By Michele Lerner

How will changes on Wall Street impact REIT coverage?

Scandals and concerns over perceived improprieties have given rise to a new era on Wall Street. A slate of adjusted rules and regulations, most predominantly the changes led by New York Attorney General Eliot Spitzer and the Sarbanes-Oxley Act of 2002, have affected the operations and financial reporting of nearly every public company. In turn, this has focused the spotlight on the reporting process and all financial dealings for public companies and the analysts that cover them like never before.

At the same time, belt tightening has put an additional strain on sell-side firms leading some in the REIT community to wonder if REITs will be negatively impacted through reduced coverage.

REIT experts agree that while all publicly traded companies, including REITs, have been somewhat impacted by the changes on Wall Street, REITs are not expected to suffer in particular. Many actually predict that Wall Street adjustments could have a positive influence on REIT performance.

"There have been significant cutbacks on the sell side especially in research coverage, so to some degree REITs do have less coverage," says Rahul Bhattacharjee, director of research at Cohen & Steers Capital Management and formerly a sell side analyst at Merrill Lynch. "But, overall, all public companies are getting less coverage and this has actually affected REITs a little bit less."

Bhattacharjee says the increasing popularity of REIT stocks in recent years reflected in record fund flows will ensure coverage levels do not fall dramatically.

"The market capitalization for REITs may not be that large but there is widespread ownership among the client base," he says. "This means that, for example, Merrill Lynch has to cover some REITs because they are so widely owned. Companies that are institutionally owned are the ones that firms are more willing to drop from their research. There's a greater proportion of REIT ownership versus the average S&P 500 company, so firms are loathe to give up that REIT coverage."

State of the Sell Side

With several firms initiating REIT coverage for the first time and other more-established firms trimming their sell-side team, it is difficult to gauge an exact reading on whether there are more or less eyes watching the industry now than over the last decade. Opinions vary as to how dramatic the actual change in the number of analysts has been.

Ralph Block, author of "Investing in REITs," has been a REIT investor for 28 years and has seen a lot of changes in the industry—but this isn't one of them. "There's not much evidence of coverage being curtailed," he says. "Musical chairs are happening a bit, with analysts leaving one company for another, but even that's not happening a lot."

Further analyst cuts are not anticipated, and some REITs have seen an expansion of their coverage by analysts.

"Our company has actually picked up analysts, but that may be simply because we've grown larger," says Scott Estes, vice president of finance at Health Care REIT, Inc. (NYSE: HCN) and a former REIT analyst with Deutsche Bank. "Most of the companies are now relatively compliant with the new rules, and the most senior people who have been impacted have now found different opportunities and will work in other places. There's been a rotation among the analyst companies which is probably complete."

Anatole Pevnev, chief executive officer of Interactive Digital Properties Group and formerly an analyst with McDonald Investments, agrees that the impact of the new rules, including the Sarbanes-Oxley Act and new Securities and Exchange Commission Corporate Disclosure Reforms from 2002, have done little to hurt REITs.

"The new rules are trying to put a wedge between the bankers and the analysts, and they add a layer of complexity and time to the research that needs to be done," Pevnev says. "But none of this has affected what stocks companies would or would not cover, and it doesn't affect REITs any more than any other company."

According to Block, "Under the new regime everyone wants the analysts to be more independent from the investment bankers, so now the research guys have to be their own profit center. They are under pressure to distinguish themselves by finding some kind of niche."

While these pressures and other fiscal concerns in the post-Enron environment have contributed to the lay offs of some sell siders, Pevnev believes most are leaving out of choice, just as he did earlier this year.

"Sell siders are leaving because they are becoming administrators more than analysts," Pevnev says. "Hopefully over time the industry itself will lighten up on some things and analysts will be able to do their jobs without as much pressure to conform to so many disclosure rules. The problem is that the regulations which have been put in place can't stop some of the problems. You can't regulate honesty. Frankly, I thought even before the litigation on conflicts of interest that some analysts were not being open enough about where their information came from. My feeling was they should have been doing that [disclosure] all along. But the regulations are making it more difficult for everyone to do their jobs."

With the benefit of having worked on both sides, Estes says that while the new rules have leveled the playing field they have also slowed the process.

"In the simplest sense, the old way Wall Street used to work was the buddy-buddy way," Estes says. "Analysts were sharing information based on their relationships with managers and information was learned on a personal level. Now the SEC regulations mean that all information must be disseminated to the general public at the same time and that there is no longer any preferential disclosure. This means there's a lag in information time and that everything needs to be documented. Ultimately the changes in the way they work have meant that some analysts have chosen to leave the sell side and do something else. I think that the lesser number of analysts along with the lack of experience of some of the analysts means that the quality of the research is not as high."

		Regulatory Changes Affecting Wall Street Practices

The Fate of Research

In addition to questions over quality, some wonder whether the concerns over costs, regulatory changes and the potential diminished impact could spell the end for research being provided by Wall Street firms. The Spitzer-led settlement succeeded in separating investment-banking divisions from stock analysts to eliminate potential conflicts of interest. The consensus seems to be that the analyst field has stabilized now and that research will always have a vital role to play on Wall Street.

