Pension fund investors may not be happy about REITs these days, but they're hanging on to them anyway, taking a long-term view and hoping for a turnaround.
Several plan sponsors, portfolio managers and analysts say that REITs, which lagged the broad stock market in the first half of 1998, could be poised for a comeback. But others think REITs will continue to underperform.
For the year through July 20, the Standard & Poor's 500 index is up 23%, while the Morgan Stanley REIT index was down 5% for the period.
Jerry Clark, who manages a $470 million REIT portfolio for the $40 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, said a lot of money managers have been selling REITs in the last six months because of the strength of the broader markets.
However, he expects REITs to do better over the next six months, because the fundamentals are strong, and there are good growth prospects in several markets, particularly office REITs and selective hotel markets.
He said he has been concerned about overbuilding in certain sectors and changes in the laws which could affect the favorable tax treatment. But his main problem with REITs is that some are issuing secondary offerings in a down market.
"There is no reason to raise capital in this market. Anyone doing that today is crazy," declared Mr. Clark. He is reviewing some of the losers in his portfolio of 65 REITs, particularly those that have done secondary offerings. "It impacts our strategy, and forces us to focus on that. In this market with the stocks trading below what we paid for them, I get offended when companies do offerings. When I complained about this to one CEO, he acted as if I didn't know what I was talking about," said Mr. Clark.
Instead of raising capital, REITs should be doing stock buybacks, he added, pointing to Starwood Lodging Corp., Phoenix,, which initiated a stock buyback program a few weeks ago.
A secondary offering by First Washington Realty Trust Inc., Bethesda, Md., done in June hurt its share price, noted one money manager who owns the stock. "It was trading near 25 until the offering was announced, which pushed down the share price 7% to around 23, and it still hasn't recovered," said the manager, who requested anonymity.
But Mark Yost, REIT analyst at Wanger Asset Management, Chicago, whose firm also owns First Washington, took a different view. He said even though First Washington didn't get the price it had hoped for, it won't make any difference over the long term.
He believes the market is rebounding now, attracting new buyers.
"Deep value buyers are starting to look at REITs now, because they can buy them at good discounts compared to their net asset value," he said.
Candice Ronesi, spokeswoman at New York State Teachers' Retirement System, Albany, said the pension fund's internal real estate managers expect the performance of REITs will improve significantly in the second half and are considering boosting their REIT holdings.
Historically, REITs have done better in the last six months of the year than the first, and they are attractively priced compared with non-REIT stocks, she said.
The fund managers will consider additional investments in REITs at the July 30 board meeting, she said.
The $75.8 billion fund currently owns between $600 million and $700 million in REITs, with more than half passively managed.
A spokesman at Sears Investment Management Co., Hoffman Estates, Ill., which manages $12 billion in pension assets for Sears Roebuck and Co., said there would not be a change in the strategic allocation of 1.32% of assets to REITs, despite market moves. Sears has had the allocation for two years.
"If we were going to follow market moves, we would put everything in Coca Cola," he quipped.
Public Employees' Retirement Association of Colorado, Denver, is still upbeat about REITs, said spokesman Don Schaefer. "We had been moving away from buying specific properties and going toward REITs, because it's less labor intensive for us. Rather than having to look after every property or partnership we have, REIT investments mitigate the risk and offer more diversification in terms of types of properties and the geography."
The $25 billion Colorado PERA pension fund currently has 8.5% of its assets invested in real estate. Of those, 20% are in REITs, which is above its 15% target, so PERA won't be adding more REITs to its portfolio at this point, Mr. Schaefer said.
Analysts are divided about the prospects for REITs.
Several like Lou Taylor, senior real estate analyst at Prudential Securities Research, New York, said the selling in REITs has been way overdone.
"We think construction concerns were overblown and the perceptions about earnings growth have been misplaced. There are several factors that should help. Expenses are better controlled. Costs have been restrained. There are development opportunities and rental income is strong, which should lead to 10% growth rate, not counting acquisitions. But it will take a couple of quarters for the market to realize this," Mr. Taylor said.
He recommends buying industrial building and office REITs.
But Lee Schalop, who covers real estate for J.P. Morgan Securities Inc., New York, takes a more bearish stance, and expects REIT share prices to continue to decline, lagging the broader market before they rally.
Over the last five years, earnings growth among REITs has been driven by a combination of secular change and cyclical recovery, he said.
The shift from private to public ownership -- which created, and continues to create, enormous opportunities for well-run real estate companies by implementing cost-saving strategies through economies of scale -- will continue, said Mr. Schalop. But the cyclical recovery, -- a period of strong demand for real estate unmatched by supply -- is over, he believes.
Even though many quality companies are currently trading at attractive prices, it's unlikely that value investors, who could be big buyers, will be heavy buyers of REITs until they think the outlook has stabilized, he said.
"Companies will be able to grow now that they're public, but not as fast as they could a year ago," Mr. Schalop said.
There are still a few REITs that he favors, especially those that have a limited exposure to overbuilding, mainly in California. He also likes niche REITs such as outlet developers and high end regional malls, because there is not a lot of competition in either area, he said.
