BARRY VINOCUR Realty Stock Review

Vinocur focuses primarily on company management when evaluating REITs. On that basis, he decided that Catellus was a company whose time had come.

"Nelson Rising's team has done a great job for shareholders for years," he says. "At the beginning of 2003, we thought the company's plans to convert to a REIT would draw even more attention to the stock." He was right. Catellus returned 45.95 percent in 2003.

CenterPoint, a second industrial pick, delivered a 36.34 percent total return for 2003. Vinocur was attracted to the management team assembled by CenterPoint's co-Chairman and Chief Executive Officer John S. Gates, Jr. "CenterPoint is one of the best-run companies," Vinocur says. "They have a very focused business model that produces results. Over the trailing five-year period ending in 2002, the company posted an average annual return of 22.8 percent."

In the retail category, Vinocur selected The Rouse Company. "At the beginning of 2003, everyone was watching the situation between Taubman and Simon," Vinocur says. "Whenever there is an episode like that, investors look for alternatives. We thought this would benefit Rouse, which hasn't received the attention it deserves from the marketplace." The theory proved out. Rouse returned 54.78 percent for 2003.

Like Donnelly, Vinocur has been a Chelsea fan for years. "We've recommended Chelsea since 1994," Vinocur says. "They have a solid business model, a talented management team, and a 10-year compound annual growth rate of just over 14 percent."

While those companies were all solid performers, Ventas was the pick that put Vinocur's portfolio over the top.

"Ventas is a superior turnaround story," Vinocur says. "In 1999, the company had a negative 64.4 percent total return and was on the verge of bankruptcy. In 2000, they brought in Debra Cafaro as chairperson, president and CEO, and she has proven herself as a truly exceptional manager."

Heading into 2003, Vinocur also believed that investors had undervalued Cafaro's work, which showed immediate results. In 2000, the company grew by 59.4 percent. The next year saw even greater growth: a total return of 123.1 percent. While the company cooled off in 2002 with a 7.4 percent return, it surged back in 2003 with a 105.75 percent total return.

Vinocur's prediction for 2004 calls for an 8 percent to 12 percent total return for REITs. "Yields remain attractive; the economy is recovering, and earnings will likely increase as a result," he says. He backs his analysis with a 2004 Stock Challenge portfolio that spans the entire REIT industry: Chelsea in retail; Weingarten Realty, a retail owner with some industrial properties; Trizec Properties in the office sector; Ventas in health care; and Host Marriott in hotels.

At the same time, Vinocur notes that analysts disagree widely about the year ahead (as seen in this issue's "By the Numbers" section). David Shulman of Lehman Brothers, the most bearish, predicts negative real estate returns of 11 percent. On the high end, Citigroup's Jonathan Litt looks for an overall return of 15 percent. Vinocur's take on those differences: "The REITsters have a horse race this year."

JEFF DONNELLY Wachovia Securities

REITs entered 2003 with three consecutive years of outperforming the S&P 500, NASDAQ and Dow Jones Industrial Average, and many analysts predicted the REIT run would end right there. The outlook for retail and lodging REITs in 2003 looked particularly weak by most accounts. But in making his picks for the 2003 Stock Challenge, Donnelly, who covers retail and lodging for Wachovia, decided, as they say, to ride the horse that brought him. Four of his five portfolio selections came from the retail and lodging sectors.

In the retail category, he picked Chelsea, an outlet REIT with a growing portfolio of properties in Japan. Because Chelsea had performed well for the two years prior to 2003, some investors thought a slide was due.

"But I was confident about Chelsea's work internationally and in the U.S.," Donnelly says. "I believed they would relatively outperform the market." Turns out he was right. Chelsea's 2003 total return was 72.72 percent.

Federal Realty, Donnelly's other retail pick, also looked chancy at the start of 2003. "Federal owns Santana Row, an asset everyone loves to hate," Donnelly says. "But without Santana Row, the company's core shopping center portfolio was roughly worth its December 2002 stock price. At the time, most strip center REITs were trading at 10 percent to 20 percent premiums to net asset value. I figured that whatever Santana Row was worth, it was definitely not zero."

While Santana Row led the market to undervalue Federal, Donnelly valued the stock, picked it, and earned a return of 44.53 percent.

Donnelly hedged his lodging bets with Innkeepers, an extended-stay REIT, and LaSalle, an upscale full-service hotel REIT. "They seemed like a yin and yang for each other," he says.

Intuition has its ups and downs. LaSalle paid off with a 40.19 percent return. However, Innkeepers returned less than any other Donnelly selection, growing just 11.84 percent for the year.

Senior Housing, Donnelly's only pick outside his area of expertise, returned 78.63 percent for the year—the highest in his portfolio. Donnelly picked the stock on the advice of a colleague, who described the Senior Housing dividend of 12 percent as extremely safe.

"At that time, the average dividend yield on REITs was running about 7 percent and maybe lower," Donnelly says, adding that the downside at the time involved management issues. While institutional investors might balk at a company with management problems, Donnelly theorized that the dividend would attract individual investors looking for high yields. "That theory proved out," he says.

While staying away from picking specific companies for 2004, Donnelly remains intuitively optimistic about the lodging and retail categories that paced his 2003 Stock Challenge performance.

"As the economy turns the corner, I think investors will be looking for ways to leverage up with lodging," he says. "In retail, consumers remain strong as the economy begins to rebound. This bodes well for retail—as long as economic growth is consistent, steady and mild. But if the economy grows rapidly, I think investors might shift into properties like apartments, where the economy's impact may be stronger."

LEE SCHALOP Banc of America Securities

Following a detailed analysis of real estate company performances in each major property category, Schalop and the Banc of America Securities research team expected a good but not remarkable 2003. In early January 2003, Schalop co-authored a research report that predicted 12 percent growth in the RMS, one of the highest of any REIT analyst. The prediction was based on a dividend yield of 7 percent for the index, average cash-flow growth of 0.2 percent, and a slight growth in multiples.

For the Portfolio Stock Challenge, Schalop shaved a little bit off that 12 percent forecast and predicted a rise to 475 for the RMS. He also predicted that the NAREIT Index would rise to 3,960 from 3,552, an 11.5 percent increase.

Even though he produced one of the most aggressive forecasts in the industry, Schalop's research also noted a possible hiccup in his projections. Between 1978 and 2002, real estate stocks generated consecutive double-digit total returns in three or more years only four times (1975 to 1980; 1982 to 1986; 1991 to 1993; and 1995 to 1997). Double-digit growth in 2003 would mark a fourth consecutive year. Was a fourth year in the cards?

Turns out it was more than in the cards as both the NAREIT and RMS indices made dramatic gains again in 2003. The NAREIT Index ended 2003 at 4,871.12, about 900 points higher than Schalop predicted. The RMS shot up to 585.25, a full 110 points over Schalop's estimate.

"I was surprised by the strength of real estate stocks in 2003," he says. "I think two major factors caused the indices to go up so much. First, fund flows, including open-end, closed-end, and institutional flows, exceeded $10 billion in 2003. Second, there was a lack of other yield alternatives."

What happens next? Will real estate stocks turn in a fifth straight year of double-digit growth? "I think they are overvalued now," Schalop says.

Schalop's published projection for 2004 notes that average real estate stocks are now trading at 12.4 times over estimated funds for operations (FFO), 22 percent above the historical average of 10.2 times FFO. While acknowledging strong, safe dividends and wide investor interest in real estate, Schalop's research concludes that the real estate stocks will likely stand pat this year.