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Investment Strategy Weekly REITs Should be Considered as a Core Portfolio Holding

We have studied the implications of holding Real Estate Investment Trusts (REITs) in an investment portfolio after analyzing their risk and return characteristics over the past three decades. The short-and-sweet of it is that REIT ownership has the potential to significantly enhance portfolio returns. ! North American REITs have outperformed on a long-term basis.

They are primarily income-generating vehicles, with a relatively long history of producing superior total returns versus stock and bond indices on an absolute, as well as on a risk-adjusted, basis. For example, average annual returns for REITS have exceeded those for equities by 140 basis points and for bonds by 500 basis points since the early 1970s, and with lower volatility.

! REITs might be the beneficiaries of secular tailwinds. REIT

performance seems to shine brightest in an environment characterized by a general lack of capital gains opportunities (e.g., 1970s). If we are in for a number of years of sub-par equity gains, at the same time that an aging population raises the demand profile for total returns, there could be a lot more good news in store for REITs.

! Trends in interest rates might represent an important hurdle for

REIT performance. REITs, like other income-generating assets, are negatively impacted by rising rates. That said, the impact is smaller than what conventional wisdom would lead you to believe. One reason for this could be because rising interest rates are typically accompanied by rising inflation, and the underlying asset value of REITs usually improves in an inflationary environment.

! Portfolio math argues for outsized exposure to REITs as a means

to augment risk-adjusted returns. Based on over 30 years of performance risk and return data, we find that upwards of 35% of a balanced portfolio should be invested in REITs, practical investment considerations - such as consultants’ wellbeing and the depth and breadth of the REIT market - notwithstanding. Granted, the exposure dictated by these statistics is unrealistic but it does raise an important talking point for professional money managers.

Myles Zyblock, CFA Chief Institutional Strategist & Director of Capital Markets Research (416) 842-7805 [email protected] Neil Downey, CA,CFA (416) 842-7835 [email protected] Tyler Hewlett Associate (416) 842-7491 [email protected] September 27, 2004

For Required Disclosures, please see page 8.

Investment Strategy Weekly RBC Capital Markets

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September 27, 2004

Investment Strategy Recommendations

Asset Mix Past Range Fall '03 New Year '04 Spring '04 Summer '04 Fall '04Stocks 40% - 70% 65% 65% 65% 65% 60%Bonds 10 - 55 25 25 25 25 25Cash 0 - 40 10 10 10 10 15

This sector carries many of the attributes that seem to be out of favor such as earnings volatility, excessive valuations, and high beta. We continue to favor software and services over the hardware names.

Information Technology Underweight

Health Care Market Weight

Financials Underweight

Comments

The benefits of a relatively strong investment spending cycle are under appreciated. The recent sell-off, especially among some capital goods names, provides investors with attractive buying opportunity.

Our underweight is tied to our interest rate call. We favor Insurance over Banks, and have become less positive on Diversified Financials in light of a more challenging financial markets backdrop.

We remain positive on media stocks, but are much more cautious on Retailers and Autos as a result of soft labor markets and rising borrowing costs.

The long-term story on oil is compelling, but crude has run up too far, too fast. The correction in crude probably has further to go, and we will wait until oil falls back into the $35-$38 range before re-loading on the sector.

The sector should benefit from a flow of funds seeking liquid names with above average dividend yields in a more defensive market environment. Sector concerns appear to be reflected in current valuations.

Despite moderation in global activity, commodity prices are holding up due to tight supply. We favor agricultural chemicals, steel, and base metals stocks for their leverage to China. Value has returned to many metals & mining stocks.

We favor quality pharma, and would avoid small-cap biotech names within the space.

Earnings stability, a history of profitability, and dividends are attractive sector traits. However, the prospect of rising interest rates limits our optimism.

Many companies dovetail nicely with our quest for high-quality stocks. However, lofty valuations hold us back from moving beyond a benchmark weight at this stage.

