Things Can Still Go Right for REITs

Investors looking for real estate investment trusts to repeat their performance of the last six months and produce another 13% gain in the second half of this year are probably dreaming. If Microsoft's (MSFT:NYSE - news - boards) first-half performance is a precursor of things to come, even Mister Softee isn't likely to do that.

What REIT investors are likely to get is a capital return equivalent to funds from operations, or FFOs -- a measure of a REIT's cash flow -- which is growth plus a nice cash dividend. Annualized FFO growth running between 6% to 9% means average REIT growth of around 4% in the second half of 2000. Stocks should mirror those results. Combined with an average annualized yield just above 7%, that adds up to a second-half potential return for the average REIT of around 8%. Don't look for any significant multiple expansion in the coming months. From that perspective, REITs appear to be fairly valued.

However, absent some unforeseen gaffe by REITs, downside risk appears limited. The industry's players seem content to recycle capital by selling noncore assets, using the proceeds to shore up balance sheets or develop new properties that provide better returns on equity.

That said, if stock prices continue to rise, some REITs may be tempted to test the markets with a secondary offering. Mark my words: The day that happens, a top in the REIT market will be in place.

In the meantime, here are some curves to watch for, some metrics to measure REITs and some picks by a real estate portfolio manager whose fund leads the pack.

Varying Debt Concerns

Look out for rising interest rates as quarterly results roll in. A significant portion of REIT debt carries floating interest rates. While many REITs hedged their interest rate risk, the rise in rates in the first half of the year may hit earnings for others. "A number of REITs may miss [estimates] by a penny or two because of increased interest expense," says Robinson-Humphrey REIT analyst Patrick Hickey.

This list of REITs with a high level of variable rate debt -- measured as a percentage of total debt outstanding -- shows who to watch as the earnings season progresses. That doesn't necessarily mean these companies face balance sheet issues. (The debt-to-assets ratio shows all to be reasonably healthy.) The impact appears limited to the shock of interest expense on earnings.

Floating Interest REITs with high variable rate debt
Company	Var-Rate Debt/ Total Debt	Total Debt/ Total Assets
Sovran Self Storage (SSS:NYSE)	97.6%	40.2%
Healthcare Realty Trust (HR:NYSE)	68.4	35.4
Post Properties, Inc. (PPS:NYSE)	60.4	43.3
FelCor Lodging Trust (FCH:NYSE)	50.1	44.5
Vornado Realty Trust (VNO:NYSE)	47.4	37.5
BRE Properties (BRE:NYSE)	47.3	45.9
General Growth Properties (GGP:NYSE)	47	63.7
JP Realty (JPR:NYSE)	41.2	57.4
Glenborough Realty Trust (GLB:NYSE)	39.3	50.8
Chelsea GCA Realty, Inc. (CCG:NYSE)	38.1	44.5
Source: Donaldson, Lufkin & Jenrette, SNL Securities, Company Filings Data as of March 30, 2000

REITs According to GARP

So many REIT stocks rallied in the first half of the year that stock selection now becomes more important for those looking to enter the market.

As this column recently noted , many analysts believe investors will begin to focus on "value" REITs -- those that may have been overlooked in the recent rally. While the difference between value and "growth" REITs easily becomes blurred, we decided to revisit an old friend of investors -- growth at a reasonable price, or GARP -- and apply it to REITs.

We classified REITs by property sector -- apartments, retail, office, industrial, hotels, health care, and diversified -- and looked at growth rates, multiples, dividends and debt levels, all relative to their peers. We looked for companies with higher-than-average growth rates trading at lower-than-average multiples, paying a higher-than-average dividend with an average payout ratio and lower than average leverage. The following eight REITs pass that test.

REITs According to GARP Real estate at a reasonable price
Company	Recent Price	Growth Relative to Sector (00-01)	2000 P/FFO Relative to Sector	Current Yield
Pan Pacific Retail Properties (PNP:NYSE)	20 1/8	116%	96%	8.10%
CBL & Associates (CBL:NYSE)	24 3/4	107	92	8.3
Camden Properties (CPT:NYSE)	29 3/4	101	85	7.5
Summit Properties (SMT:NYSE)	22 1/4	105	90	8.1
RFS Hotel Investors (RFS:NYSE)	12 3/16	108	94	12.6
Reckson Associates (RA:NYSE)	24	106	95	6.5
Crescent Real Estate (CEI:NYSE)	22 1/16	120	95	9.9
Health Care REIT (HCN:NYSE)	17 1/2	131	89	13.5
Source: Goldman Sachs, First Call, SNL Securities, Company Reports

The list contains two retail REITs, two apartment companies, two office REITs, a hotel and a health care REIT. One caution: It's clear that additional analysis is in order when the list contains names like Crescent (CEI:NYSE - news - boards), an office REIT that has experienced significant challenges in the past two years; a small-cap hotel REIT like RFS Hotel Investors (RFS:NYSE - news - boards), and Health Care REIT (HCN:NYSE - news - boards), which is in a profit-challenged sector. However, the list does provide some very intriguing ideas for REIT investors in the months ahead.

Now for the crystal ball: To get a sneak peek at the top REIT picks from a portfolio manager with an impressive record, click here .

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Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds was long Microsoft, Summit Properties, Reckson Associates Realty, JP Realty and Developers Diversified Realty, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at [e-mail] .