Can investing in small and micro-cap REITs still bring big rewards?
By Darlene Bremer

Portfolio diversification has long been a major advantage for investing in real estate stocks. But to paraphrase an old cliché, there is more than one way to invest in real estate. Real estate stocks offer investors many different opportunities in today's market. While industry leaders make headlines and generate name recognition with a broad range of investors, there were many real estate companies with smaller market capitalizations that outperformed their large-cap counterparts last year. However, there is some uncertainty whether these companies will continue to post such comparably strong results. Because a large percentage of these companies fly under many investors', and some analysts', radar, it is important to understand the differences, advantages and disadvantages that small-cap and micro-cap companies offer.

You Say Small Cap, I Say Micro Cap

Don't let the name fool you, there is nothing small about the weight this group of real estate stocks carries. Smaller cap REITs account for a combined market capitalization of $34 billion, according to Brian O'Flanagan, vice president of equity research for Northland Investment Corporation. And even though more than 100 REITs can be labeled small or micro cap, absolute industry agreement about how to define these companies does not exist.

O'Flanagan defines small-cap REITs as those with total market capitalization ranging from $200 million to $1 billion, and he says micro-cap REITs are those with a total capitalization of less than $200 million. "There is no consensus in the industry to support these definitions, as the small and micro-cap sectors are generally ignored by the investment community," he says.

"If investors ignore smaller companies, they are ignoring a great number of excellent investments," Hoster says.

Anatole Pevnev, senior vice president of McDonald Investments, Inc., says the definition of small and micro-cap REITs varies based on the investor. "Micro-cap REITs have total capitalization levels of around $250 million to $500 million, while small-cap REITs have a capitalization of up to $1 billion," he says.

According to A.G. Edwards & Sons' classification, micro-cap REITs have market capitalization of less than $500 million, while small-cap REITs fall into the $500 million to $2 billion range. "Regardless of the small or micro-cap characterization, these companies represent a very large portfolio of assets," says Art Havener, A.G. Edwards vice president.

Uncovering Investment Potential

Even the real estate companies themselves struggle to find the proper classification. With a total market capitalization of $780 million, EastGroup Properties, Inc. views itself as a small-cap REIT. "Capitalization of under $250 million would be a micro-cap REIT in my opinion," says David Hoster, EastGroup CEO. Hoster adds, however, that he is not concerned with how the company is characterized with regards to size. "There are other, more important, factors to attract investors, such as the company's track record in creating value for its shareholders."

Parkway Properties, Inc. has a total market cap of $900 million, and also considers itself a small-cap REIT. "We define a micro-cap REIT as a company with capitalization levels of less than $500 million," says Steve Rogers, president and CEO. "However, regardless of size, a REIT needs to provide higher stock prices and dividends to its shareholders."

Of the 179 real estate stocks tracked as part of the NAREIT Composite Index, 86 companies have a total market capitalization of $1 billion or less, while 52 companies have a total market cap under $500 million. "If investors ignore smaller companies, they are ignoring a great number of excellent investments," Hoster says.

According to Lee Schalop, real estate equity research analyst with Banc of America Securities LLC, REITs with market capitalizations of less than $1 billion generated an average total return of 30.4 percent in 2001, while those companies with market caps of more than $5 billion posted an average total return of 9.5 percent.

Industry analysts and investment professionals agree that there are solid investment opportunities to be found in the smaller companies. Some of the small and micro-cap REITs that Havener says investors should "watch," include Sun Communities, Inc., Home Properties of New York, Inc., Mission West Properties, Pan Pacific Retail Properties, EastGroup Properties, Inc. and Great Lakes REIT. "Each of these companies offers unique stories within their sectors and a hands-on approach to operations," Havener says.

Pevnev says there are two smaller companies in particular that investors should watch: Alexandria Real Estate Equities, Inc. and Corporate Office Properties Trust. "Alexandria focuses on developing office and laboratory space for research and development companies and has people on its research teams with scientific backgrounds," Pevnev says. "Corporate Office is the favored landlord for the National Security Agency, and its location is in demand by government defense and intelligence agencies."

Northland's O'Flanagan says that Equity One Inc. has grown rapidly in the past year and has a high-quality core portfolio in high-barrier markets in Florida, making it a small-cap REIT to watch. "Price Legacy is another interesting company. It has several significant development projects under construction that will begin to make major contributions to earnings in 2003," O'Flanagan says.

Pros and Cons for Smaller Caps

With any investment opportunity there is a level of risk, and investing in small and micro-cap REITs is no exception. Because the coverage of the smaller companies often pales in comparison to that of larger companies, investors must be sure they understand both the advantages and disadvantages smaller companies offer in this industry.

"For investors, the advantage that small and micro-cap REITs have is that they are more entrepreneurial, more focused on a particular geographic region or property type, and under-followed by Wall Street analysts, which opens opportunities for diligent investors to find bargains," O'Flanagan says.

On the other hand, small and micro-cap REITs lack liquidity, diversification and typically have less transparency and lower economies of scale relative to mid and large-cap REITs. "While there is a limited amount of stock in small-cap companies available to institutional investors, no institution could invest in a micro-cap REIT," O'Flanagan says.

Schalop says, "Most real estate investors tend to favor larger companies with better growth prospects, consistent with the historic experience that bigger companies tended to outperform and the fact that these companies tend to be run by superior management teams."

Last year's decision by Standard & Poor's to consider REITs for inclusion in all of its U.S. indices was a watershed moment for publicly traded real estate companies. While most of the coverage focused on Equity Office Properties, Equity Residential Properties Trust and Plum Creek Timber Co., Inc. joining the big boys in the S&P 500, small-cap companies were also recognized. Colonial Properties Trust and Kilroy Realty Corporation entered the S&P SmallCap 600 Index. According to Havener, the inclusion has made the two companies more attractive to investors. "This increased attention will hopefully also increase the liquidity of smaller REITs across the board," he says.

In regard to obtaining financing, small-cap real estate companies are not necessarily at a disadvantage. "There is no problem [for small caps] getting financing at the same rates as large REITs," Rogers says. However, the micro-cap REITs are usually considered too small in today's environment to get an investment grade debt rating. And, according to Pevnev, larger REITs are somewhat more flexible in their ability to obtain unsecured financing.

From the tenant perspective, the disadvantage of dealing with a smaller company is the number and variety of properties. "For national tenants, smaller REITs may not be as attractive since they usually don't have as many properties in as many cities as the larger companies do," Rogers says.

An advantage for tenants in regard to smaller publicly traded real estate companies is that some of those companies have more of a focus on customer service. "Smaller REITs tend to view their businesses as customer driven, rather than asset driven," Pevnev says. He adds that in order to compete, many smaller companies try to provide tenants with equally competitive rates and more personal, one-on-one relationships than is sometimes possible when dealing with a large, national company.

Small and micro-cap REITs continue to try to build a reputation as attractive investment opportunities. Many of these companies offer low volatility and strong growth potential in a sound operating structure guided by an entrepreneurial management team. "Individual companies need to be researched and evaluated on their own track records of providing value," Hoster says, adding that some smaller companies have proven that they are as able to provide that value as their larger counterparts.