REIT Investors Get Mixed Signals
In Light of Zell's Big Sell-Out

It is being uttered by many investors: "If Sam Zell is selling, I should, too."

The real-estate legend's decision to sell his Equity Office Properties Trust, previously the nation's largest office owner, has been viewed as proof that office real-estate investment trusts were too richly valued.

Adding to the anxiety is the word that several REIT executives exercised options or sold shares this month, including Boston Properties Inc. Chairman Mortimer Zuckerman, who sold $75 million of stock in a single day.

Yet, investors shouldn't make too much of these signals. While they should be cautious -- and refrain from flooding into the office-REIT sector -- they don't need to worry about whether to hold their positions for a while.

Some of the biggest portfolio managers of REIT funds took their cash out of Equity Office and plowed some of it right back into office REITs instead of choosing other kinds of REITs, such as hotels or shopping malls, or letting their cash levels rise. That is because, despite an incredible run in the stocks in the past six years, some upside may remain.

With relatively few new office buildings under construction, rental rates in certain office markets are expected to increase significantly in the next two years. That should give office landlords the opportunity to renew leases at higher rates, likely increasing future cash flow. These markets tend to be where some highly regarded office companies -- including Vornado Realty Trust, SL Green Realty Corp. and Brookfield Properties Corp. -- have most of their assets.

While the high price of office buildings has made market observers nervous, private investors, not REITs, generally have been the ones doing the buying. Some REITs have been net sellers. Moreover, with the hunger for real estate still unabated and interest rates still relatively low, most real-estate experts predict that the merger activity in the sector will continue this year. Thus, any REIT could still be taken out -- at a premium to trading price.

James Corl, portfolio manager at Cohen & Steers, a REIT mutual-fund firm that was one of the largest holders of Equity Office shares, said that based on the underlying value of their real estate, office REITs still aren't expensive. That is despite the fact that the Dow Jones Wilshire REIT Index shows an average stock-price increase of about 34% over the past year. Mr. Corl's funds hold positions in many office companies, including Brookfield and Mack-Cali Realty Corp., according to Morningstar Inc.

To be sure, REIT stocks don't look cheap. REIT yields are low by historical terms, and funds-from-operations multiples -- a common REIT profitability gauge that excludes gains or losses from property sales while adding back depreciation, among other adjustments -- are high. The average forward FFO multiple is 20 times consensus estimates for 2007, the highest since 1998, the year BMO Capital Markets began compiling such data. But REIT bulls say growth expectations compensate for any weakness.

Investors continue to clamor for positions in commercial real estate, seeing it as both a necessary counterweight to the stocks and bonds they hold and as a hedge against inflation. Steve Buller, portfolio manager of Fidelity Real Estate Investment Portfolio, said he put his fund's cash from Equity Office back into REITs, including some office companies. Yet, Mr. Buller says, it is important to be patient with REITs -- one of the longest-term investments. "If you're looking for a short-term pop, you're looking at the wrong asset class." Mr. Buller's fund held positions in Vornado and Duke Realty Corp. among others, according to Morningstar.

No doubt, Mr. Zell did a great job of selling his company, pitting Vornado against private-equity firm Blackstone Group, which agreed to pay $23 billion plus the assumption of $16 billion of debt. That gave EOP shareholders an additional $3 billion over Blackstone's initial offer. For its part, Blackstone has already sold or agreed to sell more than $21 billion in assets it acquired from Equity Office.

But Mr. Zell's sale says more about his underperforming office company than it does about the market. He knew that investors were paying top dollar for buildings and realized that turning his company around might take longer than the current upturn in the office cycle.

"Sam Zell is selling, but Vornado and Blackstone were out there trying to buy. I think that gave the market increased confidence to invest in similar companies," said Jay Rosenberg, co-lead portfolio manager at First American Real Estate Securities Fund. Mr. Rosenberg's funds had a position in EOP and owns shares in several office REITs, including Boston Properties and SL Green, according to Morningstar.

And though SL Green and Boston Properties executives took a little off the table as REIT stocks ran up at the close of the Equity Office merger, they are still very much tied to future company performance. Mr. Zuckerman's sale of 579,222 shares on Feb. 7, for example, was about 20% of his Boston Properties common stock and options. That doesn't include another 7.7 million in operating partnership units he also holds in the company, according to FactSet Research Systems Inc. Mr. Zuckerman didn't return calls for comment.

The insider sales are "a rational reaction to a heady bull market for office values, but aren't necessarily a negative signal about those REITs' future prospects," said Michael Knott, senior analyst with independent Green Street Advisors, a Newport Beach, Calif., real-estate research and trading firm. Neither Mr. Knott nor Green Street own office REIT shares.

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