By Steve Bergsman

REITs have ripened with age, thanks in no small part to the industry’s management teams, and investors share in the fruits of their labor

In business and industry, the positive effects of a revolutionary idea often take a long time to be realized. A prime example of that is the real estate investment trust, where the journey from creation to mainstream investment happened over four decades. Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to smaller investors. Congress decided that a way for average investors to invest in large-scale commercial properties was the same way they invest in other industries, through the purchase of equity shares.

"A $100 million office building provides a good return, but the average investor had no ability to invest in it," says Edward Linde, president and chief executive officer of Boston Properties Inc. (NYSE: BXP). "The whole idea of a REIT was to break those investments into smaller pieces so the average investor could invest."

Average Governance Rankings By Industry
Industry Group	Average Index CGQ
Real Estate	65.2
Utilities	62.6
Banks	60.7
Pharmaceuticals & Biotechnology	56.1
Energy	55.7
Insurance	55.4
Materials	55.1
Capital Goods	53.5
Health Care Equipment & Services	51.9
Average of Index CGQ	51.8
Technology Hardware & Equipment	50.4
Transportation	50.0
Diversified Financials	49.4
Semiconductors & Semiconductor Equipment	49.2
Commercial Services & Supplies	48.6
Food & Staples Retailing	48.1
Software & Services	47.9
Consumer Durables & Apparel	47.7
Automobiles & Components	46.3
Retailing	45.5
Hotels, Restaurants & Leisure	45.2
Household & Personal Products	42.1
Telecommunication Services	40.0
Food, Beverage & Tobacco	39.9
Media	34.9
Source: Institutional Shareholder Services. Data as of Sept. 15, 2004.

Despite the good intentions, Linde, like other REIT executives, says advancement of the industry as a safe and convenient way to invest in real estate happened very slowly. In 1986, Congress passed a tax bill that for all practical purposes put a lot of tax-oriented investment vehicles such as partnerships and syndications out of business. To some extent competition to the REIT format was reduced. That bill also did one other important thing for REITs, explains Hamid Moghadam, chairman and CEO of AMB Property Corporation (NYSE: AMB).

"The tax bill of 1986 allowed REITs to be internally managed. That was a critical development because management could then run REITs like operating companies as opposed to just having a collection of assets that were being run for fee generation," Moghadam says.

It took until the early 1990s with the advent of the UPREIT (a partnership controlled by a REIT in which partnership units are equivalent to shares of common stock in the REIT) before those changes really took hold, Moghadam adds.

Many of the larger real estate companies adopted the UPREIT structure, and it enabled them to grow their business, recalls David Simon, CEO of Simon Property Group (NYSE: SPG). "It meant there was another way to finance real estate. Before the 1990s, REITs were really thought of as a financing vehicle," Simon says. "The revised structure of REITs allowed real estate companies to become successful operating companies."

By the early to mid 1990s, REITs had gone from being passive investment vehicles to self-managed, actively operating companies, Linde says.

"Rather than just being an investor in a real estate asset, the investor in a REIT gets the advantage of a company that actually creates value," Linde says. "That was a major change and really added value to the process."

Changes for the Better

Real estate is one of the largest sectors of this country’s economy, and publicly traded REITs provide investors the opportunity to own commercial property in a form that is liquid, visible, registered with the SEC and offers a good income feature.

And while the growth of the industry had its ups and downs from 1960 through 1990, REITs accelerated with the inception of the modern REIT era in the early 1990s. A wave of companies followed Kimco Realty Corporation (NYSE: KIM) into the public markets and helped change the course of the industry. With the increase in the number of publicly traded REITs there were numerous infrastructure changes as well. As a result of those changes, the REIT industry fared well during the recent economic slowdown.

Three integral changes that began during the modern REIT era and that helped fuel the growth of the industry are the amount of leverage, improved governance and status as alternative equity, according to James Flaherty, president and CEO of Health Care Property Investors, Inc. (NYSE: HCP).

The levels of leverage among REITs today are relatively moderate, and it is because of these levels that even some of the weaker REITs were able to survive the recent downturn. Leverage is much lower with publicly traded REITs as compared to the private real estate market.

Flaherty gives this example: his company recently sold a $140 million portfolio to a private investor at about 95 percent leverage. "A publicly traded company would just get killed if it put that sort of leverage on a project today," Flaherty says.

As for governance, the boards of the first generation of REITs primarily included family members and friends of founders. "That doesn’t cut it anymore," Flaherty says.

Today, board members include outside directors and independents. The majority of publicly traded REITs have moved to improve corporate governance, shareholder rights programs and performance compensation structures, among other initiatives.

By external measures, REITs have come a long way in terms of governance, Moghadam says. Institutional Shareholder Services, which ranks companies and industries via its Corporate Governance Quotient, found that, as of Sept. 15, 2004, REITs had the highest average governance rankings among all industries.

"There is a fair amount of alignment in ownership, management and shareholders," Moghadam says. "We are managing ourselves better with real boards with real independence, but we can improve."

Historically for institutional investors, REITs were usually dumped in the alternative equity bucket, which also included things like hedge funds, private equity and direct real estate. NAREIT has been very successful in convincing investors to move REITs into its own bucket, Flaherty says.

There were two primary catalysts for this increased acceptance and awareness. First, REITs performed strongly when the rest of the stock market floundered in the late 1990s and early 2000s. Secondly, for all practical purposes the operating performance of real estate, whether it be apartments, offices or hotels, was almost as bad in the most recent recession as during the great real estate recession of the late 1980s and early 1990s. However, REITs remained strong investments.

"The performance of the REIT sector in the recent downturn opened the eyes of institutional and individual investors, which is why you have more REIT ownership that is more broadly held," Flaherty says.

