By Erin Corcoran

A bidding war and the sub-prime meltdown were the leads in the REIT world during the first half of 2007. What is in store for the rest of the year?

Portfolio sat down with five leading industry professionals to hear what they think about the year so far and what lies ahead.

Jan Svec
Director of REIT rating group
Fitch Ratings

The biggest story of 2007 thus far is the January bidding war for Equity Office Properties Trust between The Blackstone Group and Vornado Realty Trust (NYSE: VNO), and Blackstone's subsequent asset sales to private buyers for extravagant prices.

However, the biggest surprise of the year has been the timing of the crash in the sub-prime market and how that has affected asset-backed financing markets as a whole, including spreads on deals in the commercial mortgage-backed securities (CMBS) market.

I expect that the office sector, primarily coastal markets and select interior markets, will outperform in 2007 and multifamily will pick up again. —JAN SVEC, FITCH RATINGS

As for more high-profile M&A transactions, there is no doubt that they will happen this year. We expect the industry to continue to consolidate as stronger players purchase smaller competitors and weaker peers. The survivors will be larger and have more dominant market positions.

As for particular REIT sectors, I expect that the office sector, primarily coastal markets and select interior markets, will outperform in 2007 and multifamily will pick up again as the housing market continues to show weakness.

I think that the uncertainty in the housing market will remain as the dominant issue for 2007, which will continue to have a material effect on multifamily REITs, CMBS spreads and eventually retail sales numbers.

At this point, there's no reason to believe that the rest of the year will be any different than the first half. However, there has been more volatility in the debt and equity markets of late, which could affect REIT returns at year-end.

William E. Hauser
Portfolio manager
HVB Capital Management

Recently, the sub-prime mortgage sector has stolen the show in 2007. However, this issue is only tangential to market REITs. While much of the story remains to unfold, I continue to believe that investor concerns on this topic have been overblown. We've successfully navigated numerous challenges of far greater significance over the past several years.

For the first half of the first quarter, the meteoric returns of the REIT sector were undoubtedly the biggest surprise. Obviously, the fall-off in returns from that early trajectory has taken the shine off that story.

As for sector performance, we continue to favor the lodging sector along with select areas within office and multifamily. With that said, our bias towards supply constricted, infill markets remains strong and puts a limit on the names of interest in each of these sectors.

U.S. market participants will benefit from non-U.S. investors becoming more knowledgeable on the benefits of investing in REITs. —WILLIAM E. HAUSER, HVB CAPITAL MANAGEMENT

Activity within the office sector might be supplanted by transactions in retail or multifamily. In general, retail offers less opportunity to capture meaningful rental spikes—and while fundamentals for multifamily continue to improve, the rate of acceleration for NOI growth has certainly lessened.

As for REIT globalization, I believe that over the long-term, U.S. REITs' percentage of global REIT volume would shrink over time, even though the absolute size of the U.S. market will continue to expand. We believe U.S. market participants will benefit from non-U.S. investors becoming more knowledgeable on the benefits of investing in REITs.

Switching to M&A activity, I do not believe that it has run its course. Globally, we've seen approximately $1.9 trillion of property transactions since 2003. In the U.S., privatizations accounted for approximately 2 percent of all transactions in 2004—during 2006, that figure rose to 57 percent. Privatizations are not dead.

The outlook for earnings growth from REITs remains solid. Inflation and its expectations remain low by historical standards. Also, corporate balance sheets remain strong and private investment capital abounds. At the same time, capital continues to be raised by private equity firms in record volume.

The positive relative performance trends for the REIT sector have been in place for some time and changes in course are not dictated by a calendar. As always, the level of earnings growth and dividends are easiest to forecast, whereas multiple expansion/contraction is dependent on investor sentiment. For the full year, I'm holding a forecast of a high single-digits total return.

John J. Kriz
Managing Director-
Real Estate Finance
Moody's Investors Service

In my opinion, M&A has been the biggest story in public real estate so far in 2007. However, it is surprising that performance has continued in commercial real estate.

Nevertheless, I now believe that the most important issue for the remainder of 2007 will be managing the dénouement of private capital in real estate, and of ever-falling cap rates.

In terms of sector performance, I believe that "A-quality" retail properties are among the most stable property types. Those who seek greater stability and are interested in consistency will find retail a better bet in the long-term.

