Equity REITs: proceed with caution ... but proceed!

Equity real estate investment trusts (REITs) have boomed over the last 15 months. In 1992 underwriters raised some $2 billion for new and existing equity REITs. An additional $650 million of new capital was raised in the first six weeks of 1993, and analysts conservatively project that $3 billion will flow into REITs by year-end.

The reason for the interest in REITs is not difficult to fathom. They have substantially out-performed market averages in return on investment. They pay a dividend of approximately 6 percent, but increased share prices have been the real kicker, moving from an average discount from current asset value of some 5 percent to 10 percent in October 1992, to today's premium over current asset value of more than 20 percent. The NAREIT (National Association of Real Estate Investment Trusts) Equity Index showed a total return of 14.6 percent in 1992, of which 7.2 percent was dividends and 7.4 percent was price appreciation. REITs really took off at the end of 1992 and in early 1993. In the first 10 weeks of 1993, REIT shares rose a breathtaking 17 percent.

With so much new money pouring into REITs and such a spectacular rise in share prices, any veteran investor is likely to think it's time for smart money to start looking elsewhere. We agree that the current REIT "gold rush" will create opportunities to put good money into bad investments. On the other hand, we feel there are still compelling reasons to invest in REITs. The problem for astute investors is to separate the wheat from the chaff.

FUNDAMENTALS OF REITS

REITs are similar to closed-end mutual funds except they invest in a portfolio of real estate properties instead of stocks or bonds. The important factor distinguishing REITs from other forms of real estate investment is liquidity -- shares can be bought or sold any day the markets are open. However, unlike stocks -- where profits are taxed once at the corporate level and again as personal dividends -- profits from REITs are taxed only once, at the investor level, so long as at least 95 percent of profits are paid out as dividends. (Since all REITs want to avoid taxation at the entity level, it is extremely rare for the 95 percent pass-through not to occur.)

But liquidity and tax advantage alone do not explain the recent boom in REITs. Rather, a confluence of macroeconomic factors have created a convincing logic for using REITs as a form of real estate ownership. From the investor perspective, REITs are an extremely attractive alternative to rolling over CDs or investing in T-bills. Not only do they offer a 7-percent dividend, but even with the recent run-up in prices, the opportunity for appreciation in share value looks good because of factors in the national real estate market itself. For institutions, REITs offer a way to invest in properties with far greater liquidity than buying a building directly.

From the property sellers' and developers' point of view, few other sources of capital are available. Savings and loans have substantially left the real estate market, banks and insurance companies are reducing their mortgage loan and real estate equity exposure, foreign capital has substantially dried up, pension funds are shying away from real estate and the limited partnership syndication business is a shadow of its former self.

SUPPLY AND DEMAND

Moreover, the oversupply of properties on the market, fed by the steady liquidation by the Resolution Trust Company of bankrupt S&L assets, has made this an extremely favorable period for acquiring real estate. "Cap" rates (the operating income of a property as a percentage of its market price) are running near to 9 percent, while the cost of capital is only about 6 percent. This unusual positive spread has created an arbitrage opportunity in anticipation of a downward adjustment in cap rates (i.e., an increase in real estate prices relative to rental income).

On top of all these factors, our recent recession and the over-building of the mid-'80s have combined to virtually dry up real estate development. The overstock of offices and apartments is gradually being absorbed even without significant economic recovery. Not only will new development lag behind new demand in the event of a recovery, construction costs will be significantly higher than the prices buyers are paying in today's distressed market. Thus, implicit in the premium over current asset value that people are now paying for REITs is the anticipation of an upward movement in rental rates some time in the next three to four years.

PRUDENT-BUYER GUIDELINES

What all this adds up to is that there is no reason not to invest in REITs -- carefully. Without doubt, some "dogs" will be issued over the next year, but by observing the following eight prudent-buyer guidelines, you can avoid them.

(1) Management Team. The best REIT to entrust your money with is a self-administered operation managed by a fully integrated real estate team. You want seasoned professionals who know how to select properties and how to add value. You don't want added value distributed to third-party managers, joint-venture partners or contractors. You want management to be hard-nosed buyers, not people simply placing investor money at full market prices. The best REITs are likely to look more like real estate operating companies and less like mutual funds that own real estate.

(2) Value-Added Strategy. Look for a REIT with a clearly articulated and plausible strategy for adding value through development, rectifying deferred maintenance, active property management or repositioning the property. Avoid a management team with a passive buy-and-hold philosophy.

(3) Property Type. Pay attention to the management team's strategy for the types of property to be acquired. The office sector is the weakest sector, and will probably lag behind in economic recovery, so a REIT purchasing central business district offices had better have an outstanding management team and a sound value-added strategy. A lot of capital is chasing after apartment and retail properties, so a REIT investing in those areas should have a strategy for avoiding inflated prices. Some excellent opportunities may exist in suburban office and industrial sectors, where buyers have not been as active.

(4) Geography. Boeing's downsizing is affecting Seattle, and defense cutbacks are impacting southern California, so local economics are important. An experienced team with thorough knowledge of local markets may make excellent acquisitions in adverse times, but "outsiders" may not invest your money as wisely.

(5) Focused Expertise. It follows that local expertise and substantial experience in developing and managing the type of properties the REIT is acquiring are a big plus. Beware of the management team that promises to be all things to all people, and look for the team with a strategy focused on limited types of properties in a specified geographic area where they have extensive experience.

(6) Management Ownership. Higher "insider" ownership is desirable because of the incentive it creates to manage the REIT carefully and profitably. Average management ownership is running around 8 percent or 9 percent.

(7) Financial Strength. Leverage is not a bad idea, since it can substantially improve return on investment in a rising market, but more highly leveraged REITs can get into serious trouble if vacancies rise. Average debt is running about 30 percent to 35 percent of total current asset value. Also, be careful of REITs with large exposure to variable rate debt.

(8) Vacancy Rates and Lease Rates. REITs that can offer a solid return on a portfolio with a current vacancy rate of 15 percent or more have a built-in upside opportunity if they can increase occupancy. Similarly, a portfolio of properties with old leases at below current market rates may be in a favorable position when it is time to roll over the leases.

In sum, by paying close attention to these eight risk reduction guidelines, you can make excellent investments in REITs over the next year by avoiding overpriced or poorly managed issues.

Mr. Wollack is chairman and founder of Liquidity Fund Investment Company, a real estate securities firm. Ms. Holup is portfolio manager of Liquidity Fund's REIT portfolio.