Equity Sectors Current Recommendation

Energy Market Weight

Materials Overweight

Overweight

OverweightTelecom Services

Market WeightUtilities

Industrials

Consumer Discretionary Overweight

Consumer Staples Market Weight


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September 27, 2004

The Impressive Long-term Record for REITs Real Estate Investment Trusts (REITs) are publicly traded companies that own and frequently operate portfolios of primarily income-producing real-estate assets. To qualify as a REIT in the US and Canada, a company must distribute at least 90% of its taxable income each year to shareholders. A company that qualifies as a REIT can deduct dividends paid to its shareholders from its corporate tax bill. As a result, many REITs pay nearly all of their taxable income to investors and are subject to minimal or no corporate tax.

REIT Total Returns Dominate Their Price-Only Returns

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D e c - 7 1 D e c - 7 4 D e c - 7 7 D e c - 8 0 D e c - 8 3 D e c - 8 6 D e c - 8 9 D e c - 9 2 D e c - 9 5 D e c - 9 8 D e c - 0 1 D e c - 0 4N A R E IT P r ic e I n d e x N A R E IT T o t a l R e t u r n In d e x

As a result of the REIT structure, this asset class has developed into an income generating machine. The chart above shows the performance of the NAREIT Equity REIT total return and price return index since the early 1970s. We lean on this particular US benchmark for our long-term analysis because it is the broadest index with the longest available time series. It is clear from the chart that the REITs’ return potential would be vastly under-represented by focusing solely on price performance. Total returns are key. The next chart shows how REIT performance has measured up against the performance of other major asset classes – namely stocks and bonds – since the early 1970s. We calculate that a $100 initial investment in the NAREIT Index at the beginning of 1972, with the proceeds reinvested monthly, would have generated a portfolio worth $5566 today. This compares to a terminal value of $3244 for a portfolio based on the S&P 500 and $1362 for a 10-year Treasury portfolio. The first table on the following page summarizes the risk and return properties of US REITs, stocks, and government bonds over the past thirty years. Notice that REIT prices have appreciated annually by about 5% on average versus 14% based on a total return calculation. Notice also that REITs have significantly outperformed the other major asset classes – stocks and government bonds – on a total return basis. Not only have REITs outperformed in absolute terms, but they have also done so on a risk-adjusted basis.

REIT total returns are

driven primarily by income, not

price!


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September 27, 2004

US REITs Have Outperformed Their Stock and Government Bond Counterparts

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D ec -7 1 D e c- 74 D e c-77 D e c-8 0 D ec -8 3 D ec -8 6 D e c- 89 D e c-9 2 D e c-9 5 D ec -9 8 D ec -0 1 D e c- 04N A R E IT T o ta l R et urn Ind e x S & P 50 0 T o t a l R e tu rn In d ex U S B o nd s T o t al R e tu rn In d ex

The US: Annual Return and Risk (%) by Asset Class since 1973 (Rolling Monthly)

Time Price Indices Total Return IndicesPeriod NAREIT S&P 500 NAREIT S&P 500 US 10-yr Bond

Total PeriodAvg 5.1 8.9 14.1 12.7 9.1STDEV 15.0 16.9 16.0 17.4 12.6Risk-Adjusted Return 0.3 0.5 0.9 0.7 0.7

The table below summarizes how Canadian REITs have fared over time, as well as against the stock market and long-term government bonds. The conclusions we draw from this analysis are much the same as those found for the US. That is, income is a big part of the REIT story, REITs have outperformed stocks and bonds over the long term, and they offer superior returns per unit of risk relative to the other two major asset classes.

