Bridge Builders

The Security Capital U.S. Real Estate team builds

Ken Statz spends his days navigating between the worlds of commercial real estate and Wall Street. As senior market strategist for Security Capital U.S. Real Estate Shares, Statz and co-managers Anthony Manno and Kevin Bedell have called upon their collective wisdom in real estate and stocks to successfully maneuver their four-year old real estate investment trust fund through a volatile industry. The $116 million fund generated a 35.84% total return in 2000, pushing it into the top percentile of real estate mutual funds as measured by Morningstar.

In the 1980s, Statz served as REIT portfolio manager and managing director of Chancellor Capital Management, then in 1992 jumped to Goldman, Sachs & Co. to be a senior REIT analyst. Statz has watched the real estate business go from small and parochial in the 1980s--when it was primarily a private industry with a few shopping-center REITs--to today encompassing more than 120 companies focused on properties including office buildings, apartments, storage facilities, malls, and hotels. "My experiences in the 1980s led me to believe that you needed to be very knowledgeable about real estate, which is a fragmented market and takes a lot of research, and you also had to be very knowledgeable about the stock market," he says. It was this belief that drove Statz to Security Capital in 1995. "There really wasn't a money management firm out there that was extremely deep in real estate and very deep in Wall Street" acumen, he notes. But Security Capital filled the void by building a deep research team of real estate and stock experts that "could create something new and better for investors."

In 1998 and 1999, tech stocks and the rest of the market overshadowed REITs. But REITs churned out a stellar performance in 2000, despite a tumultuous stock market. Statz attributes the comeback to resurgent earnings growth. Despite the slowing U.S. economy, he expects a stable environment for REITs in 2001.

What's your investment philosophy? We believe we are a bridge between the commercial real estate market and the stock market. We are cash-flow-driven investors. Our models focus on current cash flow and the sustainable build in new cash flow growth as the foundation for our valuation models. And our "conviction system" at the committee level--which includes Anthony Manno [chief investment officer], Kevin Bedell [investment research], and myself--we all must agree that we know something proprietary. If we can't isolate why we believe a security is mispriced based on some proprietary piece of information, we don't own it. We try to focus our activity on the top 20 to 25 securities. In this business the top 50 names constitute the vast majority of this index. There are 120 companies that dominate, and if you have 40 or 50 stocks in the portfolio you basically are the index. The fund has only been out for four years, and we've been able to double the Wilshire Real Estate Securities Index.

REIT funds were great performers in 2000. What's the outlook for these funds in 2001? We look at everything in terms of the fundamental outlook: How are the stocks valued and then what is the liquidity incentive in this area? We always start off by measuring the fundamental valuation of liquidity, and that gives us the kind of year we think we will have. As far as valuation goes, we still have a very disciplined supply of new space in 2001. The question will be: What is the demand for it as the economy slows? In our firm we are not economic forecasters, so we study the consensus and react very quickly to it. Clearly we are now looking at a very slow, if not recessionary, environment in the first half of the year--with, of course, differences of opinion about how much better it will get in the second half. That will be the main determinant of what happens on the fundamental side for real estate stocks because it could result in some decreased vacancy. However, in real estate stocks at the higher quality end--the companies that have leases at much higher rental levels because the markets have been so strong--their earnings will continue to grow rather nicely, and they also will not have a significant increase in vacancy. Those vacancies will probably appear in the low-quality, poorly located portfolios that got filled up because there was such strong demand for so many years. Overall we are looking for a year with 7% to 8% earnings growth, which is in line with normal averages. The fundamental picture we see then is stable, despite the slowing economy. However, it will be fine in the high quality, but poor in the low quality. On the valuation front, the price-to-cash-flow multiples are about 91/2 to 10 times. And stocks are selling at anywhere from 5% to 10% discounts to net asset valuation. If you had to call it one thing or another you'd say they look roughly fairly priced. And by fairly priced, they should deliver their dividend, which ranges from 5% to 8%. And the growth will range from 5% to 8%. So total rate of return for most companies is around the 12% to 15% range.

