Investor Roundtable

Seated around a conference room table in UBS' New York City office on a gloomy early November day, a panel of leading REIT investors offered cautious optimism on the near-term health of the industry and little doubt about the long-term value of REIT investing. Addressing a wide range of issues from fundamentals and valuation metrics to IPO pricing and global REIT investing, the discussion was led by Jackson Hsieh, managing director for UBS Investment Bank. The panel featured: Jamie Behar, portfolio manager with GM Asset Management; Theodore Bigman, managing director with Morgan Stanley Investment Management; Andrew Duffy, managing director, real estate securities with TIAA-CREF; Mary Hogan, senior portfolio manager with ABP Investments; and Wilson Magee, portfolio manager at Goldman Sachs Asset Management.

Jackson Hsieh: Let's start with a good warm-up question. Are operating fundamentals improving across various asset classes? If not, which direction do you see them going?

Ted Bigman: I think we see that fundamentals are improving, albeit slowly. You really end up dividing the market between retail real estate and everything else. In retail, consumer spending has remained strong, and retailers' demand for space remains strong. So, if retail has been strong and remains strong, where we're seeing recovery is in everything else that had experienced a weakness in demand, evidenced by peak vacancy rates and rental rates that had pulled back quite a bit. In apartments, office, industrial and hotels we're seeing a recovery. To the degree that recovery is dependent on job growth, we felt better after the second quarter of 2004 and worse after the third quarter, as job growth was slow, which was disappointing.

It's interesting that the hotel sector has defied some of the negative momentum that we've seen in the apartment and office sectors. The basic rationale is that companies are slow to hire, but much more willing to increase their travel budgets. So everything's recovering, just a little more slowly than most people have wanted, particularly in the apartment and office sectors.

Hsieh: Mary, I'll shift this question over to you. With the high level of transparency that's out there today, data and key investment information can be obtained real time from a wide range of data sources. Does that fundamentally make you more comfortable when you invest over a long period, especially as the economy fluctuates?

Mary Hogan: Absolutely. I think even the fact that we have multiple sources to choose from to evaluate supply/demand is a huge change from a few years ago when you had maybe one. The fact that we now have 10 years of consistent numbers to compare with is tremendously helpful.

Hsieh: Your fund invests on behalf of Dutch institutions. Can you give us your perspective on the U.S. as it stands today, given the big run up in the REIT share prices over the past 24 months?

The impact of rising inflation is actually positive for real estate—both in terms of rental increases and constraints on new supply due to higher development costs. Jamie Behar

Hogan: Well, one thing that has really helped a lot is the fact that ABP has historically made most of its real estate investments in the U.S. 100 percent through REITs, and we've invested in the U.S. for many years. And so between the portfolio managers we have in New York and the people back in the Netherlands, we're able to monitor supply globally. Earlier in the year, we shifted more money back toward Europe and Asia.

Hsieh: Jamie, there's just no shortage of capital, and it's a great time to be a borrower if you've got a quality asset. Does this significant amount of financing liquidity in the sector trouble you?

Jamie Behar: It's true that a number of the valuation metrics look fairly rich today, when you judge them relative to their historical averages. But I also think investors are behaving rationally when you consider expected returns for competing investments. Real estate in this context still looks like a reasonable bet to me. I also think that lenders are acting rationally in terms of both the level and pricing of capital that they're allocating to this asset class. Finally, the impact of rising inflation is actually positive for real estate-both in terms of rental increases and constraints on new supply due to higher development costs. So, overall, considering the current prospects for both alternative markets and inflation, I think both investors and lenders are being rational.

Hsieh: Momentum investing was a big part of the REIT boom in the mid-1990s. Investors expected strong returns based upon strong cash flow performance because of improving fundamentals, recovering economy and re-equitization of assets of financial institutions. It seemed so obvious.

It's likely that we will not see that same pattern re-occur, it's probably going to be a less volatile industry. When you think about the potentially long-term stability of the real estate industry, does your institution change its relative weighting to the sector?

Andy Duffy: At TIAA-CREF, our view has changed over time, but it wasn't affected by any transitory view of the industry as a growth industry. We didn't jump on that bandwagon, rather we've maintained a view that real estate is an asset class that provides stable returns, that show low correlation with the returns of other asset classes, and that it deserves a place in every retirement portfolio to achieve the highest risk-adjusted return. For more than 20 years now, we've been building our real estate investment portfolio, which now stands at almost $50 billion.

Hsieh: Wilson, does your institution have a similar viewpoint?

Wilson Magee: I don't consider the average REIT investor a momentum investor. Although, if you look at REITs today, particularly with the valuations where they are, you do realize that what's going on in the market is predominantly momentum investing. Many people aren't doing it in a deliberate way. But it's an effect that's in the market because fundamentals are lagging price movements.

I think that if we have less volatility and more consistency in REITs-whether that's because of better economic data or better supply and demand data-the more consistent and predictable the returns are and the better it is for the industry in the long run. You're seeing many things that will probably have that effect that in the future, including various data on real estate markets, as well as the transparency in these companies themselves.

Virtually every week I speak to institutional investors, be it a public pension plan, a corporate pension plan, or an endowment foundation, and their view on real estate has shifted, and I don’t think that it is simply a momentum shift. Theodore Bigman

Hsieh: Following on your point regarding the correlation of the stock market, interest rates and real estate fundamentals, how much of that weighs into your decision in terms of asset allocation, i.e., fundamentals versus external stock market and interest rate moves?

Magee: In our historical analysis, we don't find that REITs have extraordinarily high correlations either to stocks or long-term bonds. Correlations to long-term bonds are quite low, and actually they have been negative, significantly negative, for a period of about three to four years. That's not sustainable. In the REIT market decline in April 2004, clearly the correlations to the 10-year increased dramatically.

