If there's one concern retail investors have, in terms of the stock prices in general, it is interest rates. Rufrano

At the 2002 NAREIT Institutional Investor Forum, a panel headed by Glenn J. Rufrano, CEO of New Plan Excel Realty Trust, met to discuss the heart of any publicly traded industry—money. With a good deal of money arriving in the pension fund and public real estate arena, the panel explored where the money is coming from and if this infusion will continue.

Joining Rufrano were: Theodore Bigman, managing director and portfolio manager, Morgan Stanley Investment Management; Elizabeth Henderson, managing director, CRA RogersCasey; Harry Knapp, senior portfolio manager, Bernstein Investment Research and Management; John Kriz, managing director, Real Estate Finance, Moody's Investors Service; and Rita Sullivan, director of global investments, Verizon.

This column, which will regularly feature the views and interests of institutional investors, contains some of the highlights of the panel discussion.

Rufrano: Rita's firm, Verizon, added real estate as an option to its $20 billion 401(k) plan [in January]. So even if a small percentage of employees choose that option, it's a big fund flow into the industry. What made you add that option?

Sullivan: When GTE merged with Bell Atlantic to form Verizon, one of the first things we did was to merge the defined benefit plans (DB) because a lot of the options we used on the DB plans we then used in the defined contribution (DC) plan. Looking back at the DC plans, neither plan [at Bell Atlantic or GTE] had been restructured in quite a few years, so they were quite stale in terms of what they offered.

When we redid the plan, we used a “wedding cake" approach—three tiers. We kept the lifestyle strategies, added asset class strategies, and then added niche offerings on the top, where there were basically branded mutual funds. The REITs fell in the asset class tier. We had used REITs on the DB side since 1995, so we had a certain comfort level. We wanted to offer our participants a chance to develop their own pension program based on their lifestyle. We felt real estate was one of the ways to add value within their own plan. Real estate offered diversification and it was not highly correlated with the other options that we had, so we felt comfortable offering this to our participants.

Rufrano: How has the reception been to the plan?

Sullivan: Well, it sounds small because we have a huge plan. We have 270,000 participants in the total plan and close to $20 billion. We started in January—[and] as it stands today, and it has been growing, we have about 1,900 participants and about $50 million as part of the plan. I looked at the numbers as of May 31, and it's the best performing option in the plan, so we expect that we'll see more participants as they see the good returns.

Rufrano: Let's try to get underneath some of the reasons why people are flowing money in [to the sector]. There's a total return concept and there's a dividend concept. What's the relevance of total return, dividend and taxation when we're telling investors to put 10 percent of their money in [REITs]?

Knapp: Actually, it's very relevant. I have to qualify the 10 percent recommendation. Basically we say 10 percent of one's total assets should be allocated to REITs provided they can be located within a tax-sheltered vehicle like a 401(k) or an IRA. For example, if an investor had $3 million, of which $500,000 was in an IRA and the other $2.5 million was in a personal account, we'd say 10 percent of the total $3 million ($300,000) can go into the IRA. In that example, the IRA would have 60 percent of its assets in REITs. The balance, presumably, in equities.

But that's an important caveat because as you model this on an after-tax basis for somebody in the highest tax bracket, you can achieve a better after-tax return through a combination of equities and municipal bonds within the tax-sheltered environment, in our view, than you can with REITs. REITs basically extend the efficient frontier beyond what you would get with just stocks and bonds. So that really is a critical factor.

Rufrano: Ted, for the money you see coming in, is dividend or total return more important? And what's the cost of money that you see to attract the sums that are coming in now?

You can only play with the accounting earnings so much if you're paying a dividend every quarter. Bigman

Bigman: I think it's total return. Most of the clients are looking for diversification and an expected return.

When it is for the defined benefit program, that program has to make payouts. We have clients where they take the dividends back—and use that to make payments when they have to pay out from their defined benefit program. I think the dividend does make them feel more comfortable in terms of an expected total return.

For the marginal buyer today, there is what others have called “Enronitis," where people are worried about companies where the cash flow may not be what the earnings look like. And just the fact that REITs pay out a dividend on a quarterly basis means that somehow they're straight with the cash every quarter to pay it out. You can only play with the accounting earnings so much if you're paying a dividend every quarter, and there's some feeling that there's a connection between the cash flow being paid out and the accounting earnings in this asset class. There is a sense that you really understand what you're getting.

Henderson: With the endowment plans, it's also on a total return basis. The endowments do scoop the dividends out every month, but that wasn't the primary reason why the fund invested in REITs, it was for asset allocation reasons.

In terms of expected returns, we expect U.S. equities to have about an 8 percent return, REITs about 7.5 percent—and a very similar volatility assumption.