How does shifting stock market sentiment affect you? Sentiment and liquidity are the hardest to call because they're really a function of what is happening in the rest of the world, which we are not experts on. The incredible volatility of the equity markets will probably result in some behavior shifts in the market. Individual investors, as they get their statements and talk to their financial advisors, and pension and endowment investors, as they talk to their boards, will really have to reflect on the kind of performance they had in 2000 with tremendous volatility and little or no return. We think the drive toward diversification and income will increase. That's sort of the theme for 2001--getting some defensive income in your portfolio and getting some diversification. We think the desire for that will shift almost in a secular sense as opposed to maybe a short-term sense. Going forward we are not quite so sure people will take their diversification needs so lightly, because these REIT stocks have very low correlations with other types of stocks. I think investors will not have such blind faith that 20% returns are their God-given right. On the liquidity sentiment side, we think it will be rather good in terms of what we have to offer as an industry versus what investors come to conclude they need. It's a longer-term shift call, and when we wrap it all together, we look at 2001 as a traditional year--one of balanced fundamentals and balanced pricing that should provide rates of return in the 12% to 15% range.

What makes REIT funds different from other types of funds? REIT funds differ because the commercial real estate industry is huge but it's still primarily privately funded. It's primarily funded away from the stock market, unlike every other industry, and it has its own liquidity flow and its own pricing conventions. Investors talk about cap rates, which is like a P/E multiple but is in the jargon of commercial real estate, in terms of what they will pay for an office or apartment building. And the reason real estate stocks are interesting to investors is that real estate is an industry that is not highly correlated in its returns to other industries, which are publicly traded. The supply and demand balance in commercial real estate is the most important thing about a real estate investment, whether it's public or private, and that translates into a real diversifier of stocks, bonds, and [other] assets.

What type of investor is right for a REIT fund? REITs have been around since 1960. But they remained parochial and small until the mid '90s, when the private commercial real estate industry needed to access capital and only the publicly traded equity window was open. So real estate companies became public, and opened the door for the first time for investors to access some of the best quality commercial real estate in the U.S. Individual investors were offered the kinds of diversified returns that had been available to institutional investors. This is a brand new investment tool for most people. The securitization of commercial real estate really allowed investors--individual investors and even some of the rather large institutional investors--for the first time to get a really diversified investment in commercial real estate into their overall assets. For most investors, once they decide their risk tolerances, they have to understand where a diversifier like real estate comes in. REITs also give you income if you need it, and an inflation hedge--which some people may or may not think they need today but over the long term they may. And it gives a total rate of return package of 12% to 15%. If you are a high-risk investor focused on this in terms of 25% plus, probably commercial real estate will not fit for you. Average investors adding 5% to 10% of commercial real estate in their portfolio will benefit from a nice total rate of return, and it certainly provides a nice source of income.

Offices and apartments were the strongest performing real estate subsectors in 2000, and that's where you focused the fund. You steered clear of the nonperformers like hotel stocks, except one, Starwood Hotels and Resorts. Is your strategy the same for 2001? In 2001 there are some subtle changes. We continue to like office, but perhaps different office companies. We are focusing on the office companies that continue to operate in very high-barrier-to-entry markets--places where it's difficult to build, like New York, Boston, and San Francisco--with tremendous demand. That's where we think rents have escalated to very high sustainable levels, and there's a lot of lease rollover potential for these companies. We are focusing on very large, well-capitalized companies like Boston Properties (which we doubled the size of our position in), Equity Office Properties, and SL Green Realty in New York. It's a very defensive mix with a common characteristic of very tight markets going into a recession. We've held out on some of the suburban office companies because that's where we think vacancies will show up in 2001.

Security Capital

U.S. Real Estate

Security Capital U.S. Real Estate Shares

Security Capital Corp.

11 South LaSalle Street, 2nd Floor

Chicago, Illinois 60603

312-345-5800

www.securitycapital.com

Ticker: SUSIX

Portfolio manager: Statz, Manno, Bedell

Managers' tenure: 5 years

Fund started: December 1996

Minimum initial investment: $2,500

Load (front-end): 0%

12(b)-1 fee: 0.25%

Net assets: $116 million

Dist. yld (trailing 12 months): 4.41%

P/E ratio: 19.0

P/B ratio: 1.8

Median market cap: $2.6 billion

Expense ratio: 1.20%

Turnover: 50%

3-year alpha: 0.19

3-year beta: 0.20

3-year r-squared: 5.0

3-year standard deviation: 17.07

Returns
2000: 35.84%
1999: 0.58%
1998: -11.94%
1997: 25.17%
1996: N/A
12-month (annualized): 32.81%
3-year (annualized): 6.14%
5-year (annualized): N/A
Top Five Holdings
Equity Office Prop Trust 7.70%
Starwood Hotels & Resorts 7.50%
Boston Properties 6.80%
Liberty Property 5.50%
Public Storage 5.50%
Equity Allocation
As reported in the February issue of Morningstar's Principia Pro.