REITs are more correlated to equities. They are a piece of the equity market, so they likely will remain more correlated to equities. But they're actually more correlated to small-cap equities and to high yield bonds than any of the major asset classes. Those correlations have tended to go down in the last six or seven years. However, we're bound to enter a period when those correlations actually start to rise.

Hsieh: Andy, can you follow up on your perspective of REIT stocks and their correlation to the equities market? Cap rates in the U.S. have seen significant compression, in fact, globally, real estate cap rates are falling. Is this due to a secular or cyclical trend?

Duffy: Well, before I take a stab at that, I want to underscore what Wilson said by highlighting the Ibbotson Associates study because I think the Ibbotson study is the best answer to the question that you raised about correlations. There's a graph in the Ibbotson study that shows the correlations over the last 20 years of rolling five-year periods between REITs, and large cap, small cap and fixed income. It demonstrates that the correlations have been declining and are now quite low. To that work I'd also add the conclusions that Joseph Pagliari and Michael Giliberto reached in their studies where after adjusting the returns on REITs for differences in valuation methodology, leverage and timing, they found that there is a high correlation between REITs and real estate.

And so the premise that we should start from is that REITs exhibit low correlations with other asset classes, and, in turn, high correlations with real estate, the punch line being that investing in REITs is akin to investing in real estate, i.e., REITs equal real estate.

Things like the reputation of the industry, the transparency of the companies in the industry, as well as consistency of performance and reliability of dividends. Those are all things that are quite important in the long run to attracting a wider variety of REIT investors. Wilson Magee

Hsieh: How about private market cap rates, where assets are traded? Is this a secular or cyclical trend, because cap rates have gone down across all asset classes.

Duffy: My answer is, I don't know. I do know that there is a raging debate about secular versus cyclical cap rates. There are good arguments on both sides. I think it's not coincidental that cap rates are where they are and interest rates are where they are. I do believe that the returns on real estate and, by extension, the cap rates on real estate, reflect or at least are informed by the overall level of interest rates because the leverage buyer relies, to a significant degree, on borrowed money. And to the extent that that money is cheaper, then they can pay more, all else equal, for the asset.

So by that measure, I think that you can make an argument that it's a cyclical phenomenon and that when or if interest rates back up, you're going to see cap rates eventually-not immediately and not one for one, but eventually-begin to track higher along with interest rates. So is it secular, or is it cyclical? To some extent it's semantics.

Hsieh: A recent Green Street Advisors real estate report analyzed real estate cap rates versus long-term Treasury rates versus corporate bonds and looked at the data over several historical periods. The data seemed to suggest higher correlation between cap rates and BBB corporate bonds. If you couple this correlation phenomenon with the high level of transparency and information flow in the real estate operating/investing marketplace, shouldn't this give rise to an asset re-pricing event for the entire asset class?

Bigman: Improved transparency is perhaps a factor, although I think if you want to identify the most significant piece of the shift in cap rates that can be seen as secular, it comes down to who has the money and how they view real estate. Virtually every week I speak to an institutional investor, be it a public pension plan, a corporate pension plan, or an endowment foundation; their view on real estate has shifted, and I don't think that it is simply a momentum shift.

Over the next two or three years, I feel very good about the sector because of stable fundamentals, great transparency, and new money coming into the sector. But in the very short term I am concerned. Mary Hogan

In the 1990s when we had these meetings, there would always be the one guy in the back of the room that would raise his hand and say, remember how much money we lost in real estate in the 1970s; remember how much money we lost in the 1980s; and your presentation was done. That guy's got his hand somewhere else right now because the data is just too compelling.

I think the biggest factor for the lower cap rates is a secular shift with regard to the view of where real estate fits among investors who have all the money-the pension plans. I think that piece of it is intact, and I think the rationale is aided perhaps by a real estate market that hopefully will not boom and bust the way it has in the past because of this improved transparency. But I'd say the transparency is just a subset or corollary to the key factor that they've looked at equity returns, fixed-income returns and real estate returns, and they've finally embraced that the percentage they've been holding in real estate has been too low.

Hsieh: At General Motors, do you subscribe to the same point of view? What is your investment committee's thoughts on real estate as a part of a broad investment portfolio for GM?

Behar: Yes, I would agree with Ted. GM has been investing in real estate for over 20 years. We began to actively invest in private real estate on a direct basis in the early 1980s, and in public REITs in 1992. From an asset allocation standpoint, real estate offers attractive risk-adjusted returns and low correlation with other asset classes. That fact, coupled with the growing transparency of the market, has allowed for a long-term commitment to the asset class. Our fund has consistently maintained a target allocation of 10 percent to real estate.

Bigman: Which means GM was way ahead of virtually every other pension plan in the United States at 10 percent.

Hsieh: Wilson, in terms of your outlook on the near/medium term, what sectors are hot and what are not?

The smart way to invest in REITs or any equity portfolio is through a mutual fund. It’s a lay-up in terms of the benefits to the individual investor, who doesn’t have the time to do what we do on a full-time basis; who doesn’t have the capital that it takes to construct a diversified portfolio. Andrew Duffy

Magee: As Ted outlined earlier; retail has been solid fundamentally for a variety of reasons. The main one is that retail tends to perform fairly well in what I would call a recessionary real estate environment, primarily due to long lease durations. And that's consistent with how retail real estate has performed the last few years.

What you're seeing in the market now is a progression fundamentally toward sectors that have shorter duration leases, coupled with good demand drivers and interesting supply characteristics. Hotels are clearly the sector where you're seeing the greatest top-line growth and the most significant margin improvement right now. It's a very volatile sector, so fundamentals could change quite rapidly. But hotels, I think, are in a sweet spot, and they may be in the very beginning of a sweet spot that lasts for some time.