Through the ups and downs of the economy since the millennium, smart investors have kept a healthy portion of their portfolio in REITs. "That kind of thing didn’t happen in 1995; it’s only a phenomenon of the last few years," says Scott Rechler, president and CEO of Reckson Associates Realty Corp. (NYSE: RA).

"The performance of REITs over the last few years has put the industry on the map at a different level," Rechler says. "You had an economic downturn and historically real estate has been a bubble that bursts at that point in the economy, but REITs continually outperformed the S&P 500 and provided income (through dividends). That gave people a tremendous amount of comfort to look at the investment as more mainstream than they would have otherwise."

The REIT sector even came through a bout of panic selling in April 2004 when the Federal Reserve indicated interest rates would rise. The NAREIT Equity Index peaked on April 1 and then plummeted 18 percent through May 10. What happened subsequent to that was a relatively quick recovery.

"It was an over-reaction, and when people thought about it more soberly they realized that REITs were not as vulnerable to interest rate changes as they might have believed," Linde says.

The individual investors didn’t panic, "it was more of the hedge funds and short sellers that were going long and borrowing short," Rechler adds. "The everyday Joe investor hung in there and the market is coming back in strength– another indicator that there is a deeper investor base, a more stable, mature investor in REITs than in the past."

Moving Into the Mainstream

While REIT chief executives obviously espouse the mainstreaming of their industry as an investment alternative, there are indicators to back up those claims.

In the initial stages of the REIT industry, from about 1960 to 1982, the aggregate value of the REIT market was probably no more than $2 billion to $3 billion, Moghadam says. "But then the market cap started accelerating rapidly, up almost $13 billion by the end of 1991 and exceeding $270 billion today," he says.

In addition, a lot of compelling academic research continues to be done in regard to REITs, showing the different characteristics of the investment and why it is a key asset in a diversified portfolio. Also, the leading equity indexes, such as the S&P 500, broke down long-standing barriers and began including REITs.

"The fact that real estate companies are included in the S&P 500 is significant in that it gives the average investor confidence that these investment vehicles are just like the rest of publicly traded corporate America," suggests R. Scot Sellers, chairman and CEO of Archstone-Smith (NYSE: ASN). "The rating agencies, institutions and investors are beginning to understand what we have said for a long time, that real estate is a stable asset class compared with many other industries."

There are now six REITs in the S&P 500, which Simon says shows that, "Standard & Poor’s feels real estate is extremely important to the economy."

The growing number of pension funds that have adopted REIT investments reflects another sign of the broader acceptance of REITs. "If you look at the state pension funds as well as corporate pension funds, they have exposure to real estate, directly, and indirectly through REITs," Simon says. "That’s because of the diversification REITs provide."

However, the industry as a whole and individual companies still have more work to do in this area. NAREIT and REIT leaders have been working diligently to get the story about the benefits of REIT investing out to the public and to institutional investors, with particular emphasis on defined benefit and defined contribution plans, says Christopher Nassetta, president and CEO of Host Marriott Corporation (NYSE: HMT).

"There is a huge pool of investment capital that is in these funds, and we want to make sure the fund managers are educated as to the benefits of investing in REITs and having REITs as part of a diversified portfolio," Nassetta says.

A lot of progress has been made, Nassetta adds, "but in the defined contribution world we are only at the tip of the iceberg. There are lots of opportunities to continue to educate that segment of institutional capital. In the end, that can have a very positive, long-term impact on REITs overall."

Sellers points to the amount of ink in the financial and business press dedicated to the industry and individual REITs as a final indicator that REITs are reaching the mainstream. "You see the industry written about much more frequently in the mainstream media–Barron’s, Fortune, Forbes, Money, etc. Five years ago, REITs were an afterthought in the media at best," Sellers says.

The Next Step

Now the major challenge for REITs going forward is the same that other industries face—finding the next step in its expansion, Linde says.

"Where do we find the next opportunity and how do we achieve growth going forward," Linde says. "With the economy slowed as it has been over the past couple of years and real estate being a lagging industry (we need real job growth before more space is leased), it has been a challenge to match the kind of growth we showed three to four years ago."

For any public company, and REITs are no different, maintaining growth is always a concern, Simon says. "You look at a company such as Microsoft, and even it is facing the challenge of how to grow," he says. "The question is, how to profitably grow your business so the shareholders reap the appropriate returns."

As for REITs, the answer to the question of growth depends on the sector. "For apartments it may require a secular turn-around, industrial could be through consolidation, retail through new development and consolidation, and for some other companies it might be through international expansion," Simon says.

Flaherty offers an optimistic prediction for the evolution of REITs as a mainstream investment. He says that the industry could replace utilities as a leading safe haven for conservative investors.

"My generation always talked about having income-producing investments such as municipal bonds, blue chip equities and utility equities in a portfolio," Flaherty says. Looking ahead, the make up of what Flaherty called the ‘widows and orphans’ (conservative and retirement portfolios) investment program could change. "Given that the combined value of real estate stocks in the United States is far more than utility stocks, and if good performance continues, REITs could end up replacing utilities as an investment choice for the ‘widows and orphans.’"

Rechler also foresees an increase in REIT allocations. "Three to five years from now, it will be commonplace for investors to have 10 percent to 15 percent of their portfolio in REITs," Rechler says.

So, have REITs met the goals set forth by Congress when the investment vehicle was created? "The answer is yes," Nassetta says. "But it has taken some time. In the first 20 to 30 years there was progress but it was pretty slow. Then when you get into the 1990s, progress started to accelerate."

And it will continue to accelerate, Nassetta adds, "to the point where REITs will become much more part of mainstream corporate America. REITs will be in most typical, diversified portfolios because it makes sense. REITs lower volatility and increase overall return, so what is not to like about that?"