Portfolio: Now that we are well into 2002, how are the real estate capital markets handling the challenging U.S. economy and what is the lingering impact of September 11?

Niehaus: The real estate capital markets have performed like a prince through this recent, difficult economic period. REIT returns have been very strong during the past year or so, increasing 23 percent since year-end 2000. They have also risen since the market bottomed on Sept. 21, 2001, one week after trading resumed. During these same periods, the S&P 500 declined 14 percent (since year-end 2000) and 17 percent (since September 21).

While September 11 obviously had a big impact, the broader question has been the U.S. economy. The last time the U.S. economy went into recession (in 1991—1992), real estate was perceived to be a leading cause. This time, real estate is the darling of the investment world. Real estate has performed substantially better than almost any other asset class—REIT stock prices are up significantly, mortgage delinquencies remain at all—time lows, property level returns remain positive and in many parts of the country cap rates have actually come down (prices have increased). The last time the economy went into recession we had huge amounts of vacant space, substantial new construction, surging mortgage delinquency/foreclosure rates and sharp capital depreciation, which ultimately lead to a major restructuring of the industry. It is 180 degrees different this time around—real estate is outperforming and should continue to do so in the near term.

Portfolio: What role has real estate taken among investors in the current market and has that role changed in the past year?

Niehaus: According to a Morgan Stanley survey, (real estate) allocations at five of the pension funds with the greatest real estate exposure have increased in the past six months to one year. Perhaps more interestingly, an increasing number of smaller funds with no prior real estate exposure are starting to add some real estate to their portfolio for the first time.

Real estate has been a big winner for many institutions during the past two years and its strong performance has prompted an increased awareness amongst many other pension funds as to the benefits of having a sizable investment allocation in the sector. Investors continue to believe real estate will outperform other asset classes, as well as the overall stock market, on both a relative and absolute basis. We are clearly seeing more dollars flow into the market. On the private, direct investment side, we see all signs pointing toward a tremendous amount of capital coming in from domestic institutions, individuals and foreign investors. Real estate is in the sweet spot right now regarding access to capital, with attractively priced public and private capital eager to invest in the sector.

Portfolio: Have you witnessed a change in the typical real estate investor? How so, and how will this play out for the remainder of the year?

Niehaus: I would say the difficult economy has caused more capital to flow into real estate, both from individual and institutional investors. The common perception among investors is that even though property fundamentals have weakened during the past year, and they clearly have, the industry is in much better shape than it was during the last recession and versus other asset classes today.

Several pension funds with large real estate portfolios have actually increased their investment allocations in real estate during the past few months-often at the expense of their stock portfolio allocations. Their rationale is simple: in an investment environment in which stocks will likely provide investors with only a 5 percent to 7 percent total return versus the double digit returns of the 1990s, real estate is a more attractive investment given its stable cash flows and high current yield. With high-quality properties trading at cap rates in the 8 percent to 10 percent range and REIT stocks providing a 6 percent to 7 percent dividend yield, real estate is seen as both a low risk investment and as providing one of the highest expected total returns over the next three to five years. I expect both public and private capital inflows into real estate to remain positive throughout 2002 as investors continue to prize stability and yield.

Portfolio: As the economy improves, will the sector's popularity among investors continue?

Niehaus: I think part of this trend is cyclical. It is a short-term reaction to what is going on in other asset classes—the huge stock market losses incurred during the tech/telecom bust and the uncertainty created by the Enron scandal and other large bankruptcies. I also believe that as long as real estate fundamentals and property values stay intact, part of this move by investors into the sector is secular and therefore sustainable. If the sector continues to provide stability during market volatility and consistent, high single-digit cash returns and low-teen total returns over the next three to five years, then it should be the net beneficiary of permanently higher capital inflows over the longer term.

Portfolio: What property markets have proved to be the strongest performers so far in 2002?