Hotels have the shortest duration leases, so you're going to see other sectors that are dependent on business capital spending and job growth react with a lag to hotels. And probably all of us could debate apartments and office and where they sit on that continuum. But clearly apartments have the shortest duration leases next to hotels, followed by office. So if economic growth in the U.S. stays at the rate of 3 percent to 5 percent real and we get sustained job growth, at least 100,000 to 150,000 new jobs per month, then I think you're going to see a nice progression right through the sectors. And the intensity of the recovery will depend on the supply situation for that particular sector.

Hsieh: In a recent article in The Wall Street Journal, hotels were cited as a great asset class to invest in during a recovering economic environment. The market capitalization of listed hotel REITs is small relative to other asset classes.

There are a handful of larger cap C-corp hotel companies like Starwood and Hilton. How do you get overexposure to the hotel sector? Do you agree that now is a good time to invest in lodging?

Hogan: Yes, I absolutely agree. And we have a very big presence in the lodging sector. Companies talk about how they want to get bigger, and why they want to be investment grade, strong fundamentals. It's all very exciting.

This isn't exactly what you asked, but the one thing I will say about retail is, that we have done well in the group over the last few years. But is it secular or cyclical? Everything always seems secular, I think, when things are good.

And so I'm just a little concerned with some of the things we're hearing about retail, many people buying retail just to get at the real estate is just one example. I wonder if we're all going to look back a year from now and say it was cyclical. Sometimes just when you think a change is secular, it proves to be cyclical.

Hsieh: There have been a number of new companies going public with unique portfolio holdings, how do you see them fitting in from an asset allocation standpoint?

Duffy: With the IPOs of companies like U-Store-It and BioMed Realty, I don't think there's really any theme or pattern there other than the window's open, and these are companies that maybe had tried to go public during the last cycle, but the window closed, and they were shut out. Now, there's a surplus of liquidity, more money chasing fewer stocks, and so the market's receptive to new issues. That's why these deals are getting done.

But I think it's instructive to note that many of these deals, if not most of them, are being done at prices that are either at or below the low end of the filing range. To me, that's indicative of the market perception of relative value with the RMS north of 700. What is the risk/return trade off that I'm being offered at this valuation range? It's also a reflection of the fact that the investment bankers have been aggressive in trying to bring many deals during a limited period of time. That shifts the balance of power to the buyers and allows the buyers to be more aggressive in setting the price.

Hsieh: I'm going to come back to the recent performance of REIT IPOs completed in 2004, but I want to finish up on the overall valuation question first. We all agree that bottom-line fundamentals are continuing to improve, however, we have interest rate risk, price of oil and new real estate supply beginning to creep into the market. What, if any, are your concerns regarding investing into REITs in 2005?

Behar: Market fundamentals, on both the supply and demand sides, are improving. The biggest risk we face right now is rising long-term interest rates. The fear is that income-oriented investors would pull money out of the sector in favor of fixed-income investments. Even though we have a more stable investor base today, such as pension funds that are increasingly establishing new allocations to the REIT sector, individual investors may prove to be less patient. This may be the case even in 401(k) plans, where investors tend to "chase performance." So, I think the biggest risk today comes from the capital markets side.

Hsieh: Anybody want to add to that or have a different point of view in terms of the interest rate issue.

Duffy: I think all you have to do is look back at the April 1 job number that spooked the bond market, and within days the 10-year Treasury went from under 4 percent to almost 5 percent, and REITs went down about 15 percent. I would characterize many of the investors who own REITs today not as long-term owners, but as renters, as bond investors who are more comfortable in fixed income.

But when bond yields got as low as they were, bond buyers looked over and saw the more attractive yields on most REITs. Some of those investors bought REITs, but it was only temporary until they could get a better yield in bonds. That's clearly the biggest risk in today's market, and the April 1 to May 10 REIT correction bears that out.

Magee: In terms of pricing and performance, REITs are somewhat dependent on the way the capital markets behave and what the expected returns are for other asset classes. In my life as an investor, I've always worried about investing just on a relative basis, although I know those of us who run dedicated products do it every day. But I really worry overall that in domestic investments, risk is being mispriced today across many asset classes. Who knows what's going to change that. It may just be that Treasury rates go to 7 percent or 8 percent, and, therefore, every other asset class has to compete with that base risk-free return. But I think that risk in one form or another is being priced as aggressively as I've seen in a long time, and if it's going to be priced less aggressively in the future, it's going to affect real estate as well other domestic asset classes.

Hsieh: Ted, you represent a diverse institutional client base, do you agree with how the market is pricing risk or does something else trouble you as a REIT investor in 2005?

Bigman: Our clients, particularly the corporate pension plans, are trying to understand how to build a portfolio that has an expected return that is going to match their pension obligations. I'd agree wholeheartedly with Wilson's comments, which is there's so much money in the markets, that it seems like risk has been pushed down at every element. Echoing Jamie's comment, I think that they're looking for asset classes that will enable them to produce the best relative performance and there may be other changes in attitudes toward real estate. But that doesn't mean that a pension plan's investment committee that took their allocation to real estate from 3 percent to 8 percent wouldn't take it back down if the long bond went up by 150 basis points, depending on their view of expected returns.

I think they're looking to invest in asset classes that offer the best relative return. Those of us in this room that are dedicated real estate investors may think real estate looks a little expensive these days. But when you speak to non-dedicated investors, they say there are a lot of asset classes that look expensive these days. The biggest risk we see is on relative valuation. Today, other asset classes look less interesting, and we're in a bit of a sweet spot.

Hsieh: The recent burden put on public companies regarding Sarbanes-Oxley seems to really be impacting the small and micro-cap REITs. Does this change bias investors away from small-cap opportunities?