I believe that the most important issue for the remainder of 2007 will be managing the dénouement of private capital in real estate. —JOHN J. KRIZ, MOODY’S INVESTORS SERVICE

However, there are certain issues this year, such as recent adoption of REIT legislation in other countries, which may impact U.S. REITs. This is a two-sided issue. The good side is that, from a long-term aspect, we will see a further broadening of REITs that will provide greater scope and stature. It will also help establish the legitimacy and staying power of public property markets.

However, in the near-term, it could pose more of a challenge for U.S. REITs. Investors may shift their focus to the growth of public property firms in other countries. In the long-term this will balance out.

The out-performance by REITs of the broader indexes has been happening for long time, longer than most of us could have imagined. The party may not be over, but it may be time to switch to water. Booms don't go on forever.

Hans Nordby
Research strategist
Property & Portfolio Research

In terms of the biggest story of 2007 so far, it's the Equity Office privatization. When we look back on this in 10 years, we will say that the Equity Office buyout was the event, but what drove the event was a bigger story of cheap debt, high net operating income (NOI) growth expectations and extended high risk tolerance. These three factors will be the hallmarks of commercial real estate in 2007.

Interestingly enough, Equity Office has not been the biggest surprise this year. The biggest surprise so far is the spread between the cap rates on the Equity Office assets put under contract versus what these same assets sold for moments later as Blackstone broke up the portfolio.

More overseas REIT activity will increase transparency outside the U.S., which leads to more efficient markets and better pricing over time. —HANS NORDBY, PROPERTY & PORTFOLIO RESEARCH

Equity Office is a tough act to follow, but there definitely will be more M&A activity. My suspicion is that it may happen in the hotel and hospitality arena because debt remains overwhelmingly cheap and NOI growth prospects in the hotel sector are outstanding for 2007 and 2008.

As for sector performance, it is a matter of public versus private markets. The retail sector has been very strong in the public REIT sector, but not as strong in the private markets. Institutional investors have moved away from retail. As the year goes on, there will be a significant softening in private sector retail, which should transfer into the public market as well.

Overall, in the long-term, more overseas REIT activity will increase transparency outside the U.S., which leads to more efficient markets and better pricing over time. These REITs will also make cross-border investing easier and more efficient.

Overall, this is a very interesting time. Usually debt is cheap when growth expectations are low, and debt is expensive when growth expectations are high. The current market proves that wrong. The dominant issues will be the same ones that drove the Equity Office deal: a high tolerance for risk, combined with high NOI growth expectations and cheap debt. These drivers may be the secret sauce of high real estate returns in 2007.

However, because expectations for interest rates are flat, meaning rates won't trend up until 2008, returns should be solid this year for REITs. We expect quite strong returns in most commercial real estate sectors for the year, and demand fundamentals are still quite robust.

Richard C. Moore II
Research analyst and
managing director
RBC Capital Markets

Without a doubt, the biggest story of the year has been the buyout of Equity Office. Yet, I believe that the biggest surprise would be the overreaction for the housing and sub-prime market. Sub-prime mortgage has nothing to do with commercial real estate and the housing bubble, yet this has been on the top of everyone's agenda. Ironically, this situation is not a big deal. Yet it has caused turmoil within the sector.

Going forward, the most important thing is for companies to generate high quality earnings. REITs that have a management team that can drive earnings and try different things other than owning real estate as well as focus on what investors really want will be the winners in the industry.

I believe there will be 15 percent to 20 percent of total return for 2007. In general, REITs will definitely outperform the broader market again. —RICHARD C. MOORE II, RBC CAPITAL MARKETS

As for sector performance, retail will remain strong because of high demand for space, and new supply is well contained. The long-term nature of leases protects companies in case of a recession.

I do believe that there will be more M&A activity this year, specifically within the mall sector. Small companies are unable to compete because their management teams aren't generating ideas to get them to the next level. They will be purchased by either private companies or larger mall REITs.

As for looking abroad, REIT globalization should be perceived as a good thing. In the near-term, investor interest may be turned away briefly as they look at some of these new markets, but in the long-term, this will not impact the industry.

However, I believe there will be 15 percent to 20 percent of total return for 2007. In general, REITs will definitely outperform the broader market again.