By Christopher M. Wright

Q & A with Martin Cohen and Jim Keagy

In order to gauge the state of the publicly traded real estate investment market, Portfolio sat down with two seasoned portfolio managers—Martin Cohen of Cohen & Steers and Jim Keagy of Barclays Global Investors—and asked them to comment on the strong run the REIT equity market has been on and where REITs as an investment alternative are heading.

MARTIN COHEN TITLE: Co-Chairman and Co-Chief Executive Officer COMPANY: Cohen & Steers Capital Management, Inc. AGE: 55 REAL ESTATE INDUSTRY EXPERIENCE: Cohen received his Bachelor of Science degree from the City College of New York and his M.B.A. from New York University. After serving as a vice president at Citibank and senior vice president at National Securities and Research Corporation, he co-founded the nation’s first real estate securities mutual fund with Robert Steers in 1985. A frequent author and speaker on the industry, Cohen received the Industry Achievement Award from NAREIT in 2001.

Portfolio: What impresses you most about REIT investing in the last few years?
Cohen: It's really quite momentous that REITs have generated outstanding returns for shareholders when most asset classes have not. REITs have had a spectacular run since the tech bubble burst in 2000.

REITs had a great year in 2003 and were up in the first half of 2004 when the rest of the market was flat or down. Investors will carry this experience with them for a long time.

Portfolio: What is your outlook for REIT stocks through 2006?
Keagy: Real estate is an attractive asset class, and fundamentals should continue to improve with the economy. REITs probably won't experience the 15 percent to 20 percent returns we have seen over the past few years, but our long-term expectation for public real estate stocks is 10 percent annually. This would be for investors with a time horizon of 10 years or longer.
Cohen: I believe that publicly traded REIT returns will revert to their norm, which is in the 10 percent to 12 percent range. Dividends account for 5 percent to 6 percent, leaving room for 4 percent to 6 percent share price appreciation.

I expect an increase in the growth rate for REIT dividends looking at the industry as a whole. This will come from good fundamentals. Earnings will grow and REITs are required to pay out virtually all their earnings as dividends. It's the growth in dividends that will drive share price increases.

Portfolio: What do you see for dividends, Jim?
Keagy: I see continued healthy dividends, especially from publicly traded REITs that have chosen their markets well, where they can pursue a competitive advantage. On the demand side, the economy is improving and the need for commercial property should increase. On the supply side, most markets are not grossly overbuilt.

I'm in San Francisco, which is still oversupplied from the tech boom, but I don't see a lot of construction cranes here or elsewhere across the country. Developers have been reasonably disciplined, which will help preserve dividends.

There have been some coincidences where REIT shares and interest rates were seemingly related, but there have also been an equal number of instances where they were negatively correlated. In the final analysis, they’re not correlated at all. —Martin Cohen

Portfolio: Most observers expect a rising interest rate environment in the next couple of years, and some say REIT shares will decline to keep yields competitive with bonds. Do you agree with that analysis?
Cohen: No, that's never been true. There have been some coincidences where REIT shares and interest rates were seemingly related, but there have also been an equal number of instances where they were negatively correlated. In the final analysis, they're not correlated at all.
Keagy: The concern about high interest rates is a bit exaggerated. When it comes to managing interest rate exposure, the real estate industry is pretty savvy. Most REITs have been careful not to abuse leverage, especially short-term debt, and Wall Street quickly penalizes REITs that do.

Multifamily REITs should actually benefit from higher interest rates. They have been struggling for years because homeownership has been so affordable. Higher interest rates could make renting apartments attractive again, and that is just one example of how rising rates will not necessarily be a big negative for REITs.

Portfolio: REIT stocks have been trading at a premium to net asset value (NAV). Do you foresee any change in that over the next 18 months to 24 months?
Keagy: A premium of about 10 percent is appropriate given the liquidity and other advantages listed REITs offer over direct real estate investments. Accurate, real-time valuations, diversified portfolios, and management teams that are aligned with shareholder interests are all attributes that justify a premium for REITs.

Listed U.S. Equity REIT Performance versus Leading U.S. Benchmarks

Portfolio: If you were speaking to an investor on the fence about investing in REITs, what would you say to him or her as to why investors should be in the REIT sector over the next couple of years?
Cohen: The REIT story is one of income, diversification and total return. About 60 percent to 70 percent of REIT returns over time come from dividends. We seem to be in a very low return environment for all asset classes. The Dow Jones Industrial Average is lower than it was five years ago. Interest rates are still close to generational lows. There aren't many places that will show high returns in the next couple of years. So, income will be a much more important component of investor returns in the years ahead.

REITs are high-yielding to start with and, as I mentioned, I expect dividends to increase. Investors can get close to achieving their investment objectives with REIT dividends alone and will do as well with REITs on a total return basis as they can expect to do with any other asset class. As baby boomers age and become more conservative in their investments, they will invest in income vehicles, and REITs will be looked upon very favorably.

Long term, publicly traded REITs have outperformed every other asset class. That's a fact. I don't know if that will continue over the next 10 years to 15 years, but REIT returns should continue to be competitive with other investments at the very least.
Keagy: There are numerous reasons to invest in listed REITs: high current yields, diversification, inflation protection, and competitive long-term returns relative to other asset classes.

Because real estate assets are costly, diversification is virtually impossible to achieve in a direct or private equity strategy. REITs, particularly an indexed REIT strategy, put both geographic and property type diversification within the reach of all investors, institutions and individuals alike.

Investors are increasingly concerned about inflation in the years ahead because of the U.S. budget deficit. When it comes to inflation protection, commercial leases are a natural hedge. They typically have automatic rent escalators tied to increases in the Consumer Price Index (CPI). And most cost increases are also passed along to the tenants, such as energy, insurance and real estate taxes. These lease provisions do a great job protecting the value of commercial real estate assets.

