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July 31, 1998

The Rise and Fall of REITs?

By Stephen Lacey

Riding the real-estate rebound of the past three years, real-estate investment trusts (REITs) helped keep the new-issues market awash with capital.

But with Congressional legislation designed to tighten tax loopholes on the horizon, REITs have dramatically underperformed in recent months due to investor concerns, several industry analysts disclosed.

"To a large extent, investors have been over-saturated," said Meredith Whitney, an analyst who follows REITs for CIBC Oppenheimer Corp. in New York. "It will have to flush out considerably before we see REITs return to the capital markets in force."

Having lost investor interest, REITs offering stock in 1998 have performed under opening prices and jeopardized several offerings still in registration.

Twenty REITs companies that manage portfolios of real-estate holdings tapped the initial-public-offering market for $4.17 billion in 1997, building another $15.03 billion from 153 follow-up offerings. And new REIT offerings had remained relatively buoyant through the first five months of this year totaling $2.02 billion for 14 issues, and $6.54 billion for 136 issues in the primary and secondary markets, according to Securities Data Co.

But since May, there have been no IPOs, and only four follow-up deals.

Whitney noted that the enormous amount of capital already raised by new issues $27.93 billion since the beginning of 1997 has increased the cost of acquisitions and slowed activity among companies.

"Many of these companies have underperformed. If that were not the case, the cycle would have continued," she said.

While the Nasdaq composite index closed above 2,000 points for the first time in late July nearing a 16.8-percent gain the Morgan Stanley, Dean Witter, Discover & Co. REIT index is down almost 3.6 percent this year.

This year's 14 IPOs have found the aftermarket even more difficult, closing on average 5.2 percent below their offering prices in July.

Some market observers are predicting continued growth for the sector, albeit at somewhat slower levels. But bullish analysts claim REITs now offer a compelling investment vehicle for value-oriented investors.

"REITs clearly have underperformed in a significant way," noted Marc Paley, head of equity syndicate operations at New York-based investment bank Lehman Brothers, one of the sector's leading underwriters. "But we believe that we have come off of the bottom, and REITs will outperform the market in the second half of the year."

According to a recent report by analysts at St. Petersburg-based Raymond James & Associates, 13 of the 27 REITs the firm handles were trading at discounts as low as 26 percent of their net asset value.

The report stated that well-run public real-estate companies should ultimately warrant up to 15-percent premiums to net asset value.

Paley noted that due to longer lease terms, the office and industrial sectors of the real-estate market are the most likely candidates to fuel the first stages of a REIT turnaround.

Hotel operators, however, could prove to be the most fruitful long-term investments, said Mark Foushee, a real-estate analyst at Raymond James. With equity prices falling an average of 12 percent in recent months, the hotel sector was the most severely impacted among REITs.

"We continue to expect the most volatility in the hotel sector over the next few quarters, driven by the sector's susceptibility to swings in the economy and the current threat of overbuilding," added Foushee.

Foushee used LaSalle Hotel Properties (NYSE:LHO) as an example. The April 1998 offering trades at a 26-percent discount to net asset value.

The New York-based company, which operates three convention centers, two resorts and five full-service hotels, made its market debut at $18 a share. In late July, its stock price hovered below $16 a share.

"They came at the worst part of the market," Foushee said. "Their timing was just a little bit off."

Foushee strongly recommends the stock as a good, long-term investment, and expects its price to rise to around $25 a share.

Despite the sector's recent travails and lack of meaningful issuance, many analysts expect REITs to regain investor interest. By law, REITs must return 95 percent of earnings to investors.

"I suspect new issues will pick up dramatically, maybe sometime in the fall" Paley noted.

With the Labor Day already on the minds of many syndicate participants, it may take until the fourth quarter before the 13 companies in registration find a home for the $2.4 billion they are seeking.

Stephen Lacey is associate editor of The IPO Reporter, a sister publication of Traders Magazine.