Annualized returns are through January 31, 2001.

What about hotels and apartments? Starwood has had a great start to the year despite worries about recession because the fundamentals on their own basis have been very strong. Investors are kind of funny because they are already seeing through the recession and seeing there is very little hotel supply coming on in 2002. And if the economy recovers, these stocks should be extremely strong performers on the earnings side. The valuations are still very low, but once we ride through the economic weakness, we think valuation multiples will increase significantly back to historic levels. So far we've maintained our Starwood position and it's worked very well. We already have prospered and we're not so sure that now is the time to increase hotel ownership. We continue to own apartments, but are not overweighted. The market has begun strong this year in retail stocks, but we remain underweighted in retail because the fundamentals are weak.

How do you go about buying a stock? We have what's called our matrix. We have a NAV approach, and then we have a five-year discounting cash flow approach. One is real estate and one is stock, and we do both because, again, we are always in two worlds: real estate and stock. What we do is weigh the target prices applied by both. Let me give you an example: Equity Office Properties is a company that we think has $34 per share of real estate value and is trading at $31. A net asset model would say this stock should really trade at par with real estate, and if it did, what kind of total rate of return would we get for that stock? The discount model says, "Well, that's just from passive ownership of a real estate portfolio, what would it be worth? Can it buy more properties, can it participate in development of more properties, and what is its five-year cash flow outlook?" And then from a stock perspective, what is its discount rate, and how risky is it as a stock? That model suggests that this company should trade somewhere closer to 37 or 38. There's a premium to its real estate because it's actually adding value above and beyond the real estate value. So our system combines those two target prices--one, let's say, is 33, and one is 38--and we mix them, either 50-50, or 75-25, depending on how aggressive we want to be. For example, we are in a neutral stage, so we are 50-50. Our system then calculates, equally weighing the two prices, let's say it's $35 as an average. It would then say "If the stock is trading at $31 and it has a 5% dividend yield, we believe you'll make a target return of 20%." Our system weighs all the calculations on 120 companies the same way: What is its net asset value potential, what is its discounted cash flow potential? And it comes up with a target list of the top 20 to 25 securities based on that. And the best opportunities for us are based on our belief of what the real estate is worth and what the operating company is worth. That is our system at the management committee level--Manno, Bedell, and myself. We look at this matrix and it helps us understand what the best securities are for us to own because we believe there is a fundamental mispricing. So we call it our "conviction system," where we have to develop conviction that we know something the market doesn't. And it has to be all three of us equally. We all have to vote "yes."

How do you sell a stock? Our matrix focuses on the return we expect and the riskiness of the stock and how variable has it been. It looks at the standard deviation of the stock. It observes the target return and the amount of risk we take by owning that stock. But we ultimately have our own decision process to really set a target portfolio so that we are not always jiggling the portfolio. And when we decide [on a stock] that has much better risk and return characteristics, we'll talk about it and we'll put it in the portfolio and sell the least attractive of the 20 to 25 securities. The most important thing is that it's a bottom-up kind of system. We do not start the day when we meet to talk about our target portfolio assuming we have to own a certain percentage in office or apartments. We let our system guide us to where we as a collective group--the analysts and the portfolio managers--think the best return is. To guard against having all office in the portfolio, for example, or all apartments, we limit ourselves to weighting no more than two times the property weight in our index. If our index weighting is 25% in apartments, we could not have more than 50% of the portfolio in apartment names. That is a risk controller we use, and it also tells us at what price we should sell the stock, because it's always calculating where we could do better in other stocks: that's the bogie current stocks have to use. Our portfolios [thus] have about 50% turnover a year.

Equity Office Properties is your top holding. What do you like about this company? It's a good company to hold during a recession because it has embedded rents--their rent levels on leases are significantly below current market rents, and as these leases turn over we expect Equity Office to maintain strong cash flow growth even in a slowing economic environment. Its current stock price is below the value of the office buildings it owns, so you're buying real estate cheaply and you are going to be in a protected growth area as the economy slows. Equity Office is one of the largest real estate companies with high quality real estate assets located in the best markets. It's a very strong operating company with a strong expense control, and they've added services to office buildings that they are able to charge for.

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