JIM KEAGY TITLE: Managing Director COMPANY: Barclays Global Investors AGE: 45 REAL ESTATE INDUSTRY EXPERIENCE: Keagy has been investing in real estate and REITs since he was 18. He has held senior roles in acquisitions, investment strategy, and asset management for Thomson McKinnon Securities, AEW, and Metric/SSR Realty Advisors. He has been in his current position at Barclays Global Investors for five years and helped launch its REIT funds. He holds a B.S. from Yale College and an M.B.A. from Harvard Business School. He recently authored a chapter entitled "Indexing Real Estate" which appears in the book "Active Index Investing: Maximizing Portfolio Performance and Minimizing Risk Through Global Index Strategies, 6th Edition" (Steven A. Schoenfeld, Ed.-Wiley 2004).

Portfolio: Marty, you also mentioned diversification as an integral part of the REIT story. What do you expect in the next couple of years regarding correlations between REITs and other assets?
Cohen: Correlations are low and I expect that trend to continue.

Portfolio: What about volatility in the sector?
Cohen: REIT volatility is somewhat higher than it traditionally has been. I expect more volatility as REITs become more popular. There are more ways to play the industry now. We have index funds and derivative-related trading today that never existed before. I believe these factors are responsible for the volatility that was experienced in April 2004.

Portfolio: Do you distinguish between industry segments in anything you've said so far?
Cohen: The different segments are on different cycles, hotels having the shortest leases and office leases are the longest. But the group overall is relatively homogeneous in its return patterns.
Keagy: Of course, the segments are all a bit different.

Portfolio: The story of REIT investing so far has been one of gradual acceptance by investors and the marketplace. Where do things stand now?
Keagy: Barclays Global Investors is one of the largest money managers in the world with over $1 trillion in assets under management, and we also rank as one of the largest REIT managers. We've seen tremendous interest in REITs over the last few years from our defined benefit and defined contribution plan clients. We see demand continuing to grow from these two enormous groups of investors. Defined benefit clients want REITs for total return potential and low correlation with stocks and bonds. They also find publicly traded REITs to be a convenient mode of investing in real estate, as some have had a hard time meeting their real estate allocation in private equity. REITs can bridge the gap.

Another advantage of REITs is that they require little oversight. Historically, direct real estate has been criticized for being the 5 percent of the DB (defined benefit) plan portfolio that absorbs 95 percent of the board's time. Listed REITs offer the same benefits as direct real estate without the illiquidity or oversight hassles.

And a final advantage is cost. The management fees on REIT portfolios are only about 10 percent to 20 percent of the cost of a direct real estate program.

Our defined contribution clients are attracted to REITs for the same reasons as defined benefit clients–high return potential, low correlations with other asset classes, and inflation protection. REITs are the most efficient way for 401(k) plans to offer real estate exposure to their participants.
Cohen: There are industry sages who say that Wall Street still doesn't understand real estate. On the contrary, REITs are highly accepted. There's a lot of money coming into the industry through institutions, open-end mutual funds, and closed-end funds that are either real estate-centric or income-oriented. There are 45 sell-side analysts following the REIT sector that consists of a relatively small universe of companies. REITs are widely accepted now and will continue to be. They need make no apologies for their performance or the quality of their management reporting and compliance.

Our defined contribution clients are attracted to REITs for the same reasons as defined benefit clients—high return potential, low correlations with other asset classes, and inflation protection. REITs are the most efficient way for 401(k) plans to offer real estate exposure to their participants. —Jim Keagy

Portfolio: Do you expect any new classes of investors to enter the sector?
Cohen: There's a global trend toward REIT formation and acceptance. REITs exist or are under consideration in most countries–France, Japan, the United Kingdom, Italy and possibly in Spain and Portugal. The worldwide acceptance of REITs is growing rather dramatically. What that should do is attract foreign capital to U.S. REITs as non-U.S. investors look to access the U.S. property market through ownership of REITs. The global acceptance of the asset class will help everybody.
Keagy: The U.S. dollar is cheap and that may attract foreign investors to U.S. real estate, but we haven't seen that yet with our U.S. REIT funds. We have a global investor base and we are looking at the possibility of launching a global real estate index product. The nature and the timing are both uncertain, but I do think there would be significant interest. Securitized real estate is much farther along in other countries, and we think this makes a global real estate product feasible in the near future.

Individual investors are also finding REITs attractive. In addition to our collective or commingled trust funds for institutional investors, we offer two real estate exchange-traded funds (ETFs), tracking the esteemed Cohen & Steers Realty Majors Index and the Dow Jones U.S. Real Estate Index. BGI's two REIT ETFs are experiencing healthy fund inflows at the moment. ETFs are used by individuals and institutions alike.

Portfolio: Does indexing make sense for real estate investors?
Keagy: Absolutely, for all of the same reasons that indexing makes sense for equities and fixed income. Because there are so many different ways to participate and profit in the real estate sector in terms of property types and geographic markets, investors are very well served by holding an indexed REIT portfolio.

Currently, the major commingled funds that we offer to our large defined benefit and defined contribution plan sponsors are all index strategies and the performance has been impressive.

Portfolio: What hurdles remain to the full acceptance of REITs as a mainstream investment vehicle?
Keagy: None. REITs are a mainstream investment vehicle right now. They are an important subcomponent of broad equity indexes like the S&P 500 and the Russell 3000. REITs are such a superior vehicle over direct real estate that there is a possibility that REITs will eventually surpass traditional forms of real estate ownership.