Hogan: It certainly does when looking at some of the smaller companies for whom, obviously, the burden of funding Sarbanes-Oxley is much more onerous. We've seen that in earnings reports throughout 2004. One thing we've been pondering is that a lot of the smaller companies happened to have come public between 1992 and 1994. And so 10 years later, a lot of those companies just might be at the point where they start exploring strategic alternatives. Then you layer in Sarbanes-Oxley and the demands of that, and maybe now is the time that some of them look to sell.

Hsieh: As your clients think about the proposed accounting changes for REITs and public companies generally, does that change your pricing of risk?

Bigman: I would say our clients are far less focused on it than we are. From our perspective, a large focus of our research process is forensic accounting. There are six of us, and we spend everyday ripping through the financials and trying to figure out what's really going on at the company. I think some of the changes are good, but some of the changes are bad. Sometimes it's hard to understand what some of the accounting changes were supposed to do because they just make these earnings measures harder to understand. And, frankly, from our selfish perspective, it just gives us an ability to work hard and figure out what the numbers really mean.

The accounting changes have become very confusing, I would imagine, for someone who doesn't have the luxury of spending a lot of time focusing on the numbers. For example, take a company that refinances a preferred security and takes a hit of seven cents to FFO. How does the average person even understand that?

The accounting changes are meant to be favorable, but we find that we'll work through them whether they make sense or not.

With regard to Sarbanes-Oxley, I think it will be painful for a lot of companies, but it sounds like a process that might help us judge whether these companies really have their procedures and accounting processes in order; although March of '05 could be quite a strange period. Even the very talented companies that have deep infrastructures don't know what sort of letter they're going to receive from their accountants, don't know what criteria they need to meet to pass the test, and not all the accounting firms are treating it in the same fashion. So it's added a nice security blanket to know the accounting statements and tests are being administered properly, but it's added a heck of a lot of confusion as well.

Hsieh: Given all the complexities surrounding accounting, how should the average man on the street invest in the REIT industry?

Duffy: For that reason and others, the smart way to invest in REITs or any equity portfolio is through a mutual fund. It's a lay-up in terms of the benefits to the individual investor, who doesn't have the time to do what we do on a full-time basis with our staffs; who doesn't have the capital that it takes to construct a diversified portfolio that they can instantly get by buying a mutual fund. It's yet another reason for the average individual to invest via mutual funds, whether it's in a 401(k) or, in our case, in our 403(b) plans.

Hsieh: I'm going to switch to the outlook investors should have for REITs in 2005. Over $35 billion in merger transactions have been announced in 2004, do you think that is a good phenomenon from the point of view of investors?

Magee: It's certainly a good thing for the investment banking business. And you know what? I think it's good for the industry because it reflects some maturing. None of us want it to be a fully mature industry, but the M&A activity probably reflects some consolidation that needs to happen.

When it comes to the M&A we see in the retail sector, it looks like a peak indicator since the acquirers are going out and paying big prices following strong fundamental and price performance. While some of the consolidation certainly makes sense from an operating perspective, I worry about it from a pricing perspective.

If you look at the apartment market, where you've also seen some M&A activity, I suppose companies can legitimately be betting that there's going to be significant operating improvement over the next four or five years. Apartments are certainly poised for both rental rate growth and margin improvement. And it appears that public mergers are, while expensive, one of the cheaper ways to buy portfolios today.

When you look at hotels and consider what Blackstone has done in the last 18 months, buying four public hotel companies, that's because there's an arbitrage, and they can buy hotels cheaper in the public market than they can in the private market. Having opportunistic private investors playing that arbitrage is very healthy overall for the industry.

Hsieh: The acquisition leverage that is available for buyers, especially the private market buyer, is incredible. There are numerous lenders willing to finance 80 percent to 85 percent of the purchase price. Jamie, to follow up on this M&A point, as you think about your portfolio today, what are some of the challenges when a big deal like the Simon-Chelsea acquisition is announced, from the point of view of redeployment of funds?

Behar: The main challenge is the prudent redeployment of the capital-both in terms of timing and sector allocation. There are advantages to rotating out of the acquired company's stock prior to the time the deal is consummated, but there are also risks associated with doing that. Redeploying the capital back into the same sector may make sense from the point of view of your desired sector allocation scheme, but it's inherently more risky since the capital is spread over fewer names.

Hsieh: Sounds like you have two decisions to make in the context of a large announced M&A deal where you are an investor-sell the stock and reallocate within the sector that the deal was just announced or invest into another real estate sector. Or you could just sit on the cash. After the Rouse transaction was announced, there were a large number of overnight equity transactions completed; most of this was a result of buyer demand to reinvest Rouse stock that was sold into the market after the merger announcement. Andy, what was your position relative to the Rouse announcement? If you sold, were you going to redeploy the proceeds into retail or into other sectors?

Duffy: My reaction? It looks a bit toppy. General Growth paid a lofty premium for Rouse. You've got issuers coming to market to sell stock. I don't think they're coming to market because they think prices are low. To me, it indicates that this is a time when it's better to be a seller than a buyer. So I haven't yet redeployed the capital from Rouse proceeds back into retail, and I've been wrong because the stocks have continued to go up.

Hsieh: Ted, what was your strategy? Do you agree with Andy's "toppy" comment?

Bigman: GGP paid a high price at the time and history will determine whether or not it was a good price. With regard to your question about the equity issues that followed the major announcement, if you remember, we were about a week and a half before the equity market closed for the Labor Day holiday. If you look at the six or seven companies that issued equity or convertible preferred in that period, each of them had some significant acquisition leading up to that period, or were preparing to announce an acquisition. In general, we have been thrilled that the REITs have shown discipline in terms of issuing equity. In fact, existing REITs have issued equity primarily to fund acquisitions.

It comes back to the question that we talk about everyday-should companies be buying assets at these prices or should they be selling? Those that have determined they should be buying have access to the equity markets. So I think it was a unique period where two things happened. One, people had extra money from the Rouse transaction, and two, the REIT market rallied 6 percent in those two weeks. As a result, REITs were more comfortable issuing equity.

