At the NAREIT 2000 annual convention held last October in Washington D.C., a panel of experts discussed current issues affecting real estate. The panel moderator was Samuel Zell, chairman, Equity Group Investments, Inc. Panelists included: Steven J. Buller, portfolio manager, Fidelity Investments, Inc.; Patrice A. Derrington, fund manager, Victory Real Estate Investment Fund; Eric Hemel, deputy director of U.S. Equity Research, Merrill Lynch & Co., Inc.; Mike Kirby, principal, Green Street Advisors; Jonathan Litt, senior real estate analyst, Salomon Smith Barney; Gregory J. Whyte, managing director, Morgan Stanley Dean Witter & Co., Inc.

Below are some of the highlights of the discussion dealing with taxable REIT subsidiary (TRS) legislation, net asset value (NAV), technology and the future of the REIT industry. An unabridged tape of the panel's comments may be obtained by calling Audio Transcripts Limited at 1-800-338-2111. Virginia residents call 703-370-8273.

Zell: There are a lot of things going on in our industry, and I thought I would start with what's the most current, which is TRS legislation. How profitable will TRS legislation be and how will it impact our industry?

Litt: TRS brings the ability for the REITs to get into businesses that can foster their core business. Ancillary businesses can generate profit and drive rent growth and occupancy growth over time. This will evolve over the next three to five years.

Derrington: I think REITs, such as Equity Residential Trust, AvalonBay Communities and Camden Property Trust, are starting to decide whether to build their own technologies or go outside. That's one advantage of the present-day REIT that we tout when we say these are not the REITs of the '80s.

Whyte: There will be greater risks, but we are going to expect greater returns.

Zell: Let's move on to another subject: NAV, or net asset value. How critical is NAV?

Kirby: NAV is a very helpful valuation benchmark that helps us put value into components. I think you can be a disciple of NAV and still believe that REITs deserve to trade at premiums or at discounts to NAV. The evidence is very mixed—we've been keeping data now for nearly 11 years and there have been extreme swings in pricing. I think the real tone of the question is where REITs deserve to be relative to NAV. You can use NAV as a valuation benchmark and still believe that good management teams deserve to trade at a substantial premium.

Buller: NAV is a tool that is best used in an extreme bear market when you want to find floor-end values.

Hemel: I disagree. NAV represents orderly liquidation values. REIT numbers have been pretty good in terms of establishing a floor-end value. But I find cash flow multiples in the sector to be extremely misleading because two companies can have the same cash flow multiple, but if they have different debt structures it's an apples and oranges comparison. More important, the companies with the lower cash flow multiples on average can have more property. We realize NAVs flaws, but we really don't have a better alternative.

Derrington: REITs are being used as a hedge in times of volatility, and they are being dumped in times of growth in the technology sector. That has no relevance to NAV, and that is distressing to REIT operators trying to improve their NAV. An investor in a REIT stock is looking at total return. The broader market has been spoiled over the last five years with an average return on the S&P 500 of 28 to 29 percent. So an expectation of rates of returns on stocks has risen. What sort of return do you expect on a REIT stock given an average 7 percent dividend yield and an anticipated growth rate of somewhere between 8 and 10 percent on average? If traded at NAV that would give you roughly a 12 percent total return. We are looking today at them trading at something that indicates a 14 to 15 percent return—that seems to be what the market wants in comparison to 28 or 29 percent return on the S&P.

Whyte: If REITs want to combine NAV into an analysis, they have to do it along side growth.

Zell: That brings me to a subject that we have all been opining about: technology. What impact, if any, is technology going to have on our industry?

Kirby: I'm very comfortable with REITs taking an equity position in technology startups.

Hemel: If they don't do it right, REITs will not be providing a public utility and will suffer in the long run. Office REITs have to provide a variety of broadband access venues. Apartment and retail companies will be in that same position in the next year or two.

Derrington: I am very excited about the fact that real estate companies will start to employ technology to achieve efficiency and accountability. Real estate has traditionally been an activity that has made money based on inadequate and insufficient information. Now we are going to put in systems that provide full information. It can cost an apartment company $100 to make a $200 acquisition by the time it does the approval processes necessary to fulfill a procurement order. If technology reduces that cost to $40, then it is achieving a lot for a real estate company. For example a maintenance person in an apartment building is more accountable if the complex has an instant relay of a tenant order to the property manager and the maintenance person at the exact same time. The property manager is able to know when the maintenance person received and fulfilled the request.

Zell: As we look forward, what do you all think is relevant to the future of our industry, in particular the next three to five years?

Whyte: Let's not forget what put a lot of these companies on the map was the tax advantages of the UPREIT. Whether it's two, five or ten years, the tax issues are going to be less of a problem. I think that will facilitate more consolidation. The other relevant fact will be the impact of Regulation FD (full disclosure).

