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COHEN & STEERS
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SPECIAL EQUITY FUND
QUARTERLY REPORT
SEPTEMBER 30, 1998
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COHEN & STEERS
SPECIAL EQUITY FUND First Class Mail
757 THIRD AVENUE U.S Postage
NEW YORK, NY 10017 PAID
Boston, MA
Permit No. 56712
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
October 15, 1998
To Our Shareholders:
We are pleased to submit to you the report for Cohen & Steers Special
Equity Fund, Inc. for the quarter and nine months ended September 30, 1998. The
net asset value per share at that date was $21.78. Regular dividends are
reviewed semi-annually; therefore, no dividend was declared for the quarter. The
Board of Directors will review the next regular dividend in December.
INVESTMENT REVIEW
The third quarter was a very difficult investment environment for all
equity investors, and was a particularly difficult period for real estate
security investors. The Fund's total return was -24.7% in the quarter. By
comparison, the NAREIT Equity REIT Index total return was -10.5%, The Standard
& Poor's 500 Index total return was -10.0%, and the Russell 2000 Index total
return was -20.3%. The Fund's year-to-date return was -31.8% compared to the
NAREIT Equity REIT Index total return of -15.0% and the Russell 2000 Index
total return of -16.2%
Never before has the state of real estate finance deteriorated as quickly
and dramatically as in the latest three-month period. Whereas at mid-year the
equity market was beginning to close to REITs in need of capital, the decline in
REIT share prices in the third quarter completely shut off access to equity
capital for all publicly-traded real estate companies. Despite a sharp rally in
mid-September, this year's price decline remains on track to be the worst in
REIT history.
Of greater near-term consequence, however, is the recent shutdown of the
real estate debt markets. It is estimated that somewhere between $30 and $40
billion in mortgage loans and commitments have been made by financial
institutions to real estate developers and owners. These loans, which are now
held on the books of these financial institutions, were expected to be
'securitized' and sold to investors in the form of commercial mortgage backed
securities ('CMBS'). The recent widening of yield spreads between U.S.
government debt securities and nearly all other debt has left these securities
unsold, and in many instances unsalable. The financial institutions holding this
paper face substantial losses and, moreover, can no longer make any further loan
commitments. Whereas the problems in the equity market primarily affected public
companies, the difficulties in the debt market affect the entire real estate
industry.
As a result, the real estate industry is facing a liquidity crisis that is
typical for this stage of the economic and real estate cycle. Unlike the end of
nearly all other real estate cycles, however, property market conditions are
exceptionally good: vacancy rates are low, rents are rising and new construction
is sufficient only to meet existing strong demand for space -- hardly the
circumstances which should cause investor concern. This has led many in the real
estate industry -- both public and private -- to question the wisdom of the
financial market mechanism.
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
We believe that the absence of demand for both debt and equity real estate
securities is a reflection of the market's concern with respect to three issues.
First is the future course of the economy. If the weakness in the stock market
and strength of the government bond market signal an economic recession, then
the resulting decline in demand for space would clearly remove the strongest
underpinning of the real estate recovery of the past several years. Second, the
dramatic growth of the real estate equity and debt markets over the past several
years has raised the specter of potential financial excesses in the real estate
markets; simply put, too much money has been chasing real estate. And third, the
threat of deflationary pressures on the prices of both hard and financial assets
is potentially a devastating one for all investors, particularly those in real
estate.
In contrast to the opinions of many, we believe that the capital markets
have behaved magnificently with respect to real estate. Cutting off funding for
new development before severe over-building could take place, for example, has
dramatically improved the probability of a more mild real estate downturn, if
there is to be one at all. Similarly, the closing of the debt markets is
punishing not only those resorting to high leverage but also their lenders for
imprudent financial practices. Finally, the liquidity squeeze has put an end to
an upward spiral of property prices which, if allowed to go any further, would
have reached an unsustainable high level.
INVESTMENT OUTLOOK
Regarding our investment strategy it is clear, with the benefit of
twenty-twenty hindsight, that the past nine months was a period in which maximum
defensiveness would have produced superior investment returns. Looking forward,
however, a defensive strategy -- while comforting in the midst of difficult
conditions -- will not produce the best returns, in our opinion. While risk
levels appear to be high, we believe that the next twelve months will present
high-return potential investment opportunities that are well worth their
attendant risks. This assessment is predicated on the rapid decline in real
estate financing, which has shut down construction quickly and has reduced
competition for acquisitions. These factors should lead to stable if not rising
profit growth for certain public real estate companies. At the same time that
these fundamentals are turning positive, REIT valuations are at historically low
levels.
We expect that construction starts will decline significantly. Construction
lenders are at the forefront of the capital retrenchment, motivated by greater
uncertainties of tenant demand for space and the availability of long-term
financing. It is significant that construction has been shut off before
fundamentals began to deteriorate, which should enable property owners to enjoy
better earnings than previously expected. For historical perspective, the Office
sector entered the 1990 recession with 19% vacancy -- the result of 5.5% annual
supply growth during the five years leading up to the recession. Today, office
vacancies are 10% and supply has been added at a rate of only 1.5%.
