financial leverage, will probably mean that we're going to see the rest of the broader stock market post higher growth rates than REITs.

WINOGRAD: This is not an argument for good relative performance for REITs in 2004?

WHYTE: That's what I would contend.

LEUPP: I would agree. There's no question that as a diversification tool and as a legitimate equity investment, REITs are here to stay. What's going to change over time, both for the retail and the diversified institutional investor at any one time, will be the overall weighting in the portfolio. For individuals, it could, at times, be as little as 5 percent and as high as 20 percent. That also depends, obviously, on the age and the investment objectives of the retail investor.

However, I do think that we are going to be entering into a period where the earnings growth rates of the REITs are going to probably fall significantly behind the broader market. We could, in fact, under perform in 2004 and possibly in 2005. That's not to say that REITs won't serve a purpose in a portfolio and won't continue to post respectable, historical performance by REIT standards. We're thinking a return in 2004 in the neighborhood of 8 percent to 10 percent. It could be a little bit better than that if we can see an acceleration in the 2004 to 2005 expected earnings growth rate, which right now we're pegging at about 4 percent to 5 percent.

SCHALOP: From a cyclical perspective, I would agree that the advantages of real estate may be less apparent in 2004. But, we also have to keep in mind that in the early 1990s real estate was on the radar screen of very few investors for a variety of reasons, including very small market caps, lack of liquidity and bad memories of investment in real estate stocks.

Today, as a result of a variety of factors, including strong performance, inclusion in indices, diversification, and sophistication among institutional investors, real estate stocks are a bigger part of the investment menu. We could see real estate benefiting from increased weightings in people's portfolios, even as they face some head winds on relative earnings growth.

WINOGRAD: Are you arguing that retail investors are beginning to behave more like institutional investors in the way they think about and use REITs in their portfolios?

SCHALOP: I would argue that institutional investors are increasingly behaving like, let's call them model institutional investors. You have more and more institutional investors looking for diversification in their portfolios, including real estate.

The change in the 401(k) laws that allow companies to provide guidance to individual investors will also have an impact on retail investors. Previously, a 401(k) plan provider could not provide any guidance at all. They had to tell plan participants, "Here are the choices; you figure it out." Now, they can give their employees access to a third party that can say, "Hey, you have these goals, this is what a good portfolio for you would look like." As a result, I think we'll see a lot more REITs show up in individual portfolios than we have in the past.

Today, the weighting of REITs in 401(k) plans was something like 10 basis points. The weighting of REITs in pension funds, defined benefit plans, was about 5 percent. So, there's a huge difference there and an opportunity for investors who have defined contribution plans to increase their real estate allocation and put a lot of fresh money into the real estate group.

WINOGRAD: There's a lot of institutional money trying to get into real estate. Is that net good or is it net competition for a REIT?

LEUPP: Well, short term it's been net good. I think it'll be really net good if it stays, which is the most important question. If we enter into a period where the relative performance lags the broader market, will this capital actually stay in the sector and enjoy the benefits of diversification and stable income? If it does, I think it'll be very good for the sector.

PREFERRED STOCK

LEUPP: The other thing I wanted to bring up is the importance of the preferred security and its growing prominence in the last couple of years, particularly for the retail investor. But in this last cycle, even institutional investors have played a larger role in purchasing preferred issues. I think these are excellent instruments, both for the companies that issue them and the retail investors that can get a very safe 8 percent return, long-term and not have a lot to worry about.

I think that's been good for the sector in terms of providing it with a consistent flow of capital. These types of securities have often been issued in periods where common stock has not been able to come to market. It's actually been a very good security for retail investors, both in retirement portfolios and in portfolios where investors are living off of the income.

WINOGRAD: Let's follow that for just a minute. Thierry, is this something you encourage in companies that look to you for advice?

PERREIN: What's interesting is that, typically, when I see companies rushing to the preferred stock market, it means that either they don't have access to the corporate bond market or they don't have good access to the equity market. So, the last leg left is the preferred stock market.