Rufrano: My next question relates to the three arms coming in (dedicated, retail and non-dedicated) and what is the percentage of capital that's coming in from each. I think the percentages of each will dictate longer term whether capital stays in [the industry] or flows out. What do you think the percentage is of those three lines to the total pool?

Bigman: Well, for simplicity, let's say it's a third, a third, and a third. Although none of us have done a lot of work on that subject, I would agree with your thesis that the more we have capital in dedicated real estate and retail hands, the less volatility it will have.

Knapp: Again, I think it comes down to is it an asset allocation decision or is it a security selection decision, neither of which is opportunistic. We've made the decision, within our private client business, to recommend a 10 percent asset allocation to real estate. At the same time, we're considering whether we should include REIT stocks within our U.S. value portfolio for the first time. We haven't actually bought any yet, but that's an issue that we're considering. And to the extent that you see more REITs included in the S&P index and the like, there's going to be a stronger impetus for U.S. stock managers to include them in their portfolios.

Rufrano: I think we feel very good about the debt side, but there's a lot of banking consolidation. Is that going to affect the industry going forward?

Kriz: I think it will. When our [REIT] clients find that some of their key banks merge, they go from $50 million each to $75 million in total, and they have to find other capacity for the $25 million that's left over.

Also, a number of banks are full on commercial real estate exposure. I think the REITs and other real estate companies that have been dependent upon banks [for funding] need to diversify that debt, and that's why they're looking to unsecured debt, preferred stock, common stock and secured debt as a way of doing that. So I think this bank consolidation is going to be a growing issue, not just for the real estate sector, but for many other sectors, too.

If one of the companies has a problem or simply wakes up one morning and decides it wants to decrease its lending allocation, there will be a very large ripple effect throughout its customer base, and this is something we really haven't faced before.

Rufrano: We have very good fund flows that are increasing and coming from a variety of sources. The cost of money expectations are reasonable, and so for some foreseeable future, it's not going to stop.

But then you have to say, what can make it stop? Is there something that can cause some of the flow of funds that seem to be coming in stop?

If there's one concern [New Plan's] retail investors have, in terms of the stock prices in general, it is interest rates. The retail investors will ask, “if interest rates go up, will the REIT stocks go down?" Harry, if interest rates go up 300 basis points, what are you going to tell your investors?

I would say the worst thing for REITs would be a sustained tech stock rally. Knapp

Knapp: I think that would hurt, but it would hurt stocks and bonds as well, so I don't think that's really a key factor that would differentiate the impact on REITs.

Somewhat tongue-in-cheek but not completely, I would say the worst thing for REITs would be a sustained tech stock rally, because that would just suck money out of all kinds of places. I don't think that's a particularly high risk right now, but that probably is the biggest negative correlation there is.

Bigman: I agree with Harry that interest rates would affect all asset classes, and again, investors are looking at relative returns. I'd say relative returns on other asset classes would fall, and it may affect the sector in terms of how different stocks perform. Clearly, some stocks that are played on the difference in their dividend yield and what investors can get for short or long-term rates may get affected more than other stocks, but I don't think the sector would be badly affected.

[One] thing we worry about is other asset classes looking more attractive. We keep talking about the models that strategists do. Other asset classes could look more attractive through no fault of our own and the marginal dollar would go somewhere else.

The corollary to that is to the extent fund flows continue to move up for REIT stocks, there could be a level at which they look too pricey. Obviously we don't think they're there at this point in time, and a flood of equity issuance would serve to depress REIT share prices, but you'd have to have another uplift to have that downlift. But investors have to be wary if there's a huge uplift due to a flood of capital, and expect equity issuance to drive that down to a more normalized level.

Henderson: That is similar to one of the issues we have, which is trying to convince our clients to invest in emerging market equities. If you have a persistent, weak performance in a particular asset class that always causes investors to say, “well, why should I put money in this asset class?"

So if you had something similar to 1998–1999, where the money was flowing into other asset classes and you had persistent underperformance, that's always an issue with clients.

Kriz: The questions I receive are from mostly fixed-income investors and some equity investors. The first key [question is], what do we think about the business proposition of the firm and the people running the firm? In some cases that's a pass/fail on the part of the investors. They have to feel comfortable that this is a business they have confidence in, that the people running it are good business people.

We get a fair amount of questions on disclosure, particularly in joint ventures, so that [investors] can look at adjusted balance sheets, as well as coverage and leverage issues.

We also get a number of questions on financial flexibility issues. I think much of this is really a question of what's the near-term risk of a credit reversal? Will they have the liquidity to get through the next year or year-and-a-half?

Rufrano: So if fundamentals stay reasonable, interest rates don't go crazy—everybody gets affected if they do—and as long as tech stocks don't go up, then we're OK. That's not a bad scenario. It sounds to me like there's some room in the foreseeable future for money to flow in and we don't see anything right away to see it flow out.