By Christopher M. Wright

Name: Larry Raiman Title: Managing Director, Real Estate Research Company: Credit Suisse First Boston Age: 41 Experience: Larry has 11 years of experience in the real estate industry. He moved from Paine Webber to Donaldson, Lufkin, & Jenrette, and then to CSFB where he has held his current position since 1994.

Real Estate Portfolio recently asked Larry Raiman, managing director of real estate research for Credit Suisse First Boston Corporation, to share his thoughts on the capital markets for publicly traded real estate and the industry as a whole.

Portfolio: What is your outlook for the real estate industry heading into 2003?
Raiman: The real estate industry has moved into a downturn. New properties are still being delivered, but job growth as an indicator of future demand is not robust. We're seeing excess space in terms of direct vacancies and sublet space in most metropolitan areas.

It's changed from a landlord's market to a tenant's market. This means that rental rates are going down and tenant inducements are going up. Overall, the industry is going south and this trend should persist for at least the next six to 12 months.

REIT stocks are a different story. Stocks don't always perform according to earnings fundamentals. REIT stocks have an average dividend yield of 7 percent. The dividend yield and reasonable 10-times P/E multiples have provided downside support for REIT stocks, even though earnings growth in the industry is declining. These stocks might go up a little or down a little in 2003, but we expect share prices to remain essentially flat for the year.

Portfolio: What do you expect in the real estate capital markets next year?
Raiman: We might see one, maybe two, real estate IPOs (initial public offerings) next year. There are not many private real estate enterprises looking to come public. The securitization of private companies has already largely taken place.

We will also see a minimal volume of secondary offerings. Proceeds of secondary offerings are usually used to acquire new properties, but REITs can't buy properties at attractive prices right now, as private market values are too high. REITs are thus not issuing secondary offerings because they can't put the money to use.

The outlook for mergers and acquisitions is also light. We haven't seen great performance from acquiring companies following real estate mergers in the past, and REITs are not looking to merge now. Also, REIT mergers are usually stock-swap deals and we don't see a big spread between multiples that would enable a company with a high-flying share price to make acquisitions.

Finally, we're not looking for much leveraged buyout (LBO) activity, either. There's not much of a difference between where stocks trade and where private net asset values are. As a result, there's really no way to pay, for example, $15 a share for a LBO and to sell the pieces for $20-plus a share at the moment.

Portfolio: In terms of real estate stocks, where would you recommend an investor put his or her money in 2003?
Raiman: I like four REIT sectors—retail, health care, self storage and net leased. Retail occupancy rates have been very stable. The pace of store closings and bankruptcies is much lower than it was a year ago and trends are good. Cash flows are generating core growth of 2 percent to 3 percent for retail landlords, relatively better than most other property types.

The trends are also stable for health care REITs. Most of the properties—hospitals, assisted-living facilities and nursing homes—are on long-term leases. The operating environment has improved and cash flows are up. As a result, operators are better able to pay the rent than before and these trends should continue. Dividend yields and share prices are also stable, even in this down market.

Self storage is a relatively small sector, with companies generating fairly stable operating results. Demand has remained fairly consistent. With the weak economy, a lot of people are living in smaller residences, especially on the apartment side, or moving back home. People need to store their stuff somewhere.

I also like net leased, another specialty sector. REITs buy the property and lease it to the tenant for an average of 10 to 15 years on a net-lease basis where the tenant picks up all the costs associated with ownership—insurance, utilities and real estate taxes. The landlord receives the rent with no expenses. This is done for many different types of real estate including office and industrial properties, and even golf courses. Much like in the health care universe, leases are long term in nature, making rents and revenues more stable than in other sectors. As a result, net leased REITs are generating more stable earnings and cash flows.

Portfolio: I detect a pattern here. All your picks emphasize stability when many people are still expecting an upturn in the economy.
Raiman: That's because real estate is a lagging indicator by about 12 to 18 months. The economy may be expected to improve but there won't be movement in real estate until sometime later. The time for making cyclical plays in real estate investments based on earnings growth is still many months away.

Portfolio: What sectors would you avoid?
Raiman: [I would avoid] apartment REITs, office REITs and industrial REITs. Weak job growth hurts new household formation and demand for apartments. However, there continues to be new construction so supply continues to be fairly high. Prices for apartment buildings are still high, so apartment REITs cannot buy their way to top-line growth. All these factors are creating a tough environment for apartment REITs.

The dynamics are similar with respect to office and industrial REITs. Demand is slow, and in some cases, negative. But despite that, new deliveries keep coming. So the supply/demand dynamics continue to be negative, not positive.