This year, 45 REITs issued some $4.4 billion of preferred securities and almost half of that was issued from REITs we would consider below investment grade. Clearly, investors, and in this case individual investors, were chasing yield. I might add that several institutional investors passed on those deals because they felt they were not compensated enough for the risks.

Sometimes, I'm afraid to say this, but there is a lack of sophistication on the part of some of these retail investors when it comes to buying these kind of securities. If you were to look at some of the credit and other fundamentals, I can assure you that one would have some serious doubts from investing in some of those companies, given some of the returns that you're being awarded.

WINOGRAD: Greg, do you look at it the same way? If a company's issuing preferred it means they're at the bottom of the barrel in terms of accessing capital and it's a sell sign?

WHYTE: I don't know if I'd go on record as saying it's a sell sign. I believe there are a couple of things we need to consider. The first is that a number of the preferred issuances have been done in order to ratchet down the cost of previous preferred issuances, or merely as replacement debt. To the extent that the preferred is a new issuance and it's just another layer in the corporate structure, I'd probably look at that as somewhat appropriate.

But, I believe Thierry raises some important issues. At the end of the day, it's a question of cost of capital. Preferred stock is just one of the layers and it hasn't proven in the past to be the cheapest layer. From an investors' perspective, I fear that in a rising-rate environment, your principal erosion could far exceed what you might pick up in an annual coupon.

TAYLOR: From a company perspective, the preferred stock is a good layer in the capital structure. I think the fixed income community has done a pretty good job of putting constraints in terms of how much it should be. From an investors' standpoint, I'm a little bit like Greg, in terms of not quite sure why you'd really want to own it long term. That up-front coupon certainly has been alluring to a lot of people. What I've seen from retail investors is they're interested in yield and are willing to stretch for it. So, that can get a company some pretty favorable capital.

PERREIN: You've got no refinancing risk either.

LEUPP: The beauty from the company standpoint is that it's permanent capital, if they want it to be. Most of this paper has a five-year call option. The worst it does for investors is, essentially, gives them their principal back and become the equivalent of a five-year, high yield CD.

We've found, at least among our 2,000 retail brokers in the U.S., that the primary retail investor in this type of security is the senior citizen that's actually living off the income in their portfolio. We always recommend, obviously, to diversify and to own a basket of these. But, many of the investors that are looking at these preferreds like the higher yields and are not really that interested in getting their principal back right away. They're interested in principal safety. But, they're not interested in selling these securities a year or two out. They typically hold them until they're called. If they have excess proceeds, they continue to reinvest in other, higher-yielding types of securities.

REITS IN 401(K) PLANS

WINOGRAD: I was intrigued by your statistic, Lee, about the REIT exposure in 401(k) plans. What is it that the industry should be conveying in order to ratchet that number up and get the retail investor involved?

SCHALOP: I think it's something that the industry has clearly been doing. It's just something that will increase organically over time. It used to be that my father-in-law had to explain to people what it was I did for a living. Now, he can just say that I'm a REIT analyst and people know what that is. There's a tendency among retail investors to swing for the fences. That's something that REITs generally don't naturally do. As people create a more disciplined approach to investing, a la 401(k), a la 529 plans for college savings, that you're going to see more and more money end up in the REIT area. You could also make a case that with the aging of America you could see an increased focus on stocks that provide yield. Real estate stocks could benefit from that.

WINOGRAD: Everybody here, presumably, spends time with financial advisers who are talking to people about long-term plans. Do you see retail investors beginning to be introduced to REITs as part of their retirement savings as opposed to individual stock purchases? \

WHYTE: Obviously, we've seen ebb and flow in terms of general equity appetite amongst individual investors, particularly in the last couple of years. And in much the same vein, the appetite for REITs has ebbed and flowed. When we would really have liked them to be there, they weren't, in part because they were lured away by the high potential returns expected from technology stocks. However, there has clearly been some gravitation back to the sector today because of the attractive yield aspects of REITs.