"I do not think that Wall Street will abandon sell-side research, but I believe that the amount of resources allocated to fundamental analysis will likely continue to decline which will in turn potentially reduce the quality and/or breadth of coverage," says Stuart Seeley, executive director of Morgan Stanley Asset Management and former sell-side analyst. "The pressure to commoditize and standardize sell side research is an irony with REITs in particular because there is substantial information available on both the public real estate companies and the private real estate markets resulting in an ability to truly analyze this sector."

Given the changes in the environment, Seeley says he believes there are inherent advantages of having broad proprietary research capabilities on the buy side.

Bhattacharjee shares that view, adding that Wall Street's clientele of institutional and retail investors will always demand investment research from broker-dealers selling securities.

"Thus, the Street will continue to provide research in the post-Spitzer-settlement era. Investment banks will view research as a loss leader and subsidize research costs from revenues generated in other parts of these firms," Bhattacharjee says. "The breadth of REIT stock research, in particular, should endure. Vis-à-vis stocks in the S&P 500, retail investors disproportionately own REITs. Hence, brokerage firms like Merrill, where REITs are widely owned, will always have a large REIT stock research team."

For a long-time REIT investor like William Hauser, managing director and portfolio manager for HVB Capital Management, Inc., research has its place and adds value, but he feels the industry had an excess of coverage by sell-side analysts.

"This didn't give an opportunity for any one firm to offer an advantage over another, so nothing has necessarily been lost by the trimming back of analysts. The only real concern is that REITs with smaller market capitalizations might suffer, because the economic reality is that of course researchers have to cover REITs like Equity Office Properties Trust (NYSE: EOP), but they are more willing to eliminate coverage of the less well known names."

Hauser believes the future of research may lie in the formation of third-party providers.

"There is increased opportunity for a third-party researcher who will be more willing to do research on less well known companies because all they will do is provide research," Hauser says. "They can get paid by people directing some commission dollars to them in gratitude for their research. The increased independence and objectivity of third party providers will likely lead to this type of company providing the larger part of research eventually."

Richard Imperiale, president of Uniplan Real Estate Advisors, Inc., also speculates about the potential for independent researchers.

"A big question is whether the good analysts will remain with the big companies or whether they will become part of smaller independent research companies. We haven't seen that happen yet, but it may be the trend in future years," Imperiale says.

		Slim Coverage for Small REITs For small-cap REITs it is a struggle to receive coverage from one analyst, let alone a handful of analysts.

Ongoing Impact for REITs

Forecasting what lingering impacts these changes, and other unforeseen rulings that may come, will have on REIT coverage is a difficult task. For the most part, the outlook seems to be favorable and impact on REITs minimal.

"If there was less interest in the REIT sector then there would be less coverage. I expect the coverage to expand along with the sector," Imperiale says. "We're just at the beginning of a long-term trend, in the early part of an expansion of publicly traded real estate. Ten years ago, there were probably three REIT analysts, and now there are a dozen or so. In another 10 years there will probably be three times as many analysts covering REITs."

Estes, although he believes Wall Street's research is weaker today than in the past, does not feel that the industry's changes have impacted investor interest in REITs.

"The Wall Street changes haven't slowed the momentum of REITs at all," Estes says. "Investors still find where they want to put their money, which makes you wonder if maybe analysts are not so valuable or important after all. I honestly think markets are above and beyond what analysts are doing, and market performance is based on the fundamentals of the performance of the companies themselves as opposed to what analysts say."

Block also trusts that investors will be guided by REIT accomplishments rather than analyst reports.

"My overall view is that the new rules and regulations and a new philosophy on Wall Street to some extent is changing how some firms cover REITs. But I think the effects of this change are fairly muted because the REIT industry is populated by investors who tend to be less subject to people who have fits of irrational exuberance," Block says. "People who invest in REITs tend to be flinty-eyed and cynical and their expectations are not that high for rapid growth. Funds have flowed steadily into REITs and their performance has been good."

Block adds that because the REIT industry has responded well to the new required bureaucracy, any lingering effects should be limited.

"But REITs have done a good job, better than the rest of the equities, in making the corporate governance rules much more shareholder friendly," Block says. "REIT corporate governance is improving and their disclosure to investors is very extensive. REITs have matured a lot, learned what their shareholders expect of them, and that, coupled with the entrance of REITs into the S&P 500 has put REITs into the mainstream. Some of the changes on Wall Street are making investors more aware of what they're buying, which plays into the REIT industry very well. The REIT industry is seen as a solid conservative investment. REITs will be seen as a stable investment vehicle to the extent that they have the ability to increase investor confidence in their performance, and so they will be seen as a vital type of asset to have in a diversified portfolio."

In fact, most REIT industry experts agree that other factors besides Wall Street rules and sell-side analysts seem to have had a greater impact on the momentum of acceptance of REITs as a mainstream investment.

"Analyst coverage certainly helps REITs, but the major things that have helped REIT performance have been not just the stock performance but the performance of the companies themselves," Pevnev says. "We just went through a recession and yet this time, because of capitalization plus the structure of companies and how they are financed, REITs didn't go negative. Maybe we saw a reduction in their earnings, but we certainly didn't see bankruptcies in real estate the way we did in previous recessions. REITs own a significant portion of the real estate in this country, and it was a huge comfort to a lot of investors that they survived the recession."