Niehaus: If you look at total return or stock price appreciation within the public sector, the hotel REITs have been the best performing sector, up approximately 26 percent through April. Obviously, a good deal of that performance is recovery from their sharp declines post–September 11. Hotels are still struggling from an operations perspective but the lodging industry is clearly in a recovery period and investors have signaled their belief that these companies will outperform as the economy gains strength and business travel accelerates.

The next market would be the retail sector with regional mall REITs up about 12 percent through April, based on surprisingly strong consumer spending and stable occupancy levels, followed by industrial REITs which have posted an average 10 percent return. The two under-performing sectors would be apartments and office buildings, both up only about 6 percent through April. What the market is saying regarding these sectors is that concerns about weaker operating performance have not been fully reflected in valuations.

Portfolio: What can you tell us about the state of various geographic regions?

Niehaus: Generally speaking, the markets that had the most technology/telecom exposure (northern California and suburban Boston, for example) suffered the most negative impact from rising vacancy rates as companies in these industries either downsized or ceased operation. Areas with less exposure to the boom/bust industries have not been as badly affected. I think these tech-driven markets will take longer to recover because they have more structural vacancy, unless of course there is substantial pickup in corporate tech/telecom capital spending, which is not being projected right now.

Markets with significant government or defense exposure (Washington D.C., Northern Virginia and San Diego) have generally performed better based on the stability of federal government space needs and rising defense spending following September 11. New York City has also performed relatively well following September 11. Even though vacancy rates have risen and rents are off slightly, a flood of domestic and foreign capital has driven office building prices in midtown Manhattan to record levels in recent months.

Portfolio: What are your feelings on REITs' use of private equity to raise capital? How is it impacting the industry and is the use of private equity by REITs happening more or less now?

Niehaus: I think one of the benefits that public companies have always had is that they can access public or private capital. The real estate market is currently trading at a slight premium to NAV. As a result, we are seeing more equity issuance in the public capital markets and less of an interest in accessing private equity. Right now REITs are in a win-win situation-they have the ability to access capital from both markets at favorable pricing. It really depends on the company and on their specific need for capital as to where they should go to raise it.

Raising capital from the public market is generally simpler, faster and cleaner (meaning there are fewer structuring issues). If your stock is trading at or above NAV and you have a good, identified use of proceeds it is a very efficient way of raising capital. Private equity takes longer to raise and adds more complexity to a company's capital structure but can often end up being less dilutive and cheaper capital than is available in the public market. As pension funds have gotten, and continue to get, more comfortable investing alongside public companies, private equity transactions between the two should become easier to structure and more efficient to execute. At Morgan Stanley, we recommend to our clients that they keep all of their options open and make financing decisions based on their specific use of proceeds and timing requirements.

Portfolio: What factors will have the greatest impact on real estate stocks in the next 12 months?

Niehaus: I can think of three major issues off the top of my head. One is the economy. What happens to the economy will still be the most important factor in determining REIT performance going forward. To the extent we have already emerged from the recession and the unemployment rate begins to drop and interest rates stay low, then we are off to the races. If we experience the dreaded "double dip," then I think operating performance will decline and REIT prices will be negatively impacted.

Number two is interest rates. Real estate has been a major beneficiary of Mr. Greenspan's willingness to keep interest rates low. Eleven consecutive rate cuts by the Federal Reserve significantly reduced borrowing costs for REITs and private owners able to refinance existing, higher—coupon debt, thus helping to offset weaker operating performance during 2001. However, a major upward move in interest rates would have a negative impact on the industry causing earnings and FFO growth to slow and real estate's relative attractiveness versus other investment options to potentially diminish.

Lastly, I am watching capital flows and supply/demand dynamics. The real estate industry has attracted positive capital flows from individuals and institutions due to its attractive relative valuation versus other investment options. A somewhat constrained supply of quality assets and limited REIT stock issuance has resulted in REIT prices rising. If those flows reversed and investors began pulling money out of real estate, either because other investment options became more attractive or REIT stock issuance exploded, then real estate valuations may stall.