The first half of the year wasn't kind to many investors. However, it was considerably more pleasant if you were fortunate enough to own real estate investment trusts. As the S&P 500 slipped more than 13%, the Morgan Stanley REIT index posted a positive return of more than 13%, including a current dividend yield of 6.6%.

But can the REITs' run continue? With a weak economy, real estate is feeling a pinch. Vacancy rates in commercial real estate have increased, and rents are declining. Many investors wonder how long REITs can hold onto their gains as fundamentals deteriorate.
Last month, the TSC REIT Roundtable gathered to address the question of whether REITs were at an apex. Members also offered their outlook for various property sectors and their best ideas for REIT investors. At the table were Ritson Ferguson, president and portfolio manager at CRA Real Estate Securities; Christopher Haley, director of real estate research at Wachovia Securities; Art Havener, senior real estate analyst at AG Edwards; Jim Kammert, senior real estate analyst at Goldman Sachs; Jim Sullivan, senior real estate analyst at Green Street Advisors; and Todd Voigt, senior analyst at Cliffwood Partners.

Here we'll examine the current state of the REIT market and what the second half of 2002 holds for REIT investors. We'll also look at multifamily and retail REITs.

Chris Edmonds:

REITs have been tremendous relative performers so far this year as investors look for places to hide. What's behind the success, and can REITs continue their run?

Jim Sullivan:

Real estate is quite simple compared to other industries where a lot of the valuation mistakes were made. You have tangible assets, easily identifiable cash flow and durability to the cash flow. That's comforting for nervous investors.

There's been a flight to safety and companies that are easily understood, including REITs. You can debate whether a REIT is worth $21 or $23 a share but you aren't debating whether it is worth $100 or nothing, as was the case with some telecom companies.

Chris Edmonds:

Todd, Jim makes a great point, but are there any REITs that still look cheap?

Todd Voigt:

I would love to find a few. There may be a few that are relatively inexpensive. But, very few are trading at a discount to their net asset value

or NAV without a good reason, such as balance sheet, property or dividend coverage reasons. We actually have struggled to find inexpensive stocks.

Real estate values are remaining relatively firm, at least on the private side. However, tenant improvements are skyrocketing, and there is pressure on cash net operating income

or NOI. Either prices have to come down or net operating income has to improve. Something has to move.

Chris Edmonds:

Jim, do fundamentals improve or do stock prices moderate?

Jim Kammert:

The fundamentals have to improve before we see another meaningful leg-up in the REIT market. We are trading at just about NAV in most of the stocks, and it's becoming much harder to find real value. There has been a real rush to hard assets, and it's been easy for investors to get into REITs because you can quantify asset value.

Art Havener:

I'm not sure it's fair to say that REITs are just a place to hide. Over the past decade, REITs have earned their stripes. REITs had to prove themselves as a legitimate asset class. Now you are seeing more general mutual funds and individual investors invest in REITs as a distinct asset class.

Yet, if you see a snapback in the economy and the market, these stocks could cool off. We all recognize that the fundamentals aren't as strong as they were two years ago. As a result, we will see more arguments over valuations.

Chris Edmonds:

But, Chris, isn't most of the gain related to money flows? A lot of money has come from other sectors. Is that permanent?

Christopher Haley:

The length of time that money will hang in there is a relevant question. For example, in the March to April 2000 period, we would get calls from diversified money managers asking for six stocks to own, and they didn't care about the fundamentals. A good portion of that money came right back out over the next 12 to 18 months.

The money coming in over the last year, we hope, feels like it's a good place to stay. Our sense is that the longer we have choppy markets, the better it is for REITs. We are finding more and more general managers asking whether it's time to buy more, simply because there is less volatility, they can sleep a little better and have become more comfortable with REITs.

So, it's really about both how much and how fast.

Ritson Ferguson:

And, I would argue, what are the alternatives?

If you believe broad equities will return 5% to 7% over the next five to 10 years and bonds about 3%, then buying an asset that can throw off 6% to 7% income and have just modest appreciation makes a healthy alternative. The money flowing into REITs is coming for a lot of good reasons, because real estate and REITs look like an attractive investment.

Christopher Haley:

There is a fear from some that big-money flows into a small sector can have some damaging effects in terms of overvaluation and prices getting way ahead of the fundamentals. Longer term, I would agree having real estate in the portfolio is a good strategy.

However, we are very cognizant of valuations relative to fundamentals. At the beginning of the year, we started out with a dozen companies with our top rating; now we are at five. We aren't as bullish on the fundamentals and are much more cognizant of valuations.

Jim Sullivan:

Compared to Main Street real estate prices, REITs are not cheap. REITs are trading at a 5% to 10% premium to net asset value in our analysis. But, compared to the broader equity markets, REITs still look cheap. And, if you compare REITs to the bond market -- using earnings yield vs. bond yield -- REITs still look cheap.

Chris Edmonds:

Todd, are you concerned about new equity being issued as stock prices rise?

Todd Voigt:

It's ultimately the right thing to do if they have a good use for the capital. As most of these stocks are richly valued, it's a good time to issue equity; however, it is a sign of the times. I think you will see a significant number of secondary issues coming to market.

That creates a supply issue. You have seen a lot of supply sucked up with new closed-end REIT funds, but how long will that last?

Ritson Ferguson:

I think we are being asked to reconsider the context in which we make these valuation judgments. Relative to the early 1990s, there is no such thing as a cheap real estate asset out there. The real challenge now is to determine whether or not real estate offers us a good relative investment if we can buy it with returns of 10% to 12%.

Chris Edmonds:

Where do we go from here? In general, how will REITs perform in the next six months, both in relative and absolute terms?

