From the March 2007 issue of Research Magazine • Subscribe!

Historic Highs

Analysts expect the valuations of REITs to remain solid in 2007, though the sector may experience some volatility.

Christopher R. Lucas

Robert W. Baird & Co.

703-821-5780

crlucas@rwbaird.com

Area of Coverage: REITs

Outlook: Given the significant run REIT shares have had over the past seven years, we are cautiously optimistic in our outlook for 2007. The most recent REIT bull market run, which began in March 2000, has been buoyed by improving fundamentals, historically low interest rates and improving private market valuations for commercial real estate. While trees do not grow to the sky, we expect REIT returns to moderate and provide low double-digit returns in 2007 based upon slight 2 percent to 3 percent multiple contraction, solid 8 percent to 10 percent per share growth and an average dividend yield of 4.5 percent.

Our outlook is tempered by historically high valuation levels as measured by price to funds from operations (or FFO) per share multiples, the length of the current up-cycle and the reality that markets rarely find equilibrium through a soft landing but instead are likely to overshoot to the up or down side. Median prices to current year FFO multiples have expanded from 7.2 times to 16.8 times, or 133 percent, since the nadir of the cycle in February 2000, to year-end 2006. In 2006 alone, median P/FFO multiples expanded 18 percent.

In general, we would expect 2007 to be more volatile than prior years as many forces come to bear on REITs, including valuation concerns and the length of the REIT bull market. While we expect overall multiples to contract slightly, we believe that real estate valuations will remain at historically high levels as the global liquidity glut will continue to factor into the demand for real estate, primarily in the form of institutional investors seeking to privatize established portfolios such as REITs.

Taking a more technical look, we would expect REIT shares to be particularly susceptible to weakness in the beginning of the year as investors who have enjoyed significant gains in REIT shares may have likely held on through the new year, delaying their profit taking and recognizing gain this year. In general, we believe that overall current REIT valuations make the alchemy of an M&A transaction difficult to pencil, but we also believe that any sell-off will likely be met by a privatization transaction waiting in the wings if the opportunity were to arise.

Sectors we expect to exceed expectations include lodging and retail.

The lodging industry is a more cyclical real estate segment than many others. The lodging segment has experienced a remarkable period of growth since 2003, with gains each year in occupancy and revenue per available room (RevPAR). Industry fundamentals indicate that the recovery remains strong.

Our call for better performance in the retail sectors relates to our belief that new sector leadership will emerge. The retail sector was a relative underperformer in 2006 generating a 29 percent total return, and valuations remain generally in line with the overall REIT industry.

We expect two primary drivers to retail returns in 2007 -- the M&A opportunity in the shopping center business and the recognition of redevelopment potential by mall owners. First, after rolling through the lodging, apartment and office sectors, we expect private equity shops to seek opportunities in new sectors in 2007. We believe the shopping center area may be the most attractive given the number of potential targets and the cap rate spread to financing opportunity that exists.

Second, regional mall owners have seen their business transform from consistent income generators to, in many instances, income-generating land banks. Regional mall owners have been in-process on up-zoning or master planning their in-fill suburban malls and transforming them into large mixed-use development projects, which should drive valuations and earnings.

Outperforms: AmREIT (AMY); AvalonBay Communities Inc. (AVB); BioMed Realty Trust, Inc. (BMR); Corporate Office Properties Trust (OFC); DiamondRock Hospitality Corporation (DRH); Equity Inns, Inc. (ENN); Hersha Hospitality Trust (HT); Highland Hospitality Corporation (HIH); Host Hotels and Resorts Inc. (HST); Industrial First Potomac Realty Trust (FPO); LaSalle Hotel Properties (LHO); Red Lion Hotels Corporation (RLH); Supertel Hospitality, Inc. (SPPR); Spirit Finance Corporation (SFC); Urstadt Biddle Properties Inc. (UBA); Washington Real Estate Investment Trust WRE; and Winston Hotels, Inc. (WXH)

Corporate Office Properties Trust: Corporate Office Properties Trust has developed into the premier landlord/office space service provider to key agencies of the federal government. The company has both the key skill set from a heightened development requirement standard as well as the necessary security clearances to meet the highest level of security requirements that either the federal government or their contractors require.

The company has built a reputation for quality customer service leading to a higher-than-industry-average retention rate which lowers both capital output necessary to bring in and build-out the space for a new tenant as well as limiting the down-time associated with new tenant retrofitting. It is the dominant owner of both existing office buildings and land available for additional development in key submarkets including locations proximate to the Fort Meade Agency, which is located between Washington D.C., and Baltimore near BWI airport and the Westfield's, the largest suburban office park in Northern Virginia, located near Dulles International Airport.

