Sakwa pointed out that the REIT sector has been regaining life and is actually up 17% this year, but said the level of growth will begin to decrease next year. Reasons for this, he noted are what he sees as increasing development risk over the next year to 18 months "as the economy continues to slow." He also said that real estate values in the suburbs, which have benefited greatly from the overspill in major markets, "appear to have plateaued and in many cases are declining modestly."

Cities such as New York, San Francisco, Boston and Washington, DC remain strong, according to Sakwa, in terms of their real estate value. Areas such as Texas, however, are overdeveloped and facing decreasing values he said. Areas that are difficult to enter with tough permit processes still are okay for development he noted. He predicted, "There will probably be more earnings disappointments. With that said, we would not avoid all development companies, but rather want to be selective." He said the focus will be on well-established companies and areas such as California and the Northeast.

"In September, we forecasted that the REIT sector would post FFO per share growth of 8.9% in 2000 and 9.2% in 2001. This compared to 11.7% in 1999. Based on third quarter results, we now expect the REIT sector to post FFO per share growth of 8.8% in 2000, but our 2001 growth rate dropped by 60 basis points to 8.6%," he noted. "In addition to decelerating earnings growth, we were also troubled by the high number of downward estimate revisions made for 2001 (20). This is not a trend one would expect to see if real estate fundamentals were extremely robust."

"Earnings quality is deteriorating slightly. This is best illustrated by the increase in fee income many companies are generating from their merchant development business (i.e., PLD, FR)," he adds. "Based on our analysis, we believe that cap rates (which is the key driver to determine net asset values) have increased 10 to 50 basis points depending on the product type, the quality and the location of the assets."

Sakwa concluded by listing his picks for the stocks to focus on for 2001. In the apartment sector, on which he was notably sour, he selects Archstone, AvalonBay and Equity Residential. On the office side, a safe bet according to Sakwa in most markets, he picks Boston Properties, Equity Office, Spieker Properties, Brookfield Properties and Reckson Associates. On the retail side, which he was very sour on, he picks Kimco Realty and Simon Property.

Instant Insights /

Merrill Lynch: REIT Sector Earnings Growth Will Decelerate in 2001

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