REITs Outperformance May Yield to Caution

When it comes to real estate, value continues its reign.

Real estate investment trusts, or REITs, lately have shown their inherent steadiness. "While the third quarter was one of the worst three-month periods for the stock market, REITs exhibited their defensive characteristics and dramatically outperformed most major indices," notes Steve Sakwa, director of REIT research at Merrill Lynch.

In the third quarter, the Morgan Stanley REIT Index's 2.6% decline looks like success compared with the broader market. The S&P 500 lost nearly 15% and the Nasdaq Composite lost 31% in the same period.

By Comparison, REITs Don't Look So Bad Year-to-date performance of the Morgan Stanley REIT Index, the S&P 500 and the Nasdaq

A key component of REIT total returns is the dividend. The average REIT still yields more than 7%, and that payout is crucial to stability in troubled markets. Yet, even with the dividends, the future success of REITs is becoming clouded.

"Despite the group's high dividend yield, which helps buffer REIT stocks in a down market, investors need to remember that real estate is a lagging economic indicator and will be negatively impacted by slowing GDP growth and rising unemployment," notes Sakwa. "As a result, we continue to believe that the risk to our FFO [funds from operations, a REIT's measure of cash flow] estimates lie on the downside." He adds that estimates are likely to come down about 5% on average.

One fund manager who asked not to be named said he thinks it could be worse. "First Call estimates suggest 8.5% year-over-year growth from this year to next," he says. "That is 1 to 2 percentage points too high."

Growth (What's Left) at a Reasonable Price

As growth slows, a keen focus on valuation becomes more important. Hence, my quarterly "growth at a reasonable price," or GARP, metric is a valuable analytical tool in the process.

My GARP picks outperformed both REITs and the broader market in the third quarter. The seven stocks that passed the GARP test posted a loss of 1.8%, well above the Morgan Stanley REIT Index's 2.6% decline.

Gaining With GARP Third-quarter REITs according to GARP outperform
	Price 7/3/01	Price 10/2/01	Quarterly Dividend	Total Return	Current Yield
Apartment Investment & Management (AIV:NYSE)	$48.90	$44.36	$0.78	-7.69%	7.03%
Camden Property Trust (CPT:NYSE)	36.64	36.92	0.61	2.43	6.61
CBL & Associates (CBL:NYSE)	30.46	26.85	0.53	-10.10	7.94
Developers Diversified (DDR:NYSE)	18.28	17.70	0.37	-1.15	8.36
Duke Realty (DRE:NYSE)	25.23	23.98	0.45	-3.17	7.51
Equity Office Properties (EOP:NYSE)	30.90	31.73	0.50	4.30	6.30
Regency Centers (REG:NYSE)	25.48	25.69	0.50	2.79	7.79
GARP Portfolio Average				-1.80%	7.36%
REIT Average*				-2.60%	7.30%
S&P 500				-14.70%
Source: Goldman Sachs, SNL Securities, Thomson Financial, Company Reports * Morgan Stanley REIT Index

The best performer in the group was Equity Office Properties (EOP Quote), the nation's largest REIT. Its performance was bolstered by speculation that the company would be added to the S&P 500. That speculation will become reality Tuesday when this office REIT is set to replace Texaco (TX Quote) in the benchmark index. With a market cap of nearly $9 billion, Equity Office will become the first REIT in the index.

However, the company warned Thursday that 2002 FFO would be considerably lower than previously expected. The company's FFO guidance for 2002 has been adjusted to a range of $3.40 to $3.50, down from a range of $3.57 to $3.62.

Equity Office President and CEO Tim Callahan blamed the economy for the projected shortfall. "The continued general economic weakness across U.S. markets and the added uncertainty from the tragic events of Sept. 11 have caused us to revise certain of the assumptions in our earlier 2002 FFO guidance," he said.

The fund manager expects other office REITs to follow suit. "You're crazy if you don't think it's just as bad, if not worse, with other office REITs," he says.

The laggard in the third-quarter group was CBL & Associates (CBL Quote), a regional mall REIT that lost ground as retail sales softened. Mall REITs receive a portion of their rent from a percentage of sales above a certain baseline.

Revisiting GARP: Uncertain Support

As the GARP portfolio gets recalibrated for the fourth quarter, I used the same quantitative analysis as in past quarters: I look for REITs that have above-average projected growth rates for 2002 and that trade at multiples below the property-sector average. I also screen for companies that pay an above-average dividend with below-average payout (based on FFO) and have a below-average debt-to-market-cap ratio.

With earnings growth slowing, only five companies met the criteria this quarter.

Down the Stretch Fourth Quarter REITs According to GARP
Company/Ticker	Current Price	Property Type	Relative Growth Sector: 2001-02*	Relative 2002 P/FFO to Sector*	Current Yield	Payout Ratio**
Camden Property Trust (CPT:NYSE)	$36.92	Apartments	102%	93%	6.61%	65%
Developers Diversified (DDR:NYSE)	17.70	Retail - Shopping Centers	122	78	8.36	58
First Industrial Realty (FR:NYSE)	28.84	Industrial	107	81	9.12	60
ProLogis (PLD:NYSE)	20.90	Industrial	104	99	6.60	54
Regency Centers (REG:NYSE)	25.69	Retail - Shopping Centers	128	95	7.79	67
Average					7.70%	60%
Source: Goldman Sachs, SNL Securities, Thomson Financial, Company Reports *Relative to companies in property sector **Based on funds from operations (FFO)

Three are repeats from last quarter, Camden Property Trust (CPT Quote), an apartment REIT, and Developers Diversified (DDR Quote) and Regency Centers (REG Quote), both community retail center REITs.

As the economy slows, apartments and community shopping centers are better positioned to weather the storm. While apartment rents may feel pressure, tenants looking to buy homes typically postpone purchases during periods of economic uncertainty. Camden continues to trade at a discount to its peers, and the company affirmed Thursday that it would meet its third-quarter earnings guidance.

Strip centers tend to house essential businesses such as grocery stores and pharmacies, which aren't as exposed to economic volatility. Both Developers Diversified and Regency pay solid dividends, which should provide a buffer in more difficult markets.

The two newcomers to the portfolio are both industrial REITs specializing in large warehouse space: First Industrial Realty (FR Quote) and ProLogis (PLD Quote). While both could feel the impact of an economic slowdown, both stocks have recently underperformed the REIT average. First Industrial recently lost ground after Warren Buffett disclosed he sold his stake in the company. ProLogis shares have lagged as investors have struggled to understand the company's international operations.

Yet both pay solid dividends, and, while earnings could feel an economic pinch, any pullback could present good entry opportunities.

Clearly, I'm not as optimistic about REITs -- even with the GARP method -- as I've been in previous quarters. Economic uncertainty suggests a more cautious stance is prudent. The fact that only five stocks passed the screen speaks volumes about the sector's relative value.

Remember, this is purely a statistical exercise. While it eliminates subjective judgments, it also eliminates qualitative analysis, something that can be very important in more difficult property markets. And, of course, revisions to growth rates by any of these companies could change their position in the GARP portfolio. With earnings revisions just beginning to affect REITs, even these five values should be scrutinized carefully.