By Christopher M. Wright

NAME: Mike Kirby TITLE: Principal and Director of Research, Green Street Advisors, Inc. in Newport Beach, Calif. (www.greenstreet advisors.com) BORN: 1960 EXPERIENCE: Kirby co-founded Green Street in 1985 where the dress may be casual but the research is anything but. Barron's calls Green Street the pre-eminent source of incisive and independent analysis for the real estate sector. The firm, which is not engaged in underwriting, regularly issues "sell" recommendations on a fourth of the stocks it covers, more than twice the industry average. Kirby has a B.S. in finance from Arizona State University and an M.B.A. from the University of Chicago. In 2003, NAREIT presented Kirby and Green Street's co-founder Jon Fosheim with an Industry Achievement Award recognizing their participation in NAREIT activities, including the Investor Advisory Council to the Board of Governors and the FFO Task Force, among many others. Green Street has also won awards from the Wall Street Journal (named to the "Best of the Street" list five times), Realty Stock Review (multiple awards), Institutional Investor (best research boutiques list in 2002, 2003 and 2004). Green Street's consulting group provides analysis to companies not in its coverage universe in connection with REIT M&A, share buybacks, joint ventures, equity swaps, litigation and other REIT valuation questions.

Mike Kirby, co-founder of the independent research firm Green Street Advisors and co-winner of NAREIT's Industry Achievement Award in 2003, has watched the REIT industry grow from a market cap of less than $10 billion 20 years ago to its current level of nearly $350 billion. Portfolio spoke with Kirby to get his views on interest rates, mergers, international expansion and other hot button topics facing the REIT industry.

Portfolio: You called REIT shares "pricey" way back in April 2004 and have since pointed out that REIT earnings multiples are high relative to the average P/E on the S&P 500. "Historically, when this has been true, REITs have subsequently underperformed," you have written. Will REIT stocks underperform in 2006? Why or why not?
Kirby: The big valuation question of the last couple of years has been whether the current low interest rate environment is reflective of a secular change or whether we're merely seeing a delay in the type of interest rate increases we would normally expect to see in a recovering economy. So far, the secular forces have prevailed, which is why we see Alan Greenspan scratching his head and pondering conundrums.

There may be something to the school of thought that REITs have been re-priced upward as the world has come to appreciate their merits, but it's not wise to get carried away with this line of reasoning. The primary reason REITs have done so well is that real interest rates have plummeted. As long as they stay low, REITs will be OK, but watch out if real rates shoot up.

Portfolio: Why do you view interest rates as the key driver of REIT share prices?
Kirby: Interest rates have clearly been driving the bus, and anything with a high yield has had a very fun ride. The direction of rates will continue to have a huge impact on REIT valuations, but a critical question is the source of the upward pressure on interest rates. If rates go higher merely because inflation has increased, REITs may be OK. While the market will likely ascribe lower multiples to earnings, this may be offset if earnings rise due to inflation. If, however, rates go higher because today's ultra-low real interest rates shoot upward, REIT prices have nowhere to go but down.

Portfolio: Martin Cohen of Cohen & Steers told us last year that REIT shares are uncorrelated with interest rates in the long run. You have written that "the performance of REITs vs. the S&P has been heavily influenced by interest rate swings since at least the beginning of 2004. REITs have underperformed the S&P every time interest rates have moved up more than 40 basis points in the last 16 months ..., and they've outperformed when interest rates have dropped." You say this is a change from the previous 20 years of data showing no correlation. Why are REIT shares now correlating with changes in interest rates in your view?
Kirby: It used to be the case that real estate marched to its own drummer. When interest rates were 11 percent, cap rates were 9 percent. When interest rates dropped to 7 percent, cap rates were 9 percent. The link between real estate pricing and the capital markets used to be virtually non-existent.

This is no longer the case. Those of us who've been making the case for REITs over the course of the last couple of decades have finally gotten our wish: REITs are now a mainstream investment vehicle. Like a lot of wishes that come true, however, this one comes with some strings. Higher correlation with interest rates and higher volatility of share prices are two of those.