Canada: Annual Return and Risk (%) by Asset Class since Dec. 1997 (Rolling Monthly) Time Price Indices Total Return Indices

Period CDN REITs TSX CDN REITs TSX CDN 10-yr BondTotal Period

Avg 5.1 5.84 16.0 7.57 7.08STDEV 10.8 22.6 11.7 22.9 5.39Risk-Adjusted Return 0.5 0.26 1.4 0.33 1.31

Before moving on, there are some important caveats that need mentioning. The Canadian index data is only seven years old, when in nearly half of this time we have been witness to abnormally strong followed by abnormally weak equity returns. Also note that this benchmark was created in October 2002, backdated by the index provider to Dec 1997, thereby limiting our ability to take a longer look back in time. As well, representation within the Canadian benchmark is not as broad as its US counterpart since the S&P/TSX REIT Index is limited to 11 constituents from a universe of 24 REITs – accounting for about two-thirds of the market capitalization for the entire sector. Bottom Line: North American REITs are primarily income-generating vehicles, with a relatively long history of generating superior total return performance versus stocks and bonds on an absolute, as well as on a risk-adjusted, basis.

REITs are a big total

return winner!

US REITs offer superior

returns per unit of risk!


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September 27, 2004

The Interest-sensitivity of REITs Rising interest rates are detrimental to REITs, as they would be to any other income-generating vehicle. The chart below highlights the relationship between bond yields and REIT total returns, stressing three important episodes of rising rates.

US REIT Total Returns Versus Bond Yields (Reciprocal)

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N A R E IT T o t a l R e t u r n In d e x U S 1 0 Y e a r B o n d Y ie l d s ( In v e r t e d ) ( R S )

8 M o n t h s

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1 7 M o n t h s

We find that REIT total returns typically fall in the initial stages of rising rates, but the impact appears to be relatively short-lived. This is probably because rising interest rates are often accompanied by rising inflation, and the underlying asset value of REITs usually improves in an inflationary environment. In fact, many studies – including our own – show that REITs tend to perform particularly well relative to other asset classes in a rising interest rate environment (e.g., see the next section for REIT performance in the 1970s).

There Are Times when Higher Interest Rates Hurt REIT Performance Start End Duration Start End Basis Point Start End PercentageSate Date (Months) Sate Date Change Sate Date Change

Feb-87 Oct-87 8 7.3 9.5 220 911 755 -17.1Oct-93 Dec-94 14 5.4 7.8 240 1653 1611 -2.5Sep-98 Feb-00 17 4.4 6.4 200 2566 2356 -8.2

Rising Bond Yield Period 10 Year Bond Yield (%) NAREIT Total Return Index

The bigger risk for REITs is when interest rates rise by enough to short-circuit the economic outlook and the tenants’ ability to pay rent. This risk can be mitigated with careful selection within the REIT universe – that is, to ensure REITs considered for portfolio inclusion have tenants of high quality, they have executed solid long-term leases, and there is no overexposure to any one tenant. However, these considerations fall outside the scope of this analysis. Bottom Line: REITs, like any other income-generating asset, are negatively impacted by rising rates. That said, the impact is smaller than conventional wisdom seems to believe because rising interest rates are typically accompanied by rising inflation, and the underlying asset value of REITs usually improves in an inflationary environment.


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September 27, 2004

Demographics and Poor Stock Returns Could Extend the REIT Bull Market We have partitioned REIT performance since the 1970s by decade, and have compared their returns against those of stocks and government bonds. On a total return basis, REITs have outperformed bonds in every segmented time period under study (see the following table). Notice that they narrowly underperformed stocks in the 1980s and lagged far behind the performance of stocks in the 1990s. These two decades housed one of the most impressive secular bull markets for stocks in history.