TAYLOR: I have a brother-in-law who was born in the first month of the baby boom, January 1946. He's a doctor in Cincinnati. He's going to retire in three or four years. He is extremely focused on principal preservation from now until retirement, as well as yield. He's very interested when I talk about REITs.

LEUPP: Among our U.S. retail brokers, there will always be a retail constituency that has an appetite for the common and preferred securities just because of their yield in this sector.

PRIVATE REITS

WINOGRAD: When you're talking to the financial advisers in your network, do you get asked about private REITs and whether they're appropriate investments?

LEUPP: We do, from time to time. For the retail investor, we recommend that they focus on the public-market alternatives, both from a liquidity and transparency standpoint. There's so much to choose from in the public market, both in the common and preferred arena that is properly managed from a fiduciary standpoint. We don't see the need, at this point, to recommend that our retail client base purchase private REITs.

WHYTE: I do not know every aspect of the private REITs, but I am sufficiently concerned that the fee structure is too high. As an investor, you're starting out way behind the curve. So, I would echo some of Jay's sentiments. It looks to me as though the premium you might get off a private REIT doesn't justify the lack of liquidity, the lack of real-time valuations, decent financial disclosures, etc.

TAYLOR: I get a number of inquiries on private REITs, as well as investing in small partnerships with family and friends. I just shake my head and say, "Why would you want to do that when you have more than 100 public companies to pick from."

With a publicly traded REIT you can get out tomorrow if you change your mind or need the money. And, you're really not giving up that much in the way of valuation or return. It just boggles my mind that people want to tie their money up in something you really can't get out of. I advise against it in every case.

SCHALOP: I would agree-with an emphasis on the fees associated with private REITs. If you're putting $1 into something that's going to have $0.85 being put to work in real estate, you obviously need to generate significantly above average returns to achieve the same as if you put money to work where every $1 you put into it is going directly into real estate.

WINOGRAD: Thierry, do you get asked to analyze the credit of the private REITs?

PERREIN: Once in a while. But, again, it comes down to transparency and disclosure. In this environment, I think investors want to get paid enormously if there is very limited disclosure and transparency.

2004 EXPECTATIONS

WINOGRAD: Let's try to get 2004 expectations down to a single number. Jay, you said you thought the 2004 expected return for the REIT market would be in the 8 percent to 10 percent range?

LEUPP: We're staying with that outlook prediction, at this point. We officially publish our numbers in January, but we're leaning toward an 8 percent to 10 percent number, 6.5 percent in terms of dividend yield and 3 percent to 5 percent in terms of appreciation in the coming year.

SCHALOP: Given that we are having this discussion in mid-November, it depends where real estate stocks finish the year. I think we could see the RMS similar to the 550-level at year-end 2004. This would mean 0 percent total return in 2004 with 6 percent yields and a similar decline in the stock prices. Assuming cash flow grows in the low single-digits, it means multiples will be down 10 percent.

WINOGRAD: Greg, have you come to a conclusion yet?

WHYTE: We haven't set a definitive estimate yet. We typically publish that figure in mid-December. If our current prognosis for the economy remains unchanged, with some decent GDP growth from here and moderate job growth at least in the second half of next year, we would argue that the S&P is likely to out perform the REITs. In aggregate, the per-share earnings expectations we have for the REIT sector next year is only between the 0 percent to 5 percent range, which I believe might argue for some slight multiple erosion.

TAYLOR: I'm in Lee's camp. I think it's going to be a 10 percent to 12 percent type of year because I think as the year goes on people are going to start to anticipate better earnings in 2005. It's tough to net all the sectors against each other, but I think the apartment and the office group, toward the end of 2004, are going to be acting a little bit better than they are right now. When you add it all up, with the weights and everything else, I think it's going to be low double-digit growth.

WINOGRAD: Well then, are you ready to predict which sector you think will be the best performer? Which is the most likely candidate, if you want to hedge?

