By Christopher M. Wright

NAME: Joseph Battipaglia TITLE: Executive Vice President and Chief Investment Officer for Ryan Beck & Co. AGE: 49 EXPERIENCE:Battipaglia graduated Phi Beta Kappa from Boston College and earned his M.B.A. at the Wharton School of Business, University of Pennsylvania. Prior to joining Ryan Beck, he held posts at Exxon, Elkins & Co. (a division of Prudential Bache) and Gruntal & Co., L.L.C. (before it was acquired in part by Ryan Beck). His market comments have appeared frequently in such national media outlets as The New York Times and The Wall Street Journal. He is a former trustee of the Securities Industry Institute.

Joseph Battipaglia, chief investment officer for Ryan Beck & Co., has been called one of the market's best-known and most persistent bulls. Portfolio recently sat down with him and asked, among other things, what's in store for REIT shares for the rest of 2005.

Portfolio: What's your basic view of REITs as an investment proposition?
Battipaglia: From an asset allocation perspective, I believe REITs play an integral part in the fixed income-total return portion of a portfolio. Fixed-income investors view REITs as an alternative to bonds. REITs give investors inflation protection, unlike a conventional bond portfolio. But REITs have additional volatility due to market and company risk. A first-class portfolio of real estate properties is just as blue chip as anything else, but market forces can take equity share prices down as happened in the savings and loan crisis and after September 11. Those two events show that REITs are susceptible to market risk, even though the underlying fundamentals were quite solid and share prices eventually moved higher.

Portfolio: What about company risk?
Battipaglia: In the 1970s, REITs were highly leveraged pools of mortgages. They were too risky and collapsed upon themselves. Today, REITs largely represent diversified real estate equity portfolios instead of mortgages. These equity REITs perform better through the entire earning cycle. They're bigger, more seasoned, and their dividend yields are more sustainable.

But some REITs make wrong decisions. Some consistently overpay for new properties, leading to lower rates of return. Some stay stuck in declining areas instead of diversifying geographically.

Portfolio: What do you look for when picking individual REITs for client portfolios?
Battipaglia: Management's judgment and track record, geographic and property-type diversification, relative leverage—the same analysis as in other industries.

Portfolio: There was much discussion in the second half of 2004 that we were headed into a low-return environment and that investors were going to focus on dividends and total return. Have things worked out that way?
Battipaglia: I believe they have. High-yielding companies have performed well compared to companies that don't pay dividends. Investors are seeking stability and want strong dividend payers like REITs and utilities. You can find high-yielding securities in any sector but they're not attractive without a healthy growth rate like REITs have. A company with a low growth rate paying a high dividend today is not a good investment because it will underperform in the future.

Portfolio: What's in store for REITs for the rest of 2005?
Battipaglia: Back two or three years ago when the performance of the economy was still questionable, REITs had higher yields than bonds. In the last couple of years, REITs have delivered spectacular total returns driven by share price appreciation. That dynamic has played out. Now REIT yields are almost comparable to Treasuries. I expect more moderate total returns, mostly coming from dividends. We are looking for total returns of minus-5 percent to plus-5 percent for REITs in 2005.

Portfolio: Why that range?
Battipaglia: We are in a rising interest rate environment engineered by the Federal Reserve. With higher energy costs and a moderating economy, we expect 10-year Treasury yields to rise to between 4.75 percent and 5.25 percent. The yield curve is flattening, as you would expect in the third year of an economic expansion. Other yield categories—corporate and municipal bonds and REITs—will not have a great year as this process unfolds.

Portfolio: Based on that assessment, what are you advising clients?
Battipaglia: We're not telling clients to dump REITs from their portfolios and move on. REITs have had three great years and the long-term trends are favorable. This year is the pause that refreshes, like the commercial says. REITs will continue building the franchise values of their real estate portfolios. Cash flows will rise, filling in the premium valuations, and REITs will lift their dividend distributions.

All of this will renew the attractiveness of REITs as an asset class. But REITs will be challenged through 2006 and 2007 while we see how far interest rates will rise. Interest rates are the critical factor in determining the relative attractiveness of asset classes. If the Fed funds rate only rises to 3 percent and 10-year Treasuries stabilize at 4.75 percent to 5.25 percent, the balance will eventually tilt back in favor of REITs as they build their businesses.

But history shows that interest rate swings are usually much wider. Inflation could come from several sources, like the current account deficit, and this would cause the Fed to ratchet up interest rates further. The yield spread for high-yield bonds, corporate issues and REITs would narrow in that case and investors in those asset classes would be disappointed.

Portfolio: Your firm's overall “Market Outlook,” published in late 2004, forecast a range of possible returns for REITs for 2005, with gains of 15 percent at the high end. Based on the previous range you gave, what would it take to reach this more optimistic scenario?
Battipaglia: If interest rates do not rise as much as we expect, then REITs could return as much as 15 percent on a total return basis for the year.

Portfolio: You offer your clients three all—ETF (exchange-traded fund) portfolios, reflecting growth, balanced and conservative approaches. REIT funds figure in all three portfolios in varying proportions. Why did you decide to offer portfolios composed entirely of diversified funds?
Battipaglia: We have watched the evolution of the ETF market for 10 years. Investors now have more than $200 billion invested in ETFs, which run the gamut of asset classes—Treasuries, equities and international. ETFs eliminate individual stock selection risk. They're low cost and trade all day like securities.

With ETFs, you can move quickly along the seams of the market, shifting from large cap to small cap, for example. With nine or 10 positions, we can cover 1,500 U.S. stocks, 760 international equities, 140 bonds, and, through an ETF based on the Dow Jones U.S. Real Estate Index, 80 different REITs. We can meet all our diversification needs with a very compact portfolio.

Portfolio: You have said that REITs are a good inflation hedge. How so?
Battipaglia: Historically, both cash flows from REITs and property values have accreted faster than the underlying inflation rate for goods and services. In previous economic cycles, hard assets have tended to outperform. Hedge funds might be the flavor du jour but REITs have hard assets, as well as liquidity, cash flow distributions, and operating businesses that have stood the test of time. Few asset categories can offer all of this.