I think they were being opportunistic. We have maintained our opinion that REITs have to be good at two things. They have to be good at running their core assets, and they have to be good at navigating the capital markets. I think accessing the equity window during that period made sense for the REITs. If it implies that the REITs were toppy, well, unfortunately, many have gone on the record in previous years of saying the REITs looked toppy and real estate values have continued to improve. Since REITs are correlated to real estate and real estate valuations have moved up, REIT share prices have continued to improve. So we'll look back and see whether they were toppy or not, but right now, they're trading a lot like real estate values, which continue to improve.

Hsieh: Just some statistics to throw out. As of Sept. 30, 2004, in terms of total capital raised, it's been approximately $28 billion, which includes corporate equity, debt and preferred. During the same period of time, existing public issuers sold approximately $6 billion of follow-on equity. Most of those issuers chose to do "bought" deals, shifting the risk of price onto underwriters, who would in turn try to put the stock into the market as quickly as possible. As a buyer, do you like this trend, or do you prefer the traditional market equity deals where the existing issuer takes pricing risk?

Magee: I'm no expert on how overnight deals get priced, but you hear anecdotally that the spreads are very thin. That's because securities firms are comfortable they can call us at the end of the day and have us invest in those equity offerings, and their risk is relatively low. I'm sure that will change. All of us were around in late 1997 and 1998 when the equity window shut down completely for REITs, and it will happen again. The firms that buy these deals overnight and remarket them at very narrow spreads will react quite rapidly when the window begins to close. But some firms are going to get burned when that happens.

Honestly, I'm not a big proponent of REITs issuing equity, but it can be a source of growth. Clearly there are good reasons for companies to do it at times and it has represented a safety valve for REIT valuations, so in that sense it's been healthy and not problematic.

Hsieh: There have been numerous trends that have occurred resulting in strong valuations coupled with significant investor liquidity and demand. We just spoke about reinvestment after a big merger announcement. Last year, the whole closed-end fund phenomenon had an enormous impact on common and preferred stock. Do you see any other events that could have a positive impact on REIT stocks, which would in turn result in further equity issuance?

Hogan: How many new hedge funds have been started in the last year? And then the way pension funds are increasing allocation to real estate. All else being equal, I also am not a huge fan of too much equity. But how is our industry going to get bigger if companies don't issue more stock? It's actually a necessary evil-not even evil, just a necessary aspect of how the industry's going to grow. It's remarkable that we talk about all this capital that has to get put to work by next week, and IPOs are not getting done anywhere near their filing range. But I think it says something about the discipline of the industry.

Hsieh: Lets come back to the issue of IPO pricing in the REIT sector. The majority of the 15 IPOs (in the first nine months 2004) have been completed below the issuer's price expectations, the lower end of the filing range. It doesn't make a whole lot of sense given we just talked about all this liquidity in the market and investor demand for REIT equity.

Bigman: But still at no IPO discount. Just because these deals were executed at the low end or below the initial offering range doesn't mean they were priced appropriately by the investment bankers. In every one of these deals, we were not provided with an appropriate IPO discount. Given that there's a flood of capital into real estate, why are IPOs having trouble getting done? I still believe the IPOs are being executed at better prices than they deserve, and that's because there's a flood of capital.

I think the man in the street thinks, "wow, if you've got a discount to the range, then you will be getting it cheap." No. It's actually not cheap relative to its peers. By the way, my pet peeve is how do you restructure the transaction when the deal is priced below the range.

Duffy: Structurally, REITs are going to be more active issuers than their industrial company peers because of the payout requirement. The average industrial company doesn't have to pay out 90 percent of its net income. That increases the reliance on external capital for REITs to grow. If they are going to grow, they have to raise equity externally, and that's why they're always going to be more frequent issuers than you're used to seeing outside the real estate securities market. That's not a justification for REITs to irresponsibly issue equity, but I think it's something we need to take into account when assessing the level of equity issuance.

I agree with Ted's point that just because an IPO is priced below the range doesn't necessarily mean that investors got a good deal. It speaks more to the bankers' aggressiveness in setting the filing range than it does to the value proposition that investors are getting. Oftentimes a deal is priced below the range, but it may not be as good a deal as it seems to be on the surface because it may simply mean that the company has more leverage coming out of the box. And, therefore, the NAV is lower, and, the premium to NAV may actually be higher.

What I look for is when a deal is restructured, the pre-money valuation on the company is adjusted so that the sponsors and founders get less equity, not just the public getting a smaller piece of pie and paying less for it.

Hsieh: Jamie, you own a large and diverse portfolio of REIT stocks and you have probably had solid investment returns, so when a new IPO opportunity is presented to you is there reluctance on your part to invest? After all, new public companies pose several additional risks for investors as opposed to existing REITs.

Behar: When you look at some of the IPOs that have been done in recent months, I think that pricing below the range was a reasonable result. I don't think the overall quality has been that high in all cases. Yes, there is a lot of capital in the market today "looking for a home," but that doesn't mean that investors are being indiscriminate with their capital. I think pricing for many of the specific deals that have been done was set at aggressive levels, and investors reacted in a rational way.

Magee: Also we're not seeing many IPOs of traditional real estate companies. It would be more interesting to analyze the pricing if more apartment, retail, office and industrial companies were going public.

Hogan: Think about these IPOs that have gone public this year. Not so long ago we just consolidated into three storage companies, and now we have five again. There are many well-regarded private real estate companies who are not coming public. Wilmorite is for sale.

Hsieh: Clearly, many of these quality private real estate companies could go public but they have other funding alternatives. Many private companies have commingled funds to invest. So going public isn't as compelling to private real estate operators who have discretionary institutional funds that they manage.

Duffy: And maybe the onus of Sarbanes-Oxley is influencing their decision.