Litt: I am looking forward to the broader stock market returning to more average returns, and I think it will be very good and productive for the REIT industry in terms of attracting new investors. I think probably the biggest event that I see happening is a separation of companies within property categories as defined by the service level they provide to their tenants. We will have a spectrum of office and retail types where you can get the no frills or deluxe version—it will create differences in rent and valuations that will be very dramatic. The final thing is an increased number of giant companies on the next five years.

Hemel: Supply will still be the most important factor, followed by the economy and the impact of technology, such as its impact on e-commerce, or the amount of office space we will need per worker.

Derrington: If interest rates rise, it will cause REIT prices to soften to push up yields. Second, I think we're got to look at the general election and the broader economic trends put in place by the next White House and Congress.

Kirby: I hope we see the continued evolution of managerial skill. We started a few years back with a bunch of people who had never run public companies, but I think the industry started to show that it knew how to react by developing new strategic models. That said, during the worst 18 months of the bear market, when REITs were generally trading at discounts of greater that 10 percent, the 40 biggest REITs invested $28 billion in new properties, about evenly split between development and acquisitions, and they bought back $2 billion worth of their stock. I think the bear market was an opportunity to create NAV, to create shareholder value. Some companies jumped on it, and we view that very favorably. My point is that we've got to see REIT models evolve. But I also think the obsession with growth needs to still calm down quite a bit. There are a million arguments as to why consolidation should happen and there is probably one really powerful one why it may not: just as in corporate America, where no matter how many mergers and acquisitions we study, the acquiring companies generally underperform the stock market. Investors don't have an awful lot of patience for that type of strategy, and the same has been true of REITs. Our last study showed that the acquirers underperformed the overall REIT Indexes by three percent after they announces their merger.

Buller: We want the "anti-tech" investment label that we have had this year. Another thing is that we should attract more long-term investors. Diversified fund managers would rather play in a different sandbox than the REIT world. Sure, they'll play in our sandbox, but they would rather go to bio-tech or telecom or something hot, sexy and exciting. I don't know how we attack this, but we need to continue to generate good earnings, growth and total return.

Zell: I'd like to pose the question that Steve Roth of Vornado Realty Trust recently raised. Are we moving into a period of a shortage of real estate?

Hemel: There is a shortage in Manhattan, the Bay Area, and parts of Washington D.C., Boston and Los Angeles, but office development did go up 11 percent between December and June. So supply will catch up with demand in most places. I don't think what we are seeing in Manhattan and San Francisco is a precursor for what will happen elsewhere.

Derrington: I think a shortage is great because all who have already invested should enjoy the value that has been built, and not be distressed that overbuilding will cause that value to deteriorate.

Zell: Finally, how big will the REIT industry be in '05 and '10? What will be the average inflation and interest rate over the next five years? If the Morgan Stanley REIT Index (RMS) or the NAREIT Index is at "X" today, what is it going to be at '05?

Hemel: I think REITs are undervalued. I predict that if the RMS is 350 now, it will double to 700 in 2005. Inflation I expect to be at 3 percent, average 10-year Treasuries, so my prediction is by 2005 it will be 250 basis points. I am going to predict the REIT industry to be worth a trillion dollars in 2010.

Litt: I agree, but I think rates might be down 50 basis points.

Buller: The REIT industry in '05 will be worth $500 billion and in '10 will be $1.5 trillion—not from equity issuance, but rather from private to public conversion using the currency. Inflation will be 3.5 percent over the next five years; 10-year Treasuries over the next five years will be 6.5 percent on average. The RMS is going to return to 12.5 percent on average over the next five years.

Whyte: I estimate the industry at about 400 billion by 2005, but I think there will be more work to be done inside before we expand out. Inflation is a concern—I am surprised that we haven't seen more of it in terms of labor or occupancy. I think it will be 4 to 4.5 percent over the next five years. In terms of the RMS, I think we are going into a period of lower total returns for investments. I think we would be pretty lucky to do 10 to 12 percent out of the RMS in each of the next five years. So my guess is probably for about 600.

Derrington: Six hundred for the RMS. I think we are heading into a rockier period because of the broader economy, not because of real estate. I think real estate will suffer less than it did in prior cycles. I think we could see a recession the end of 2001 and into 2002. Greenspan will probably step on the brakes. I think we'll see 10-year rates fall a little, but inflation kick up.

Kirby: Probably 2.5 percent for inflation, and interest rates right around where they are now, high fives for the 10-year. I think the more interesting question is where the RMS will be, and that is where I think there has always been an overshooting in terms of what this industry has advertised and what it has delivered. I think we will do well to turn on 10 percent, and I think that may beat the S&P.