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Some of the industry's leading REIT leaders gathered recently atthe Ritz-Carlton in Orlando for the 2014 edition of the EYREIT CFO and Tax Directors' Roundtable. With recovery infull bloom, it's still a question as to what will happen withinterest rates in the foreseeable future. A panel of experts talkedabout the REIT outlook in the face of a recovery that still holdsmany questions. The panel consisted of: JamesCollins, managing director, MorganStanley; James Sullivan, managingdirector, Green Street Advisors; and AdamMarkman, in his new position as EVP and CFO,Equity Commonwealth. The session was moderated byMichael Straneva, partner, Ernst &Young LLP.

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MICHAEL STRANEVA: While economists tell me theworld's recovery is still uneven, the REIT regime is spreadingaround the world. The search for yield explains the popularity ofthe REIT sector. Jim Sullivan, what are youseeing?

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JAMES SULLIVAN: REITs have outperformed theS&P so far this year. That has a lot to do with what interestrates have done relative to people's perspectives. A year ago,there was almost a consensus view that interest rates had to gohigher in 2014, and that hasn't happened. Interest rates and caprates are very much correlated. So, we have this dynamic whereoperating fundamentals range from good in some property types tofantastic in others, capital is abundant and cheap and real estatevalues continue to rise. We're in a position today where prices foralmost all property types are above the peak in 2007. The averageis about 10% over peak pricing in 2007.

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STRANEVA: What's happening to REITs compared to theS&P 500 fixed and income prices?

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SULLIVAN: We're often asked whether REITs arecheap, and that's a tough question unless you have some context,and the context we use is relative to the S&P 500 and thefixed-income market. The total return that you get from real estateis higher and the spread is wider than it has ever been. That meansone of two things: real estate is cheap or the fixed income marketis overpriced. Time will show us which of those is correct, butthere's a real mismatch now between real estate and the bond marketin terms of overall valuation.

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JAMES COLLINS: I'll just add that it's hard togeneralize real estate as one buying type, because you havelong-leased assets, such as triple-net healthcare, that seem toreact very strongly to predictions in the bond market and interestrates. Then you have shorter lease types, apartments or hotels,that are less sensitive.

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STRANEVA: Let's discuss the abundant sources ofcapital that are available today.

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COLLINS: For the past several years, there'sbeen a very strong bid for yield product as investors gravitatetoward equity and still face allocations. I don't see that abatinganytime soon.

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ADAM MARKMAN: Given my role as the CFO of anewly reorganized office REIT, all of a sudden I'm the prettiestgirl at the dance. That's a testament to the abundance of capital.Meeting with bankers both on the equity side and the debt sidecould be all I do all day. There's an inordinate amount ofopportunity and capital.

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SULLIVAN: It's important to realize that we'restill well below the 2007 peak in terms of transaction volume. Andactivity is disproportionately weighed to the gateway markets, thebig markets. A lot of this capital we're talking about is verypicky, and it wants to go only to certain places. For us, wheneverybody is over here crowding this auction tent, we get reallyinterested in that tent over there. So, when you think aboutrelative pricing between, say, gateway markets and secondarymarkets, do the cap rates reflect that?

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STRANEVA: What's occurring with REIT NAV premiumsand discounts?

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SULLIVAN: We've had a bit of a downdraft overthe past few weeks in REITs and the average discount to NAV is nownegative 4%, negative 5%. The public market has been a terrificpredictor of subsequent moves in CRE values. There's a strongcorrelation between premiums to NAV and future appreciation.There's also a strong correlation to when REITs trade at discountsto NAV with subsequent decreases in values. The public market seemsto do a really good job of predicting the future when it comes tovalues, so the signals you get from them, you ignore at your ownperil. In the major property types, we're at NAV or below, and it'sthese niche property types where we're seeing big premiums—hotels,self-storage, net lease and healthcare—and when companies trade atbig premiums, they have a real opportunity to raise capital and buythings. It also gives opportunities to companies in those sectorsthat want to be public to effectuate an IPO in a way that'sbeneficial for the sponsors. So, premiums and discounts to NAV cantell you a lot about future prices. They can tell you a lot aboutoptionality with respect to raising capital.

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MARKMAN: There's a new perspective I'm startingto gain now that I've switched from advising the industry to my newrole managing and operating from within a REIT. Remember, these arelevered NAV premiums. The real estate underlying these companiesisn't trading at these discounts. To make the math easy, if theREIT is 50% leveraged, the asset value premium or discount is halfof what you're seeing at the share level. So the arbitrageopportunity isn't as great as it appears based on NAV discounts,especially after you layer on the costs of going public, or fromthe other side of this spectrum, what we're more interested in isthe cost of M&A. If you're interested in looking at a companythat's trading at a discount, that discount can go away quicklywhen these market factors come into play.

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I agree with Jim that you must pay attention to NAV premiums anddiscounts, and that's the barometer we think about most in terms ofwhether our foot should be on the accelerator or thebrake.

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STRANEVA: We were discussing that REIT performanceis outpacing the S&P. What are the implications forM&As?

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COLLINS: If you look back over any reasonableperiod of time, REITs have outperformed the S&P. That'spartially attributed to strong corporate governance. On thestrategic front, there's a heightened level of dialogue. It'sincredibly difficult to buy assets in the open market, particularlyin gateway cities. You have the C-suite and directors thinkingabout different ways to grow shareholder value. It's probablystandard practice for each of these blue-chip REITs to be lookingat their comp group every day and see who is mispriced. When youapply the filter of reasonable control premium to find deals thatare actionable, that funnel gets very narrow very quickly.Nevertheless, we expect to see a pickup in M&A activity at theend of this year or next year.