Magee: And I think to your point, they can get a better deal selling the assets privately.

Hogan: Exactly, without a lot of pain and suffering.

Magee: You have to think seriously about that if that is a true trend. That definitely says something about the real estate market.

Hsieh: Now I wanted to spend a little bit of time on the implications of REITs managing commingled funds on behalf of pension funds for direct real estate investments. Do you subscribe to the capital models like ProLogis, Developers Diversified, AMB and Kimco Realty? They each have different ventures that they manage, enabling the REITs to acquire property without necessarily raising the equity in the public market.

Magee: Generally it has to do with how a REIT can borrow venture money, whether it's equity or debt, versus its corporate cost of capital. If it's an attractive equation for them to issue equity privately in some kind of specified property joint venture or raise funds in commingled structures for institutional investors and get various management fees and a promoted interest, then certainly those are interesting business models and they have begun to proliferate. Over time they help increase the return on equity to the REIT, which is very important. We would all like to see high returns on equity.

It is causing what you would call recurring NOI or recurring FFO per share to be much more complicated to analyze. That is probably advantageous to those of us who spend our lives analyzing REITs, because we can spend the time to look at different pricing metrics for those different income streams. I assume the market as a whole is less discriminating.

Bigman: I think it's like other issues we have discussed. If we did this panel 10 years ago, we would have spent a half hour discussing the advantages of the local sharpshooter. I did a panel a few years ago in Europe where they were talking about whether we should just invest in a single country, or if we should be investing on a pan-European basis. I think this reflects a natural evolution.

Today, there are a couple of business models that appear to work. ProLogis is the poster child for including an investment management structure. The company appears to be getting excellent valuation for it. It comes back to the question of whether your strategy fits within your core competency? Does it work for your company? Arden Realty is still a local sharpshooter. Have they been left behind? No. They're a local sharpshooter in a market where there are national players, regional players and super-regional players. You do what you're good at.

To the extent companies go after these side businesses, management businesses, opportunity fund businesses and JV businesses, it has to be part of their overall strategy and it has to fit. To the extent you're doing it because you see that ProLogis has been getting the same multiple on its operating income as on their one-time gain, you may be making the wrong choice, and you may find yourself pursuing the wrong business strategy.

I do think it makes the companies more complicated. You do have to decide what sort of multiple to put on the income that is generated. Of course, the companies, particularly those that ask you to use the same multiple on their income stream as on their one-time gain, run the danger of what happens in the quarter or the year when they have a fall off.

Our European clients, who invest with us both in the U.S. and Europe, are asking us to better understand how much of the valuation of these U.S. companies is from their management business and/or joint venture business, as opposed to the pure real estate business.

So I think it's muddying the waters a little bit, but the companies that are going to do it right shouldn't stop doing it. They should expect a reasonable valuation for it. The companies who start to do it because it's the trend may find themselves in trouble at some point in time.

Hogan: We happen to invest in many of the companies that are executing that model very well. But, yes, now everybody is doing it. And we also have to wonder about the exit strategy on all these joint ventures. There could be a lot of surprises.

Hsieh: We all see the data that institutional investors, pension funds, endowments and foundations are all increasing or adding real estate to their investment portfolios. Some are focusing on REITs, others private vehicles like separate account relationships or funds. It seems like from the fund venue, institutional funds can invest in opportunistic, value add or core strategies, where there are no shortage of private real estate operators sponsoring such vehicles. I think it is a great opportunity for public REITs to offer this type of product/service so long as they have the infrastructure and can manage the conflicts, like ProLogis. Do you agree?

Behar: The one positive I would note with respect to REITs using joint venture arrangements is that you have an alignment of interests between management and shareholders, which hasn't always been the case. The company can leverage its activity with third-party capital, earn significant fee income, and shareholders benefit from that. The fee income doesn't just enrich management.

Bigman: Up until they do it and it's a huge success, and then they pay themselves huge bonuses for successfully doing it.

Hsieh: We recently advised a public retail REIT in a sale of itself through a select auction process. The ultimate purveyor was a public REIT with a fund as its equity partner, the deal was split 80/20 in favor of the fund. They are going to leverage the company in the 75 percent to 80 percent range. It really gave them a pricing advantage over the competition, which were other public REITs looking to finance with stock or the sale of their stock. I think the REIT was able to take the high return for the entire portfolio. These private funding relationships and structures give REITs an advantage in competitive auctions of large portfolios.

Also, a number of potential target REIT companies usually tend to have three strata of assets, there's an A class, a B class and then there's the properties that no one wants. REITs that manage different funds which have different return expectations based upon investment thesis are likely to prevail in these types of opportunities.

On to another question, there's been a huge debate globally on how to value REITs-NAV, FFO, NOI. What do you focus on? Do you have any one particular bias toward any one of these, or are there other benchmarks?

Bigman: We have a pretty strong bias. We have been a NAV-oriented investor since we started in 1995. Since we launched a business in Europe and Asia in 1997, we have been investing from an NAV perspective on a global basis. It comes back to the fact that the vast majority of our clients are pension plans, and we tell them that their allocations to us should fit in their real estate basket as opposed to their equity basket or perhaps even fixed-income basket. We view ourselves from an investment perspective as getting our clients exposure to real estate, and I think investing on a NAV basis is consistent with that objective. You want to know that you are buying properties at a fair price relative to underlying real estate values and that you are buying the right stocks to get that exposure at the cheapest possible price. That is what makes perfect sense to us.

If you told me we could not use NAV as a tool and that we had to use FFO, we would just take the same analysis that we do, and make sure that we've rescrubbed the earnings to make sure we know what's recurring, what's not recurring, what's from properties, and what's from third-party management and apply the appropriate multiples.