Portfolio: Speaking of correlations, REITs have been lowly correlated with the market historically and negatively correlated since REIT shares went up after 2000 when the overall market went down. But correlations shift all the time. What do you expect for REIT correlations going forward and what's behind any change you see coming?
Kirby: While REIT prices are likely to be more closely linked to interest rates than they have been historically, they will still offer material diversification benefits versus other investment options. In many ways, the historical record of REITs—which has been one where returns have been terrific and prices have zigged when everything else zagged—is just too good to be true. The story doesn't need to be that good going forward to make the case that REITs should be part of most portfolios.

Portfolio: You have criticized REIT mergers for failing to create value in most instances. You argue that the capitalized value of identified synergies is normally less than the upfront costs of the merger (i.e., the premium paid to the target's shareholders and transaction costs). REIT executives fail to do the math and the acquirer's share price usually takes a hit as a result, in your view. What is your advice to the industry? When do mergers make sense and have there been any good ones in your estimation?
Kirby: The experience of the REIT industry with regard to M&A isn't much different than that of corporate America, where many mergers are motivated by the egos and personal agenda of managers. Clearly, some mergers in REITland have worked, although most have merely resulted in a bigger company that has, more often than not, underperformed its peer group.

The deals that have the best chance of working likely involve REITs that have earned large net asset value (NAV) premiums acquiring REITs which, due to poor performance or weak management, are trading at low NAV premiums. Putting assets in the hands of better managers can add synergies that are hard to quantify. A caveat: even this advice is dangerous, because all REIT execs think I'm referring to them when I use the term "better managers."

Portfolio: You have called the growth of REIT joint ventures "explosive" and have argued that the sustained and growing income from such ventures is a "turbocharger" for shareholder value. What types of joint ventures have caught your attention and what do they mean for the earnings multiples investors assign to REIT shares?
Kirby: The best JVs today typically involve well-respected REITs partnering with a foreign capital source or a U.S. pension fund that is willing to allow the REIT to earn asset management fees and promoted interests [incentive payments that kick in above defined performance thresholds]. Despite the high fees, these deals can be viewed as a win-win, because the foreign capital source is often earning yields that are still higher than what is available in their own markets. At the same time, the REIT greatly increases its return on equity.

These ventures probably don't warrant a higher multiple than the REIT would warrant if it just owned the properties, but they often enhance valuation due to the positive impact on earnings. We view today's JVs as a financing option that has the ability to add considerable value.

Portfolio: You've predicted that some of the REITs undertaking international expansion will stumble and some will succeed. What mistakes do you see being made and what differentiates the winners from the losers?
Kirby: With only a few exceptions, it's hard to say anyone has won or lost yet, because the passage of time will be necessary before we can ascribe grades. One clear winner so far is ProLogis (NYSE: PLD), which probably shouldn't be too surprising because this management team has long been one of the most thoughtful players in the U.S. markets.

I suspect that other players that have long enjoyed success in the U.S., such as Kimco Realty Corporation (NYSE: KIM) and Simon Property Group (NYSE: SPG), will also turn in decent results, because the companies are run with a thoughtful approach toward capital allocation. Still, this arena will present big challenges for investors to understand. For example, some bright mall owners have already committed resources to China, while others who we view as equally bright have said it's way too early to invest in the country's still-developing system of private ownership. Time will tell which view is right.

Portfolio: Are there any real estate sectors or regions that you would get into or avoid in 2006?
Kirby: The market has become very efficient at incorporating expectations into share prices when it comes to big picture calls like picking property sectors or geographic markets. Some sectors are clearly going to achieve better growth than others in 2006, but, if everyone knows that, you can't make any money from it. Similarly, it doesn't take a rocket scientist to realize that the near-term prospects for properties in Southern California and New York look better than prospects in Chicago and Atlanta.

Portfolio: Your firm made some strong recommendations about the hotel sector earlier this year.
Kirby: Our growth expectations for hotel cash flows are much higher than is the case in other property sectors, yet the market appears to be skeptical. This is a rare instance where we believe the market is missing a pretty big macro-level point, and we therefore placed an overweight recommendation on hotel companies in mid-2005.

Portfolio: What else has been on your mind lately?
Kirby: We would like to see higher volumes of share buybacks during periods when share values pull back. REIT managers who gripe that the market is valuing their stock at a big discount to NAV seldom back up their words with action.

Disclosure: Green Street covers a number of companies that pay an annual fee to receive Green Street's core research product. Green Street does not solicit this business and, in aggregate, it represents less than 2 percent of Green Street's revenue. This interview took place in early August.