Annual Return and Risk (%) since 1973 (Rolling Monthly) Segmented by Decade Time Price Indices Total Return Indices

Period NAREIT S&P 500 NAREIT S&P 500 10-yr BondTotal Period

Avg 5.1 8.9 14.1 12.7 9.1STDEV 15.0 16.9 16.0 17.4 12.6Risk-Adjusted Return 0.3 0.5 0.9 0.7 0.7

1973-1979Avg 3.5 0.7 12.3 5.2 3.4STDEV 18.2 15.4 19.3 16.2 5.8Risk-Adjusted Return 0.2 0.0 0.6 0.3 0.6



2000-2004Avg 8.8 -2.5 17.0 -1.0 7.8STDEV 12.4 17.7 12.9 18.0 7.1Risk-Adjusted Return 0.7 -0.1 1.3 -0.1 1.1

What is clear from this table is that the performance advantage shifts towards REITs in an environment characterized by sub-par capital gains. In an effort to augment total returns, investors appear to reach for yield and REITs have typically fit well within this desire. This was true in the 1970s, when stock prices generally trended sideways, and looks like it could be shaping up in a similar fashion in the current decade. It is interesting to note how closely the stock market’s performance profile over the past few years has mimicked that seen in the 1970s (refer to the first chart on the next page). If the relationship in this chart persists, there could be another five years of relatively weak stock market gains which will ultimately sow the seeds for an extended period of outperformance by income generating vehicles like REITs. Another thing to keep in mind is that the North American population is aging, and will continue to mature until 2015 according to official US government estimates. Investors usually reach for income generating assets as they move past their peak-earnings years and into retirement. These demographic factors alone could provide an important tailwind for REIT performance, and could be magnified by an extended period of sub-par equity market returns. Bottom Line: REITs have outperformed other major asset classes on a trend basis since the early 1970s. However, their performance seems to shine brightest in an environment characterized by a general lack of capital gains opportunities (e.g., 1970s). Using history as a guide, we could be in the fifth inning of a tough nine inning game for the stock market. Importantly, an aging population could accentuate current needs and set the stage for an extended period of REIT outperformance.

REITs lagged on a risk-

adjusted basis for the first time in the decade of irrational

exuberance.


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September 27, 2004

A Tight Relationship between the 1970s Stock Market and Recent Trends

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1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121

S&P 500 1970 - 1980 (months) S&P 500 1998 - 2004 (months)

What Might an Optimal Allocation to REITs Look Like? We have derived an optimal allocation for REITs in a three asset-class world comprised of REITs, traditional equities, and government bonds. The parameters for this exercise have been anchored by the risk and return characteristics of each asset class over the last 30 years. It is important to note that we did not impose constraints on portfolio exposure to any one of the three asset classes under study, which is unrealistic but might provide an important base for discussion among professional money managers.

Unconstrained Portfolio Optimization Argues for 30% Equities, 35% Bonds and 35% REITS

8%

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15%

6% 8% 10% 12% 14% 16% 18% 20%Standard Deviation

Retu

rn

Optimal Portfolio Allocation: 30% S&P 500 35% 10-yr US Treasurys35% NAREIT Index

A More Typical Portfolio Allocation: 80% S&P 500 20% 10-yr US Treasurys

Our unconstrained quantitative work suggests that investors should carry a 30% weight in equities, 35% weight in bonds and 35% weight in REITs to maximize risk-adjusted returns. Again, while this scenario might not be feasible based on a number of practical considerations, it does emphasize the benefits that can potentially accrue from substantial REIT ownership in a balanced investment portfolio. Bottom Line: Portfolio math argues for a significant exposure to REITs as a means to help maximize risk-adjusted returns. Based on over 30 years of risk and return history, we find that up to 35% of a balanced portfolio should be invested in REITs, practical investment considerations - such as consultants’ interests and the depth and breadth of the REIT market - notwithstanding.


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September 27, 2004

Required Disclosures In the event that this is a compendium report (covers more than six subject companies), RBC Capital Markets may choose to provide specific disclosures for the subject companies by reference. To access current disclosures, clients should refer to http://rbc2.bluematrix.com/bluematrix/Disclosure?f=34 Ydf8xF or send a request to RBC Capital Markets Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, South Tower, Toronto, Ontario M5J 2W7.

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The author(s) of this report are employed by RBC Dominion Securities Inc., a securities broker-dealer with principal offices located in Toronto, Canada.

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