TAYLOR: I don't cover hotels, but I would say the malls. I think some of the business plans that are in place, some of the embedded rent growth that's there, some of the development deliveries that are likely in 2005 and later, the retained cash flow that the companies generate, I think they're going to lead next year. I really do.

WHYTE: If we're talking about 2004 total returns, I might go for the office REITs. However, I suspect you're probably going to get the lion's share of your total return in the fourth quarter of 2004. The relative valuation of the various REIT asset classes today on an FFO basis is most attractive in the office sector. Now, granted, if you adjust that for the cap ex to get you down to an AFFO number, the valuation isn't quite as compelling. But, if we really do start to see job growth pick up in the middle of 2004 into a strong 2005, the office REITs could be the sector to beat.

WINOGRAD: So far we have malls and offices. You have a different one Lee?

SCHALOP: I'd agree on the office pick. We were positive on office in 2003. We thought people under-appreciated the valuation aspect. I think the same thing is true today, that the office stocks remain, relatively, attractively valued. As we go through the course of 2004, the prospects are going to be increasingly brighter, giving people reason to take comfort in those valuations and to take action.

WINOGRAD: Jay, your pick?

LEUPP: Malls out perform to the greatest degree. Neighborhoods up modestly. We think that industrial is likely to be our neutral pick for the year. We're more pessimistic about apartments and office. We actually think apartments, probably, are just now where they should be in terms of valuation. We think that 2004 is going to be a tough year for the office companies from a cap ex stand point-big tenant improvement allowances, big commissions being paid to maintain occupancy.

INDUSTRY MARKET CAP

WINOGRAD: Let's move to the REIT market as a whole and its capitalization. The industry has had an equity market cap between $140 billion and $180 billion for a few years now. Do you think we're stalled here? Do you think the REIT sector will takes a big upward jump at some point in the next five years in terms of market capitalization? What would have to happen to precipitate that?

WHYTE: You're dead right in terms of where the market cap has gone over the last few years. But, it's probably worth putting that into context versus the general market. On a relative basis, we have seen a very substantial increase in the market capitalization of the REIT sector versus the broader market.

WINOGRAD: Fair point. Certainly true.

PERREIN: What's interesting is that you need a repeat of the past recession to see a significant growth in the sector. I don't think we're going to see that given the fact that low interest rates have helped the sector. We're not going to see much in terms of M&A because there are no distress situations out there. I think in terms of economies of scale, size, scope, lower costs of capital, we haven't seen anything working in the right direction yet.

You'll need to see a major, significant event in the economy and the real estate world and we don't see that. We don't see that much growth. I think $250 billion is what you'll get.

SCHALOP: I think the key issue is whether there's some compelling reason for the REIT industry to grow. Is there an advantage either in the operating side or on the capital side that causes companies to be able to outperform because of a structural aspect of being public?

We've certainly seen that in the mall sector where there's been tremendous growth in the market caps of the companies because they've been able to show an advantage to size. Being bigger has been better in the mall business. Until we can see that in other sectors, which I think to a large extent we have not seen, then we are going to be somewhat stalled.

If we see more efficient operations or capital providers convinced that the public companies can generate a safer return and, therefore, a lower return giving them an advantage, then we could see an upward march in the market cap.

LEUPP: I'm a little bit more bullish. I think we could see a $250 billion to $300 billion market cap in the next five years. By then, the office and industrial markets should be fully recovered. There's a fair amount of equity growth power, I think, in those two sectors, particularly office. By then, those sectors are likely to be either developing or acquiring on an accretive basis, issuing equity, possibly even doing public-to-private mergers with stock. That will have a powerful growth effect on the industry, and will be one of the accelerating events that kicks the sector up into the next wave of equity growth.

TAYLOR: As I think about the math, I think it's going to be a $250 billion or $300 billion market cap number. If we just get 4 percent to 5 percent appreciation in the stock prices, that's an additional $8 billion to $10 billion a year. With the equity issuance and the reinvestment of cash flow, you could see the market cap getting to $300 billion in five years.

WINOGRAD: OK, let's end on that bullish note.