Short sellers rush to cash in on hottest REITs.

After Lexington Corporate Property Trust announced late this February that it would acquire a portfolio of 27 office and industrial properties from Wells REIT for $768 million short selling activity on its publicly traded stock rose 58% according to a recent report issued by REIT analysts at Banc of America Securities. Also mentioned in the report was Maguire Properties, which had an even more considerable acquisition in the recent $1.5 billion purchase of an office portfolio from CommonWealth's Fifth Street Properties and consequently experienced a 48% increase of short-selling activity on its stock.

Had investors regarded the two REITs' transactions as poor real estate plays? Lexington's vice chairman and chief investment officer Richard Rouse posited a different explanation for the increased short selling activity. The acquisition, at least in Lexington's case, highlights a longstanding strategy of buying single tenant, long-term net-leased properties in smaller markets--a recipe for especial sensitivity to the current climate of rising interest rates.

"Lexington in particular would be sensitive to interest rate movements," said Rouse, who also noted that the firm's stock posted a record price just a few weeks ago at $24 per share and currently sits at a still lofty $22. "With multi-tenant buildings you have leases rolling over more often and you're therefore able to mark those leases to market. With our leases, the rents are pretty much fixed for the next six or seven years and you know exactly what you'll get just like you would with a bond. So we consider ourselves to be more stable than most REITs, but slower growing as a result."

Although Lexington's upside potential is limited despite the trend of tightening real estate fundamentals, Rouse said that the REIT locked in long-term financing for the Wells portfolio over a month ago, when Treasury rates were slightly lower. As a consequence, the firm can enjoy a better spread than the current interest rate climate would allow and one that will look attractive as heightening rates further compress returns.

Lexington isn't the only REIT to experience an influx of short-sellers however. The entire sector was flooded with a 9.6% increase in short interest in the four weeks preceding February 10, followed by a 6.7% increase in the four weeks preceding March 10.

The increase in short selling activity comes at a time when the yield for 10-year Treasurys spiked over 10 basis points with the news that the Fed was concerned about rising inflation. Many REIT analysts link rising interest rates--which the Fed has pledged to liberally stiffen at the expense of its 25 basis point measured pace in order to combat inflation--to decreasing REIT stock value. So far, the short sellers' attention to the industry has been warranted, as total returns for REITs in 2005 had been a dismal -8% according to the NAREIT composite index, a far cry from the staggering 38% and 30% returns REITs averaged in 2003 and 2004 respectively.

But poor performance this year hasn't extinguished hopes for a REIT rebound.

"A lot of research analysts have been betting against the sector in recent years and they were wrong, so this isn't necessarily the beginning of a down period for REITs," said Louis Wolfowitz, a real estate securities analyst for Cushman & Wakefield. "Year after year, everyone keeps saying this is going to be the year that REITs go down and they've continued to defy expectations despite some down months."

The general trend of increased short selling activity coupled with diminished yields isn't a phenomena occurring in equal measure in all categories of the industry. Self-storage and lodging REITs actually experienced a diminution of short sellers.

"In the wake of 9/11, hotels have taken such a hit that I think they have to start rebounding," Wolfowitz said in explaining the short sellers' retreat.

Office REITs, on the other hand, while experiencing a 12.3% increase in short activity, have been one of the strongest performers. Although their 2005 -4.3% yields aren't impressive so far, they have held ground when compared to the double digit negative returns for other categories in the sector. Office REITs that are particularly immune to the trend of diminished returns and are poised to reap strong profits from buoying fundamentals are those positioned in strong real estate markets like New York, Boston, Washington D.C., Chicago and Southern California.

"For our long investments we're very focused on REITs with portfolios in the major markets," said Matt Gillman, CEO and portfolio manager of Starwood Real Estate Securities, a real estate hedge fund that makes both long and short investments in a variety of REIT types. "I like a REIT like SL Green a lot and I also like Vornado, although the latter takes more risks than some [of] its investors may like."

Wolfowitz mentioned that the sector most at risk for further yield decreases is shopping centers, which could take a pounding as higher interest rates put a crimp on consumer spending.

Equity REIT short Interest--sector summary
Transactions through 3/10/2005, Total return as of 3/23/2005

                          Short
                        Interest         vs.           vs.
                         (000s)      Prev. Mnth    12-Mo. Avg.

EQUITY REIT SECTOR AVERAGES (Mkt Cap Wtd)

Office                    51,166        12.3%         48.7%

Industrial                11,959        12.1%         25.1%

Office/Indust.             6,151         2.5%         11.9%

Apartments                29,973         2.2%         10.3%

Manufactured
homes                      4,144        10.4%        142.3%

Regional Malls            20,121         7.7%         32.8%

Shopping centers          17,675        12.2%         35.5%

Triple net lease           5,991         5.8%         59.6%

Diversified                6,267        20.3%         78.3%

Self storage               3,903        -1.9%         30.2%

Healthcare                12,551        10.1%         26.2%

Lodging REITs             24,671        -8.4%         -0.3%

REIT total/Wtd. Avq.     201,661         6.7%         33.8%

                           S.I
                          Ratio
                         Days to        % of
                          cover         float

EQUITY REIT SECTOR AVERAGES (Mkt Cap Wtd)

Office                     5.6          2.5%

Industrial                 6.6          2.5%

Office/Indust.             4.8          2.1%

Apartments                 5.6          2.7%

Manufactured
homes                      9.5          3.9%

Regional Malls             5.6          2.8%

Shopping centers           6.6          2.3%

Triple net lease           5.8          3.3%

Diversified                8.2          4.0%

Self storage               5.7          2.0%

Healthcare                 6.4          2.6%

Lodging REITs              7.8          3.6%

REIT total/Wtd. Avq.       6.3          2.7%

                         Price %
                         change         Total
                        (3/10/05-      return
                        2/10/05)         YTD

EQUITY REIT SECTOR AVERAGES (Mkt Cap Wtd)

Office                     1.4%         -4.3%

Industrial                -1.0%        -10.7%

Office/Indust.            -0.5%         -9.6%

Apartments                -0.1%        -10.8%

Manufactured
homes                     -1.2%        -14.8%

Regional Malls            -4.6%         -8.6%

Shopping centers          -1.0%         -9.6%

Triple net lease          -2.0%         -8.6%

Diversified               -1.2%         -9.5%

Self storage               2.7%          0.7%

Healthcare                -2.2%        -11.7%

Lodging REITs              1.2%         -8.9%

REIT total/Wtd. Avq.      -1.1%         -9.2%

Source: FactSet, Banc of America Securities, LLC Total REIT
industry figures include certain companies not included in
sector totals.