A panel discussion focused on the outlook for U.S. property markets and REIT operating performance was held at the NAREIT 2001 European Investor Conference, January 31, 2001. A condensed version of the highlights of the discussion is presented here.
Jay P. Leupp, managing director at Robertson Stephens, moderated the panel. The panelists were: Bill Hauser, director and portfolio manager for HVB Capital Management, Inc.; Peter Hobbs, head of European Research at Property & Portfolio Research and Richard Brace, vice president and director for Torto Wheaton Research.
Leupp: Let's talk a little bit about the challenges, advantages and disadvantages that a European investor will face in making an investment in U.S. REITs. Bill, talk a little bit about how European investors look at making an investment in REITs.
Hauser: In the U.S., the REIT structure has clearly evolved. It has changed dramatically since it was first introduced, and it is, in my mind, an excellent vehicle to gain access to the U. S. real estate market. Corporate governance, meaning the board of directors, may have been problematic 10–15 years ago. Today, for the most part, these companies are professionally managed, professionally run, and the boards are doing a superior job. I can think of several companies that have clearly acted in the shareholders' interest rather than in the management team's interest in specific instances.
Leupp: I think the whole sector has done a very good job of maturing in recent years. The REIT sector has come out of a very tough investment performance period before 2000—two straight years of negative total returns. That hadn't happened in about 20 years. But the way the management teams in the sector reacted to that downturn showed a lot about the industry. Several management teams undertook share buyback programs and actually executed them. There are examples where the decision was made to merge with larger entities at a premium to the current price at which the REIT stock was trading. So there have been some really positive examples that have demonstrated that the sector has matured and now offers compelling opportunities for both U.S. and European investors.
Hobbs: I believe the different philosophies and approaches to management in the U.S. are a plus. The involvement of management tends to be more of an equity participation of the individuals who are leading those organizations. In Europe it tends to be more historic or older money. They both have equity stakes in the business, but they're coming from very different perspectives with different implications for how effectively those businesses will be managed.
Brace: The fundamentals behind the publicly traded real estate market in the U.S. have have actually been consistently strong over the past two, three, four years, although the stock returns, not surprisingly, have fluctuated from year to year. So it's given the opportunity for managers to say, "There is true value here."
Audience Question: Could one of you comment on the impact U.S. taxes have on foreign investors?
Hauser: I represent German retail with a soon-to-be focus on institutional as well. But the tax issue is clearly a sore spot. I took over management of a retail-based fund that was launched in the middle of 1997, right at the peak of the REIT market. As I came on board, I did a comparison of my numbers versus the index and what was being reported elsewhere, and I said, "There's a shortfall, I don't understand that, my numbers look better than that." And what we determined was that there was a problem with the withholding taxes. German investors are subject to a significant withholding tax on any dividends before they leave the United States. I don't have any immediate resolution for it, but it's something that is clearly important for us.
Leupp: Let's talk about equity market performance. What would you say the range will be in terms of high to low performance this year?
Hauser: Well, let's start with this: we have a good understanding of what earnings will be. It's relatively predictable, and that's one of the beauties of the sector. If I simply added high, single-digit funds from operations (FFO) growth with a 7 percent yield, I'd come up with a mid-teens return. Unfortunately, all portfolio managers do that year after year, and the fact is we're often wrong. And the reason we're wrong is that the biggest component of the total return has to do with the contraction or expansion of the multiple, and I will be the first to admit that getting that right is virtually impossible. Assuming that multiples stay in a range similar to where the market is currently priced, a mid-teens return is not unreasonable. I come in probably in the 13 to 15 percent total return range.
Leupp: I think that most of the reason why we've been wrong in recent years in our total return predictions has been equity market conditions.
Hobbs: Yes, I would have to agree with that. We don't forecast stock prices; we forecast the net asset value (NAV) for individual REITs based on real estate fundamentals. We leave stock price valuations to the equity market analysts like yourself. All I would say is that we are bullish on real estate fundamentals, i.e., the real estate market going forward into this year, regardless of whether or not we experience an economic recession. Certainly net operating income (NOI) will remain strong and there is a prospect of continuing capital value growth.
Leupp: What is your prediction this year in terms of net asset value growth?
Hobbs: Huge variations across markets, but probably remaining in the double digits for this year.
Brace: We take the same approach Peter does. We're really building up the fundamentals and I think those cash flow numbers give you a basis for what you would translate into returns on a discounted basis. But for the most part, I think we're in the same range as Bill. The office sector, at least from the fundamentals perspective, has the strongest cash flow growth due to a lease structure that's going to allow you to continue to gain significant income, regardless of whether rents stay the same or drop off a little bit because there's been such a pop in rents in a lot of the markets. So I would say that the 13 to 15 percent range is what our total return numbers are suggesting.
Leupp: Do you have a weighted average cash flow growth prediction for 2000–2001?
Brace: It's in the eight to ten percent range, comparable to what a lot of the analysts are expecting.
Leupp: Are you considerably bearish on the retail sector?
Brace: When we're looking at retail, we are looking at the neighborhood community centers, but we have two issues: one, the economy, and number two is that retail tends toward overbuilding itself.
Leupp: We were fortunate to be right last year after being wrong the two prior years. We're going to stay at the high end of Wall Street predictions this year—with a 17 percent total return prediction. The total return prediction assumes at 2.6 percent gross domestic product growth and a 50 basis point drop in short-term interest rates. So we're assuming that, for the time being, GDP growth and interest rate declines will counterbalance each other, share prices remain about unchanged, and total returns at about the 17 to 20 percent.
Editor's Note: For additional in-depth information on this subject see the article titled "Enticing the Euro".
