Multi-family REIT arena looking more favorable.

In our opinion, investing in the multi-family REIT arena looks more favorable today than any time during the past couple of years. Drivers to underlying fundamentals, namely supply and demand, are significantly better today than a year ago.

Specifically, while we continue to carefully monitor the construction starts and permits data and acknowledge some difficulties in some southwestern and southeastern markets, all indications are that excessive construction should not be an overwhelming problem in the upcoming 12 months.

Furthermore, the economy has continued its persistent march, leaving unemployment levels low and consumer demand for housing high. In fact, the strength of the U.S. economy and fears of inflation have resulted in higher interest rates - a plus for apartment owners as the economic decision of rent versus own shifts toward apartments.

Reflecting the solid fundamental underpinnings and financial performance that has generally met or exceeded expectations, apartment REITs have outperformed other REIT sectors year to date. Inclusive of dividends, apartment REITs have delivered an average year-to-date total return of 5.5 percent through November 18th.

Despite the fundamental outlook, multi-family REIT shares by and large remain undervalued, plagued by apparent investor apathy regarding cyclical, small cap and value stocks. While we acknowledge that the positive total returns generated by year to date make the group look a little more expensive than other sectors on a multiple basis, we continue to stress net asset value as the primary valuation gauge. We remain consistent in our long-held belief that well-managed REITs should trade at least in-line with and generally at a modest 10-15 percent premium to underlying net asset value. Currently, all six of the multi-family REITs we formally cover remain priced at meaningful discounts to NAV. We believe this valuation parameter was validated again in late September when Walden Residential announced a going-private transaction at a price nearly identical to our previously published NAV estimate for the company.

Industry Perspective - Looking Ahead

We continue to believe that over the long run, multi-family REITs can take advantage of the tremendous consolidation opportunities, margin improvement abilities via economies of scale, increased revenues from non-traditional sources, and certain demographic trends to produce attractive total annual returns for shareholders. We have historically favored middle-income apartments that we consider to be less susceptible to the negative affects from new construction, since the very nature of the economics of new construction virtually demand that it be aimed at the high-end renter. These same attributes still apply to the sector. We are also attracted to REITs that operate in economically vibrant markets where supply of new apartments is limited. Specifically, we have long favored Essex Property Trust due, in part, to its focus on supply constrained markets in the San Francisco Bay area and Southern California. We are also attracted to the investment opportunities present in Charles E. Smith Residential Realty. C harles E. Smith should realize above-average same-store NOI growth emanating from the vitality of its markets (Washington D.C., Chicago, Miami and Boston) and the higher barriers to entry existing in Smith's primary submarkets.

As long as demand meets supply, we believe the better operators should realize top-line gains in line with or slightly exceeding inflation (i.e., 3 percent rental revenue growth), while operating expenses could grow at perhaps 50-100 basis points less than the rent revenue growth rate. Adding leverage and a bit of external growth, we continue to believe over the longer-term, well-run multi-family REITs are capable of generating 6-9 percent FFO growth that, when combined with 5-8 percent dividend yields, should provide investors with attractive mid-teens total annual returns.

As we have written in past comments and reports, the combination of a robust economy featuring low unemployment, healthy job growth and relatively low interest rates enticed apartment builders to increase the pace of construction in late 1998. Furthermore, the rising cost of acquiring apartments reduced the gains from spread investing and swung the risk/reward pendulum toward development.

With multi-family starts and permits data available through October of this year, it generally appears as though developers have displayed a degree of discipline that has rarely been witnessed during an expansion phase of previous economic cycles. Although October permit data bounced off September's 28-month low point, it appears to us as though nationwide starts in 2000 should fall in the low 300,000 range.

It is evident to us that the global economic concerns of last fall, the mountains of market and sub-market specific data available to lenders, some weakness in low barriers to entry markets such as Houston, Las Vegas and Phoenix, higher interest rates, and limited access to capital on the part of REITs have combined to curtail apartment construction.

In a stable economic environment and at the current level of job growth, we believe the country can comfortably support the development of approximately 300,000 to 325,000 apartment units per annum. And while the economy has certainly been better than "stable," and thus perhaps capable of absorbing more than 325,000 new units, the relatively low interest rate environment experienced during the past couple of years has increased the appeal of single-family home ownership vis-a-vis renting.

Multi-family permits (five or more units) have averaged 316,700 units (seasonally adjusted, annual basis) during the past six months through October, a level that does not cause us overdue concern.

The Fed's hike in interest rates, announced on November 16th, could be viewed as an early Christmas present to multi-family REITs, although not necessarily immediately positive to shareholders. Over the past several months, we have witnessed an increase in mortgage rates and are witnessing declines in new orders on the part of single-family homebuilders. We believe apartment fundamentals would benefit from increased interest rates. Our thesis is based on our belief that (1) fewer renters will exit the rental pool for single family homes; and (2) new apartment construction would be moderated thanks to higher financing costs.

Rising interest rates, on the other hand, have historically caused some near-term pressure on REIT share prices. In fact, the multi-family group has declined almost 2 percent during the past week.

While we remain bullish toward the sector, our heads are not buried in the sand. We recognize that several markets continue to run the risk of - or have already witnessed - deterioration in underlying fundamentals due to slowing job growth and/or excessive new construction. Those markets include Dallas and Houston, where concessions have re-emerged in a magnitude not witnessed for several years. Portland, Las Vegas, Phoenix, Nashville and Memphis remain on our watch list. Even some northern California areas, which for years have been among the leaders in producing rent growth, are showing signs of slowing.

Many markets remain positioned to deliver very positive results in 1999, and generally produced outsized returns for apartment owners in the third quarter. Markets such as southern California (San Diego, Orange County, Los Angeles/Riverside, etc.), Chicago, Boston, Manhattan, Minneapolis, northern Virginia/Washington D.C., and some parts of the San Francisco Bay area should do well in 2000.

Industry Perspective: Third Quarter 1999 Results

Each of the 19 multi-family REITs included in this report have now reported third quarter 1999 results and, by and large, forward estimates have been adjusted to reflect the recent results. Some interesting findings are as follows:

* The average multi-family REIT reported Third Quarter 1999 FFO growth of 6.3 percent from the same quarter in 1998. The group averaged 7 percent, 9.2 percent and 9.8 percent growth in the second quarter 1999, the first quarter 1999, and fourth quarter 1998 from the same quarters a year ago, respectively. Although results are impacted from the inclusion of Associated Estates (NYSE-AEC: $7.69), Walden Residential, and Mid-America, which each reported negative year-over-year FFO growth, we continue to see some sequential slowdown in growth, largely due to much lower levels of external growth.

* Same-store NOI growth for the group of 19 REITs averaged 5.1 percent and ranged from a high of 14.5 percent posted by Home Properties (NYSE-HME: $24.94) to a low of negative 3.1 percent generated by Associated Estates. The group of REITs averaged 3.3 percent revenue growth and .3 percent expense growth in their same-store communities.

As of November 18th, the average consensus FFO growth expectations for the group for FY 1999 and FY 2000 are 6.8 percent and 8.4 percent, respectively. These expectations were revised from 7.5 percent and 8.7 percent, and 8.6 percent and 8.4 percent, respectively, in mid-August and mid-May after second and third quarter results were announced.