Jim Sullivan:

Despite declining fundamentals, REITs and real estate will hold up very well, relative to the broader market. The stability REITs provide will help performance in an uncertain market.

Todd Voigt:

I think over the next six months, REITs could be up about 5%, and relative to the broader market, they will far outperform, even as fundamentals worsen. As perverse as that sounds, the worse the broader market gets, the better REITs will perform.

Jim Kammert:

Total return for REITs over the next six months should be 5% to 7%, including dividends. That could blow away the broader market.

Christopher Haley:

In absolute and relative terms, returns will be flat for the balance of the year.

Art Havener:

I think investors can expect their dividends and stock prices will remain flat. We will trade in a plus-5%, minus-5% range in the sector for the balance of the year.

Ritson Ferguson:

For the balance of the year, investors collect their dividends and are very happy with stable stock prices.

Chris Edmonds:

Let's turn to the apartment sector -- lots of new construction in a slowing economy. What's the outlook for multifamily REITs?

Ritson Ferguson:

Fundamentals are challenged, particularly the public companies, which tend to have a bias toward higher-quality properties. They are challenged on two fronts: The economy is weak, which is hurting demand, and they have a strong housing market, which is a product of sustained low interest rates making the home-buying alternative much more affordable.

Interestingly, apartment owners used to be able to rely on a weaker housing outflow during more difficult economic times. However, this time, if anything, there has been an acceleration in renters purchasing homes.

Apartment valuations are also 10% to 15% higher than we have seen in the office sector. So, while fundamentals may not be as bad as they are in office, if you couple that with higher valuations, the underperform conclusion also applies to apartments.

Jim Sullivan:

I agree. I would add that while we have seen some supply discipline in the office and industrial sectors, that hasn't been the case in multifamily. Combined with the decline in the fundamentals,

new supply will delay a recovery in multifamily. The developers just keep building.

Todd Voigt:

That is true. However, you can't play a lot of accounting games in multifamily like you can in the office sector. It's a pretty straightforward, simple business without ways to hide a lot of costs. Apartments are probably overvalued, but I don't think the overvaluation is as wide as it is in the office sector.

Jim Kammert:

On the balance sheet side, most are very well-positioned, and if you look at year-over-year comparisons, most peaked early last year, so I think you may get better comparisons as the year progresses. Apartments and industrial should be an early indicator of a pickup in the economy. I agree the valuations aren't cheap, but there are good reasons the stocks have hung in there.

Christopher Haley:

I think we are closer to a bottom, and we have been looking for names to upgrade. We have been playing defense, looking at the B-class apartment operators like

Home Properties

(HME)

and

United Dominion

(UDR) - Get Report

, which have had good runs. Over the next one to two quarters, you are going to see a few of the other companies in our universe like

Avalon Bay

(AVB) - Get Report

,

Archstone

( ASN) and even

AIMCo

(AIV) - Get Report

move up in terms of recommendations.

We are beginning to get data points in some markets that suggest we are seeing a trough in occupancy. We think we may get a little better news out of the apartments sooner than

other sectors.

Chris Edmonds:

Dividends are an issue. Will

Post Properties

(PPS)

be forced to cut its dividend by the end of the year?

Ritson Ferguson:

I think they are on record as saying they are willing to sell assets to fund their dividend.

Jim Kammert:

It's really like a liquidating dividend.

Chris Edmonds:

Let's turn to your outlook for retail REITs.

Christopher Haley:

Let it ride. Retail stocks are suggesting it's a good environment to own retail real estate.

Ritson Ferguson:

Retail has less issues with respect to its tenant base and valuation, so I think it is an outperforming sector. Although, I'm still waiting for the next chapter in the

Kmart

( KM) story, I am leery about trying to find value plays with those that have any Kmart exposure.

Todd Voigt:

One thing about malls and retail REITs is that they tend to have a lot more debt on the balance sheet. And what has helped a lot is falling interest rates because they have massive amounts of floating rate debt and have been able to lock some of that in. In the coming year, they won't benefit as much. So, if you strip out all that noise and look at core operations, it's not that great. In most cases, the fundamentals are deteriorating.

If you look at the amount of store space being closed this year, it's 52 million square feet. I would say there is more risk in retail REITs than most realize. Now, are the valuations cheap enough for that risk? Could be, but I'm not sure the risk is fully appreciated among investors.

Jim Kammert:

I tend to agree, we are more bearish on retailers. We like

General Growth Properties

(GGP)

in the mall space because we think they are a little different and are intrigued by a recent acquisition but, by and large, this is a point Todd alludes to, there is a lot of retail space. We are over-stored, and more space is becoming available. You can look at

Gap

(GPS) - Get Report

as a bellwether for demand. In the past, they just kept taking new space, and now they are contracting. I'm not suggesting they will abandon space, but who is there to take newly developed mall space?

In the strip centers, it is clear to me it is all about volume. If you don't have the

Wal-Mart

(WMT) - Get Report

Supercenter or the

Best Buy

(BBY) - Get Report

in your center, you are challenged. I think a lot of the grocers are at risk, and it's just a big consolidation game.

Chris Edmonds:

Is the Wal-Mart threat as large as the hype?

Ritson Ferguson:

It is where they can build them, but there aren't a lot of places you can build a Supercenter. Come to the more densely populated Northeast. Aside from union opposition, there aren't sites to build a Supercenter within the close-in suburbs of places like Philadelphia. Out 15 miles from the city limits, it's a factor. But I don't think people who live within five miles of the city are going to drive just to buy groceries. Groceries have always been a convenience-oriented business. I just don't think you can take one theme like this and apply it to shopping centers.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, 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 and invites you to send it to

Chris Edmonds.