I'm a raging bull for NAV, but I think FFO is a useful tool. However, what I tell you is that at the end of the day, if you're a casual investor, you have to see what the consensus is utilizing for valuation metrics. If you're a sophisticated investor and have a team of people, then you can use whichever metric you want. You just have to adjust the numbers to a level at which you get comfortable.

Our overlying theme is we think that underlying real estate values will move the real estate stock prices. Share prices of public real estate companies will move with underlying real estate values, so you've got to keep an eye on underlying real estate value.

Hsieh: Does everyone agree that NAV is really the driving benchmark to focus on?

Behar: I would agree that NAV is probably the most important valuation metric to consider. But I would hasten to add that it's proven to be pretty challenging over the past 12 to 18 months, as the appropriate cap rates to use in the calculation have been difficult to determine. Given the ongoing strength of values in the private market, the cap rates that analysts are using in their calculation seem pretty stale to me.

GM participates in both the private and public markets for real estate, so using NAV as the key valuation metric in valuing REITs makes the most sense to us, but it's only as reliable as the underlying assumptions in the calculation.

Hsieh: Most countries actually do look at NAV. France has just adopted a REIT structure; the U.K. is debating the issue, but will likely adopt the structure. Do they actually focus on FFO? FFO is definitely now presented, but I would still say I think they have appraisal based accounting systems that support their NAV focus.

Magee: The process of valuing equity earnings is not a new concept by any means. Finance theory also tells you that you should look at the enterprise as well. And I think that's what NAV does. It helps you look at the enterprise. And FFO is a form of earnings that are conventionally valued using an equity multiple.

I'll just give you an example. Those of us around this table are willing to form our own opinions about NAVs of different companies, different businesses, both domestically and globally. But when I started investing in Hong Kong in 1997, the market was raging there, and everyone thought it would continue because for almost nine straight years they had witnessed the market going up. There was a very brief pause in 1993 or 1994, but property stocks had amazing returns over that entire period.

The analysts in Hong Kong would create NAVs on companies in such a way that they always sold at a discount. In 1997, for example, they used very aggressive forward earnings estimates and valued the prospective earnings stream at a 5 percent discount rate. So that's the way they could come up with Hong Kong property companies trading at a discount to NAV.

I know that in Europe NAVs are more appraisal-based, but there are issues with appraisal-based NAV as well. So I think there are a wide variety of metrics to try to understand stock price behavior, and none of us should oversimplify them.

Bigman: Another example of using different metrics comes from the U.K. Just in this last reporting period, there was a company that showed a NAV increase and their stock price went up. All the analysts were very excited. But if you only look at NAV and you don't look at the cash flow, you'd understand that the only reason their NAV went up was because the surveyors lowered the yield on the portfolio of assets; but in actuality, their cash flow had deteriorated.

Our team said that conventional wisdom is that maybe this company had a good quarter. But if you had already adjusted your own cap rate, the results would not have been particularly strong. This goes to the point of, you could look at NAV, but you have to know what are the sources of the cash flow analysis. That company would have probably missed FFO estimates and would have the risk of underperforming that day in the U.S., whereas in the U.K. it was almost blindly ignored. So it is important to realize that NAV in a vacuum is a bad idea.

Hsieh: NAV is one of the challenges that our industry faces in terms of attracting a broader non-dedicated real estate securities fund manager. Funds that don't have seasoned REIT and securities analysts likely don't have teams of infrastructure to calculate FFO or NAV. And so the only time they're going to play is if there's a momentum opportunity. Do any of you agree with that position?

Hogan: Don't forget, if you had a roundtable of retail investors and you asked what their primary metrics are for valuating REITs, they would say it's the dividend yield.

Magee: It's also important to consider qualitative issues as well as pricing or pricing metrics. Things like the reputation of the industry, the transparency of the companies in the industry, as well as consistency of performance and reliability of dividends. Those are all things that are quite important in the long run to a wide variety of REIT investors, and maybe more particularly to retail investors.

Not to give a big plug for NAREIT, but I do think they have done a very good job over time of trying to make sure that the industry reflects integrity and transparency. And that's very important in the long run in attracting a broad and long-term investor base to REITs, because every asset class has times when it will underperform or outperform. So if the investors in the industry have trust in the accounting and if there is good governance, those are the kinds of qualitative things that ensure that the industry will have a long-term investor base that's quite broad.

Behar: As a further plug for NAREIT, they have worked pretty hard at encouraging companies to consider adding a REIT investment option to their 401(k) plans. They've worked both directly with companies, and indirectly through consultants that work with the corporate HR people with respect to their 401(k) plans. I think attracting individual retail investors to the sector through their 401(k) plans ultimately works better than trying to do so by attracting after-tax savings dollars.

Hsieh: I want to spend the balance of our time on international public real estate securities markets. There is a global REIT phenomenon occurring. Japan is a very interesting case study since its market is probably 18 to 20 months old at this point. The increase in capitalization and the number of companies that have become public has been so phenomenal. The real estate corporate property (C-corps) market in Japan trades at about a 16 percent discount to NAV. The Japanese REITs, which there are 13 of them, are trading at a 50 percent premium to NAV. The 10-year Japanese rate is about 2 percent. The J-REITs are paying out a 4.5 percent dividend yield. So here is a great case in point of yield differential factoring into the "buy" thesis rather than NAV. The J-REIT shareholder base consists primarily of retail, domestic Japanese institutions and some global institutions. Are you guys investing in Japan right now?

Bigman: Yes, we are, but primarily in the C-corps, not the J-REITs

Hsieh: You're not touching the J-REITs?

Bigman: Well, not entirely avoiding, but we certainly favor the C corps over the J-REITs.

Hsieh: I think one of the trends as these new REIT markets are opening is how should it be valued.

