Risky Business

Hunched over his computer every Friday night, retiree Myrt Webb of Palos Verdes checks the prices of his REIT shares online. The retired management consultant gives the four real estate investment trusts he owns a cursory glance before quickly moving on.

“I don’t pay a lot of attention to them. They don’t go up much, and they don’t go down much,” Webb said.

His casual attitude stems from the shares’ stable performance in recent years. Rising prices and healthy dividend payouts have made REITs a popular low-risk investment during the 1990s and increasingly attractive as a hedge against gyrations in the broader market. But as real estate begins hitting full economic stride across the country, analysts say there are signs that some REITs not used to such heavy competition could stumble, some as soon as this year.

Already, returns have slacked off considerably. Bloomberg’s index of 160 REITs has fallen 3.5% this year. By contrast, the blue-chip Standard & Poor’s 500 index is up 15.6%; the Russell 2,000 index of smaller stocks is up 11.1%.

REITs’ lackluster performance is a matter of shrinking margins in the country’s booming economy, analysts say, and a bravado among REIT managers that has led to some minor lapses in judgment.

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Analysts say some REITs are starting to pay more than they should for trophy purchases, taking on increasing amounts of debt and diversifying into ventures they might know little about--everything from cold storage to racetracks to depressed Asian real estate.

An oft-mentioned example of what some consider to be questionable REIT judgment is the sky-high bidding for San Francisco’s bay-side Embarcadero Center, a 3-million-square-foot office and retail complex.

Originally expected to fetch between $800 million and $900 million, the center is now likely to sell for about $1.2 billion to Sam Zell’s Equity Office Properties Trust or Mort Zuckerman’s Boston Properties Inc.

These public investors’ willingness to fork over a huge sum for the Embarcadero Center’s prime location and its promise of premium rents attests to how far the country’s real estate markets have come in just a few years.

Earlier in his career, Zell was dubbed “The Grave Dancer” for snapping up real estate bargains in moribund markets. Lately, he has been singled out for paying top dollar for office buildings--in some cases, almost twice what he paid just a few years back.

“You could say, ‘Gee, we made some awfully terrific deals last time around,’ ” Zell chuckled. “Like everything else, it’s all relative to exactly where you are” in the market.

Zell claims Equity is not accepting a slimmer return on Embarcadero than it would on any other property it has purchased in the U.S. He says his company can afford to pay more for Embarcadero Center than some other firms could because it owns 3 million square feet of office properties in San Francisco and can share management and other services between them.

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Still, Wall Street was not quite as optimistic. After Zell’s firm was announced as a finalist in the deal, Equity’s stock price took a hit. It was proof, some market watchers say, that Wall Street exerts some control over the whims of real estate entrepreneurs.

“Anyone deemed to be paying higher prices for properties will see their stock fall,” said REIT analyst Ralph Block of Bay Isle Financial. “And they will have a much more difficult time raising capital for the next deal.”

But REIT managers such as Victor Coleman of Beverly Hills-based Arden Realty Inc. say higher purchase prices are to be expected, especially here in Southern California, where the economic recovery is fairly green.

“We are not at the top of the market, we’re not even close. Only now are we seeing [rent] concessions go away in certain markets. That’s why people are willing to pay higher prices.”

Much higher prices, in some cases. According to a recent study by Cushman & Wakefield, office buildings appreciated 30% to 40% last year in West Los Angeles, where Arden has made seven buys.

Coleman says investors should relax: As deals signed at the bottom of the market roll over at these buildings, higher rents will justify these steeper prices. So far, there have been no visible catastrophic blunders, or bad deals to prove him wrong.

Analysts say no major REIT has missed earnings estimates. But some could stumble later this year, they add, if REITs continue to up the ante for buildings they want. That means REIT investors like Webb might have to watch their REIT shares a little more closely and do a little more research before they buy.

“Investors have to distinguish between REITs that have good management and good discipline and are not driven to grow just because investors and underwriters have high growth targets,” Block said.

Indeed, smart managers aren’t thinking of growth at all costs. Some have quietly begun to do a little divesting, selling some of their unwanted properties--often previously obtained in bulk purchases--while prices are high.

Others have taken a different tack, snapping up widely different types of buildings and businesses (in which they might have little or no experience) to find bargains and get the 15% returns investors have come to expect.

For instance, Vornado Realty Trust of New Jersey partnered with Fort Worth-based Crescent Real Estate Equities Inc. to purchase a cold storage business.

Analysts say Crescent also has begun a campaign to purchase depressed Asian properties. Health-care center owner Meditrust surprised Wall Street, when it purchased La Quinta Inns and race track operator Santa Anita Realty Enterprises. This type of diversification makes some analysts nervous.

“Investors can diversify themselves by buying a diverse portfolio of stocks--they don’t need REITs to do that,” said Randall Zisler of Apogee, a REIT research firm in New York.

In fact, Zisler says that by mixing up their portfolios, REITs can become harder to understand and less attractive to investors. As a result, share prices may suffer.

Likewise, a potpourri of assets can be much more complicated and expensive to manage as red hot real estate markets slow down. Savvy and efficient management will become critical to boosting earnings without acquisitions.

“Most of the people who went into big successful REITs [in the 1990s] were developers, great on the art of the deal,” said Jack Rodman, a director of E&Y; Kenneth Leventhal in Los Angeles. “Now they have to figure out how to manage them.”

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Those who can’t figure it out, analysts say, will become fodder for larger REITs. Zell and others expect that in a couple of years, there will be 10% to 15% fewer REITs trading on the stock exchange.

Despite the consolidation and uncertainty regarding REITs, Webb says he will hold on, just as he has in years past, until yields drop to about 5% or 6%. Then he will sell.

“There’s risk there, but there’s risk in everything I [invest in],” he said. “I don’t think I’ll get hurt by it.”

In his corner is analyst Jonathan Litt of Paine Webber, who thinks now is a good time for investors to test the waters with REIT shares. With prices down, he says many REITs are a good buy, and during the next two years, he expects the industry as a whole to provide earnings growth two to three times greater than that expected for the S&P; 500.

Analysts say it’s only when the market flattens, demand slacks off and rents stop their rise that investors will spot the REITs that made serious blunders when the market was good. Or as Warren Buffett said several years ago, “It’s only when the tide goes out that you learn who’s been swimming naked.”