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Paul D. Puryear

Raymond James

727-567-2253

Paul.Puryear@RaymondJames.com

Area of Coverage: REITs

Outlook: We estimate that REITs are currently trading at an average premium of 19 percent to net asset value (or NAV), at the high end of our comfort range. Although, we remain comfortable given the relatively early cycle stage of the recovery and believe that outside of a severe economic slowdown or a spike in interest rates, there is no identifiable event/driver that, in the short term, would depress REIT NAVs.

Implicit in our expectation that REITs will once again turn in a positive performance in 2007 is our expectation that cap rates will only modestly increase and NAVs will grow as a result of earnings growth. We agree with consensus estimates calling for the 10-year Treasury yield to finish 2007 in the 4.75 percent to 5 percent range, putting only modest upward pressure on cap rates, and see little reason for cap rate spreads to widen given the generally strengthening real estate market. Consequently, we expect earnings growth to push NAVs higher in most property types.

Outperforms: Apartment Investment and Management Company (AIV); Corporate Office Properties Trust (OFC); Equity Residential (EQR); Highland Hospitality Corporation (HIH); Kimco Realty Corporation (KIM); Kite Realty Group Trust (KRG); Mid-America Apartment Communities Inc. (MAA); National Retail Properties, Inc. (NNN); Public Storage, Inc. (PSA); Senior Housing Properties Trust (SNH); and SL Green Realty Corp. (SLG)

Kimco Realty Corporation: Kimco provides the defensive characteristics of a large cap, shopping center REIT with a strong balance sheet, but also some hedge against a real estate downturn through its numerous business lines and joint ventures, which allow the company to invest in many types of assets outside of fee simple real estate. We believe this is ideal in a changing economic/real estate backdrop and gives the company a platform to deliver good earnings growth and secure dividends to shareholders at various points in the cycle.

National Retail Properties, Inc.: National Retail Properties [is] a net lease REIT focused on free standing retail properties. We believe the long-term nature of the leases in the company's high quality portfolio provide a good defensive play in this uncertain economic environment. Additionally, the company is improving its earnings growth prospects after half a decade of stagnation through the efforts of President and CEO Craig Macnab, who joined the company less than three years ago.

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Ross L. Smotrich

Bear Stearns

212-272-8046

rsmotrich@bear.com

Area of Coverage: REITs

Outlook: Although we are cautiously constructive on the sector going into 2007, we think the risk profile of the group has increased materially due to rich valuations, partially attributable to M&A activity. Our three main concerns going into 2007 are: one, a less favorable risk/reward trade-off; two, a perceptual shift; and, three, macroeconomic stress. We think actual REIT returns in 2007 will be a function of investment alternatives and investor sentiment; we expect mid- to high-single-digit returns.

Our cautious but positive outlook is premised on strong real estate fundamentals, continued solid earnings, and technical support. Institutional investor demand for real estate is robust and appears sustainable, particularly from plan sponsors and international investors. A manifestation of that liquidity is the $100 billion of M&A activity year to date, which we view not just as an arbitrage on public versus private cap rates, but also as an arbitrage on capital structure. While there is downside risk if liquidity migrates elsewhere, it is partially offset by a smaller investable universe.

With average REIT dividend yields below 4 percent, we believe it is fair to say investors are not buying the stocks for yield, but rather total return. In that vein, our investment stance is to seek strong earnings growth and, by extension, dividend growth at the most reasonable relative valuation (GARP). Accordingly, the most attractive sectors, in our view, are malls, industrial, multi-family, and specialty finance, while office looks expensive.

Outperforms: Alexandria Real Estate Equities (ARE), AMB Property Corp. (AMB), Archstone-Smith Trust (ASN), Camden Property Trust (CPT), CB Richard Ellis, Inc. (CBG), General Growth Properties (GGP), iStar Financial Inc. (SFI), Kimco Realty Corp. (KIM), Newcastle Investment Corp. (NCT), Newkirk Realty Trust (NKT), ProLogis (PLD), Regency Centers Corp. (REG), Republic Property Trust (RPB), Simon Property Group (SPG), Vornado Realty Trust (VNO)

Favorite Industrial REITs: AMB Property Corp., ProLogis

Both ProLogis and AMB have robust development businesses that generate: one, up-front profits; two, recurring fee income over the life of the takeout funds they manage; and, three, significant incentive fees upon the liquidation of those funds. While there may be long-term risks to this business model (such as the reliance on continually increasing demand for space, both from users and investors), the near-term growth rate and the visibility of that growth over the coming 12-24 months are very strong.

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