Bigman: Unfortunately, Japan took on the externally managed structure. We can honestly say that in the U.S., REITs are true operating companies, and no different than any other company that trades on the New York Stock Exchange. These J-REITs are vehicles; they're not companies. I think from the start they didn't set them up perhaps the way we would have preferred. If you exclude the large C-corps, which trade at a discount to NAV, you have J-REITs trading as high as 50 percent premiums to NAV, and then you put together the fact that if that's correct, then most of these are owned by retail investors, it sounds like you may have a recipe for disaster.

The danger is you have a sector that's getting notoriety. Two things may happen. Either these things are absolutely overvalued, or these retail investors are really smart and they understand that NAVs are going to appreciate by 50 percent, or it's somewhere in between. I don't know. Does anyone else worry about having a J-REIT re-rating?

Magee: It's hard to argue with Ted's point that ultimately paying large premiums to NAVs will be a recipe for disaster in Japan. I spent a great deal of time talking to investment banks and analysts before the J-REIT legislation passed, trying to advise them to have a fully integrated structure. There are many reasons why it didn't happen that way. When we meet with the J-REITs now, virtually all of them expect and want to evolve in a way that more reflects the U.S. model. Hopefully that will happen rapidly.

In my opinion, the Japanese market and the J-REIT market more particularly, looks a bit like the U.S. REIT market did in 1994 and 1995. The cost of debt capital is very low and companies have the ability to raise additional equity because share prices have been rising. The cap rate environment in Japan, while not outrageously high, is historically high. There are many assets coming out of private hands, from corporations and places like that, so it looks like J-REITs are in this period of a virtuous cycle. But it's an earnings growth cycle, not a NAV cycle, in which you can buy property at a 5.5 percent or 6 percent cap rate, borrow money at around 2 percent, raise equity if necessary, and continue to drive earnings growth.

As we know from what happened in the U.S., that virtuous cycle ultimately turns into a vicious cycle. Ted's concerns will eventually come into play and it's just a question of when. It's not obvious at this moment when it will happen, because the financing is so attractive, the cap rates are high, and there is an ample supply of property to purchase.

The interesting thing about the C-corps versus the J-REITs is that the J-REITs typically have less leverage. Much less, and they are far more transparent about their debt as well. As the property market in Japan improves, and it is improving in most sectors, you would think that investors would like the leverage in the C-corps, but the J-REITs have been outperforming.

Hsieh: We were recently involved in the NTT Urban Development Co. IPO which was a $1 billion raise for a C-corp property company in Japan. The deal priced slightly below NAV. While a J-REIT may have netted into a higher initial valuation, NTT's focus was on development and J-REITs are severely legally and operationally constrained, i.e. external management and no development. There is an interesting phenomenon that's happening there, and it goes back to the notion of investors seeking yield, whether you're in Japan, Europe, France or the U.S. We see it everywhere.

Ted, you focus on global real estate stocks, where do you see opportunities outside the U.S.?

Bigman: We have a number of separate accounts where we invest on a global basis. There has been a proliferation of benchmarks and a proliferation of Dutch investors, in particular, that put constraints on how the benchmark is supposed to look. I'd say we've been big fans of Europe for a very long time, but Europe has finally woken up, and the returns have finally come around, with France electing a REIT structure, with U.K. on the verge of electing a REIT structure, and Germany actually getting closer to a REIT structure. As a result, the returns have really come back very quickly, and so we're not nearly as bullish on Europe as we have been for quite a long time.

We had been bearish on Asia for quite some time. It was easy because it went down everyday. But Asia has some of the property markets that have perhaps the best asset reflation stories we can imagine. In Japan and Hong Kong, those turnarounds will be much stronger than they'll be in Europe and the U.S.

Having a global platform is beneficial. If you believe in investing in U.S. real estate as a diversifier for your portfolio and you are a U.S. pension fund, the data shows that real estate stocks in the U.S. versus Europe and Asia have low correlations to each other. By going global, you've enhanced your diversification with similar expected returns.

Now that U.S. pension funds have finally embraced real estate to a decent measure, they ought to be embracing global real estate. From a securities perspective, we think it makes perfect sense, and there are enough investible vehicles that you can do it on an efficient basis.

Hsieh: Anyone else want to comment on globalization?

Hogan: It is going to be interesting to see whether this concept of global real estate companies really plays out in terms of companies that we are looking to invest in. I perceive the Westfield activity as very significant.

Hsieh: To close our session, I would like to have each of you give me your range of total returns for REITs in 2005.

Hogan: I feel we're on borrowed time right now. I agree with everybody that says that our biggest concern is the inflection point in interest rates. I thought we would be 150 basis points or higher right now than we are. I think we're going to be 150 basis points-plus higher for 2005. So, I'm really not that optimistic about a great year in 2005. Over the next two or three years, I feel very good about the sector because of all of these things we talked about that are positive-stable fundamentals, great transparency, and new money coming into the sector. But in the very short term I am concerned.

Magee: We are long-term investors and try not to make 12-month return projections. I'm going to pass.

Duffy: I'm going to pass without giving you a number. But I will say that the determinants are going to be the 10-year Treasury yield, and to what extent the demographic of the aging baby boom population shifts their investment objective from capital accumulation to capital preservation and income, and to achieve it puts more of their retirement savings into real estate and, by extension, REITs. Arguably, some of it's already showing up in the market, and explains some of this influx of liquidity. If we get more of that, it has the potential to keep the rally going. So it's all about rates and demographics.

Behar: And I would agree that rising interest rates are the biggest risk from a capital markets standpoint. But the one positive I would note here is the improving picture on fundamentals. Occupancy levels and rents began to show signs of stabilizing about a year ago across most sectors, and have actually improved in some markets. And we're not seeing a lot of new supply being added indiscriminately. It's true that continuing improvement in fundamentals is dependent on a continuing economic recovery, particularly in the form of sustained job growth, but I think that this serves to mitigate the capital market risk for the sector.