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STRANEVA: What about IPOs and the efficiencies andeffectiveness found there?

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COLLINS: One benchmark we look at to determinethe cost of an IPO discount or the ease with which a company can gopublic is the volatility index, the VIX, and there's a generalcorrelation between volatility and the expense of the requisite IPOdiscounts. Presently, we're in a lower volatility environment,which we've enjoyed for the past couple of years, and it bodes wellfor REIT IPO entrants.

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SULLIVAN: People who shouldn't go public arethe folks who view it as a sale of their company to the publicmarket. That's a narrow way of thinking about an IPO. What itreally does is create an opportunity to partner with the publiccapital markets and to avail themselves of a broader menu ofcapital alternatives that they don't have as a private compa Peoplewho are hypersensitive to where the REIT index is or where premiumsare to NAV probably are not the right candidates to go public.Also, keep in mind that it's easy to focus on IPOs and privatecompanies going public, but we're seeing non-traded REITs listtheir shares. We're also seeing spinoffs from existing publiccompanies, some of which are existing REITs. We're seeing REITconversions bringing new companies public.

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STRANEVA: Is there a trend toward externally managedpublic REITs? Will we be seeing more externally managed REITsoutside of the mortgage REIT space?

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MARKMAN: We just fixed one of these problems,and so, I can tell you there are real inefficiencies. Coming upwith a structure that works for an externally managed REIT is goingto be a challenge for the bankers out there, because the alignmentof interests just doesn't work as well as internal management. It'sthe subtle things, which assets are owned and which are sold,reactiveness on the leasing front, small decisions that amount to areal difference.

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SULLIVAN: I'm more optimistic that we'll see anequity REIT that's externally advised and accepted by themarketplace, because, if you look at the mortgage REIT market, theexternally advised structure is the norm, not the exception. Theprivate equity model is in essence the definition of an externallyadvised structure. So it works in private equity. It works in themortgage industry. It doesn't work in equity REITs, at least notyet.

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STRANEVA: What are you seeing in terms of the supplypipeline of new development?

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SULLIVAN: One of the supports of strongoperating fundamentals is what's happening on the supply side.Those of us with gray hair know that it's excess supply that killsthe market, not the absence of demand. Supply is well belowhistoric norms and that's the forecast for many years to come.Also, information is much more detailed, accessible and transparenttoday, which helps construction lenders, in particular, make betterchoices than in the past.

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At the same time, real estate guys like to build and if theyhave capital, they'll build. It's fascinating to look at theramp-up since 2010 and the 2014 estimate for REIT developmentpipelines, which is $37 billion, larger than the peak in '07.Granted, the REIT industry is bigger so, as a percentage, 2014 issmaller, but you get the point. REITs have actually been theleaders in development, and because they had access to capital,they were able to develop when their competitors, the private guys,couldn't get construction loans. So, I'm optimistic that this roundof development is actually going to turn out pretty well for theREITs that are active.

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COLLINS: Our clients, by and large, aremeasured in the amount of development they do, making only smartbets and only to a limited extent. The public investor universe forlarge-cap REITs doesn't want to see more than, call it 10% of yourassets in construction, and our executives have heard thatmessage.

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MARKMAN: On one hand, development overall isnear historic lows; on the other, REIT development is at anall-time high. So, it tells you who is doing the building, right?It's disproportionately REITs and disproportionately in primarymarkets where the REITs are strongest. And it's being done by guysthat probably have a better handle on things than some of thesmaller players.

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STRANEVA: Now, it's time for everybody to get theircrystal balls out. Where generally is the REIT Index going to be 12months from now?

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SULLIVAN: Tell me where interest rates aregoing to be 12 months from now, and I'll tell you whether the REITIndex is going to be up or not. The consensus view right now isthat interest rates are going up. Don't forget, that was theconsensus 12 months ago as well. But, more importantly, tell me whythey're up. If rates go up because there's an acceleration ineconomic growth, that's good for real estate. But if rates go upbecause QE unwinds and there's no economic growth, that's a reallybad scenario for any capital-intensive industry, real estateincluded.

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COLLINS: Several of my clients are expecting an8%, 9% or 10% total return over the next 12 months from theirbusiness plans. So, when you back off of a 3%, 4% or 5% dividend,it points toward an expectation that we're going to be up modestlyin the RMZ, and it's not an unreasonable expectation. In the veryshort term, we're in a rate-sensitive sector. So it's something weneed to watch carefully.

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MARKMAN: The other panelists have said itreally well. Tell me where interest rates are going to be and I'dhave a good guess at where real estate value will land. Without atreasury or bond-market shock, IRRs in the high-single digits arewhat people would expect to achieve. Jim's right. We've beenfeeling that interest rates have to go up for a long time now. Iwish we had longer duration on the debt we have on our balancesheet, because I don't know when interest rates are going up, butit's hard to imagine them going down. We're just bouncing along thebottom. Without a move in rates, a modestly levered 8% seemsreasonable. With a change in the debt markets, all bets areoff.

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John Salustri

John Salustri has covered the commercial real estate industry for nearly 25 years. He was the founding editor of GlobeSt.com, and is a four-time recipient of the Excellence in Journalism award from the National Association of Real Estate Editors.