By Christopher M. Wright

Name: David M. Blitzer, Ph.D. Title: Managing Director and Chairman of the Index Committee at Standard & Poor’s Age: 54 Experience: Blitzer received his Ph.D. in economics from Columbia University. He has been with Standard & Poor’s in various positions since 1982. Prior to joining S&P, he was corporate economist at S&P’s parent corporation, the McGraw-Hill Companies.

Real Estate Portfolio recently asked David M. Blitzer, managing director and chairman of the Index Committee at Standard & Poor’s, to share his thoughts on the capital markets and the inclusion of REITs in the S&P 500.

Portfolio: Economics has been called “the dismal science.” As an economist, are you dismal or upbeat regarding the rest of the year?

Blitzer: I expect the economy to gradually gain some strength. We should see 3 percent to 3.5 percent GDP growth in the second half of the year, a little better than the long-term average. I expect unemployment to creep up, maybe to 6.5 percent in the second half, because unemployment is a lagging indicator.

By the end of the year, we’ll look back and see the war in Iraq behind us, the economy growing and the stock market showing positive results—maybe up 5 percent to 8 percent for the year. I also see $25 oil, low inflation (2 percent), reasonably good productivity numbers, and improving corporate earnings. Not a boom like the late ’90s but some favorable conditions for growth will remain in place.

Portfolio: Valuations have come down, but average market P/Es (price-earnings ratios) are still high because earnings are so low. Is the market overvalued?

Blitzer: Based on estimated as-reported EPS [earnings per share] for 2003 (net income under GAAP [generally accepted accounting principles], excluding extraordinary items and discontinued operations) suggests P/Es in the low 20s. Given today’s low inflation and interest rates, and expected gains in the economy, these P/Es are reasonable, but not cheap.

Who’s Next? Portfolio asked analyst firms to predict the five companies most likely to be the next REIT added to the S&P 500, and ProLogis was the unanimous first choice. Banc of America Securities ProLogis (NYSE: PLD) Archstone-Smith (NYSE: ASN) Vornado Realty Trust (NYSE: VNO) Boston Properties, Inc. (NYSE: BXP) General Growth Properties, Inc. (NYSE: GGP) Deutsche Banc securities ProLogis Vornado Realty Trust Boston Properties, Inc. General Growth Properties, Inc. Kimco Realty Corporation (NYSE: KIM) Smith Barney ProLogis Vornado Realty Trust Archstone-Smith Kimco Realty Corporation Boston Properties, Inc. Wachovia Securities ProLogis Vornado Realty Trust Archstone-Smith Public Storage, Inc. (NYSE: PSA) Boston Properties, Inc.

Portfolio: You wrote a book in 2001 advocating indexing as an investment strategy. But the market has been down three years in a row and many commentators say it is a time to be selective in picking stocks. Do you still believe in indexing?

Blitzer: Yes. Index funds still do better than more than half of all actively managed mutual funds. Indexing also means you have some money in the next hot spot of the market, whatever it may be. In addition, index funds have lower fees and offer fantastic diversification—you hold the index basket of stocks without the commissions.

People always say that active managers see the bear ahead of time and get out, but it’s a myth, obviously. Index funds diversify you across the entire market, but you should be diversified across investment types and asset classes as well. Maybe you should be 50 percent in stocks, 40 percent in bonds and the rest might be in real estate, for example. You should be indexing in this kind of context.

Portfolio: Standard & Poor’s introduced the “core earnings” concept last year which expenses stock options, backs out gains on pension investments, and makes other adjustments to GAAP net income to focus on how much money a company makes from continuing operations. How has the concept fared?

Blitzer: There are different constituencies. One corporation uses it in reporting earnings. News reporters have been very favorable and welcome core earnings as a good step toward better transparency. Financial analysts are also very positive, telling us “you’re right, it’s time to do our homework.” We’ve had discussions with FASB [the Financial Accounting Standards Board], which now requires quarterly stock options data and is considering changes in pension accounting. We’re pleased with its reception overall—it’s better than we thought it would be a year ago.

Portfolio: How would the application of core earnings affect REITs?

Blitzer: It wouldn’t affect REITs a lot because stock options and pension funds are not major factors in the REIT industry.

Portfolio: The REIT industry uses FFO [funds from operations] as a supplemental measure of earnings, which also focuses on continuing lines of business. What do you think of FFO?

Blitzer: Not any one single number will tell the whole story. There’s nothing wrong with FFO, and I would definitely look at it if comparing REITs. But when comparing REITs to the rest of the market, I’d look at GAAP net income because it’s widely used, spans the whole market, and has a long history. I can do comparisons, for example, to what happened in 1937-38.

Portfolio: How should the S&P 500 be viewed?

Blitzer: It’s a good proxy for the entire market. It’s tilted toward large-cap stocks, but it covers 80 percent of total U.S. market capitalization. With this kind of coverage, as the S&P 500 goes so goes the market to a large extent. There’s a lot of commentary on it. You can open up any newspaper and get a huge range of opinions about the S&P 500. There’s also a lot of historical data on the index. This gives investors an incredible advantage.

Portfolio: How did REITs get included in the S&P 500? There was some reluctance, initially. How was it overcome?

Blitzer: Before I get into that, let me just mention that Standard & Poor’s has a separate REIT index. The current expectations are that we will continue to maintain the index, which is used by institutional investors. So we knew there was a REIT industry and responded to that fact long before REITs were included in the S&P 500.

As for the S&P 500, REITs were popular in the 1970s, but then there were some celebrated bankruptcies and nobody liked REITs. A decision was made in the 1970s not to include REITs in the index. REITs were not viewed the same as other stocks because different tax treatment affected REIT income and because REIT accounting—FFO in particular—was not widely understood. REITs were just a small side-corner of the market in terms of value at that time. REITs were viewed as “income securities” and that was that.

In the mid-’90s, REITs underwent a lot of growth and questions about including them in the S&P 500 began to come up in our Index Committee about 1995 or so. The first inquiries came from the REIT industry, but, in 2001, a Wall Street analyst called me about it. We had a series of discussions and he proposed that a panel of money managers and REIT industry representatives including NAREIT meet with the Index Committee. The committee accepted, so that we could really understand the issue and decide whether to include REITs or say that the issue was closed for three to five years.

We had a comment process after the meeting and got 30 to 40 letters and calls from clients. Following all of this, a change was made and REITs were included in the index. I think we went about it the right way. Our former policy was right for the time and the change is right for the current moment.

Portfolio: The first two REITs were included in the S&P 500 in 2001. There are five REITs in the index today. How do you decide how many to include?

Blitzer: The index is meant to reflect the U.S. stock market. The sector balance in the index should be close to the sector balance in the market. We look at REITs the same way we look at other companies—we require things like four quarters of profitability, and liquidity so that adding the stock to the index does not cause the price to move. We also require that at least half the shares be tradable—in the public float—meaning that a REIT that is majority held by a single family will not be included.

We underweighted REITs at the beginning so that people wouldn’t guess and try to profit from what we were doing. I don’t think REITs are over or under-represented now. The market cap of the REITs currently in the S&P 500 (0.35 percent of the index) is close to the proportional value of REITs in the overall market.

There is nothing afoot for the foreseeable future to make major changes as to how REITs are viewed or how they are represented in the index. REITs will continue to be treated just like any other industry.