The real estate credit crunch, in conjunction with the decline in public
market valuations of real estate companies, has served to increase property
yields and opportunities in the private market. The catalyst, however, behind
the new set of opportunities is that many real estate operators built up
significant amounts of leverage the past several years with the belief that
equity would be available at some point in the future. Competition from
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
these debt-financed private competitors has been eliminated, while the property
portfolios amassed by many of them will soon be available for acquisition either
through outright sale or by foreclosure.
Valuations of real estate securities are compelling by every measure.
Looking at funds from operations ('FFO', or cash flow), the sector is trading at
8.9 times forward FFO -- the lowest valuation in the past twelve years
(including the early 1990s when the real estate industry was at the depths of
recession). Relative to stocks, REIT valuations are at a five-year low, measured
by relative earnings multiples: the S&P 500 Index P/E multiple is 2.3 times the
FFO multiple for REITs. Importantly, nearly all companies' stocks are trading at
a discount to net asset value (the private market value of their real estate
assets).
We are positioning the portfolio for maximum exposure to the companies that
will benefit from the pullback in real estate financing. Companies in the Office
and Hotel sectors will benefit both from the decline in new construction as well
as reduced competition for acquisitions. We expect to have at least half of the
portfolio in companies that we have characterized as 'Realty Majors'. These
companies have the strongest management teams, market positions and, most
importantly in the current environment, cash-rich balance sheets. The remaining
portion of the portfolio will consist of special situations, which may entail a
contrarian approach where companies are out of favor but their share prices
over-discount fundamentals. The Hotel sector, for example, has several world
class companies whose shares can be purchased at significant discounts to asset
value.
The Fund's top two holdings -- LNR Property Corp. and Vornado Realty
Trust -- have particularly compelling opportunities. LNR Property is uniquely
positioned to take advantage of the liquidity crisis and large backlog in the
CMBS market. LNR has the organization, relationships, balance sheet and market
position to acquire and work out CMBS at very high returns. Vornado has $1
billion of balance sheet liquidity to take advantage of the opportunities in its
principal business, New York City office management. Specifically, several New
York City office portfolios have been assembled with debt financing; these
debt-financed owners should feel pressure to restructure their debt, creating an
opening for Vornado.
The primary risk to our investment strategy is a scenario where the U.S.
economic slowdown becomes severe. In this environment, the decline in demand for
space would offset the benefits of declining construction and improving
investment opportunities. We believe that much of this risk is discounted in the
currently depressed share prices, which are cheaper today than at any time in
the past, including before and during economic recessions. In addition, the
Federal Reserve is in a good position to continue the monetary easing that began
in early October. Nonetheless, there may still be some market turbulence before
year-end due to potential further fallout from the credit crunch, particularly
if one or more major financial institutions were to fail. In addition, there may
be tax-loss selling before year-end that could further depress stock prices.
We would view any further weakness in the REIT group, however, as the final
phase of a correction that could lead to a period of strong and sustainable
earnings growth and stock market performance. Prior to 1998 there were four
years when REIT returns were negative: those declines averaged 14.0%. The
current decline (-15.0% year to date through September) seems like a full
correction in the context of how real estate conditions
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
compare to those in prior down periods. While there was one period of
back-to-back negative return years (1973 -- 74), the total return performance
for REITs following down years averaged 16.3% annually over the subsequent
two-year periods.
Real estate capital market conditions have changed dramatically in the past
quarter. These changes have vastly broadened the range of high-return
opportunities available to the leading public real estate companies and, by
translation, have renewed the return potential for the Fund. We believe that if
the opportunities for REITs expand, so too will their P/E ratios, and capital
availability will become less of an issue than it has been over the past year.
We are disappointed with the Fund's under-performance in a declining market, but
are confident that the companies in the portfolio are well positioned for the
opportunities that will become available in the coming months.
Sincerely,
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MARTIN COHEN ROBERT H. STEERS
MARTIN COHEN ROBERT H. STEERS
President Chairman
JOSEPH M. HARVEY
JOSEPH M. HARVEY
Director of Research
Cohen & Steers Capital Management, Inc.
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On September 10, 1998 the Fund's Board of Directors reopened the Fund to
new investors for an indefinite period of time. In the future, the Fund's
Board of Directors will periodically consider whether, in light of
then-existing market conditions, the Fund should impose limitations on the
sale of its shares.
Cohen & Steers is now online at www.cohenandsteers.com. Visit our website
for daily navs, portfolio information, performance information, recent
news articles, literature and insights on the REIT market.
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
SCHEDULE OF INVESTMENTS
SEPTEMBER 30, 1998 (UNAUDITED)
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NUMBER % OF
OF SHARES VALUE NET ASSETS
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EQUITIES
LNR Property Corp. ......................................... 480,800 $ 9,285,450 11.17%
Vornado Realty Trust........................................ 275,200 9,116,000 10.97
Starwood Hotels & Resorts Trust............................. 236,100 7,201,050 8.66
Mack-Cali Realty Corp. ..................................... 202,500 6,075,000 7.31
*Omega Worldwide............................................. 892,331 4,573,196 5.50
SL Green Realty Corp. ...................................... 202,700 4,256,700 5.12
Patriot American Hospitality................................ 319,600 4,074,900 4.90
Apartment Investment & Management Co. -- Class A............ 107,300 4,050,575 4.87
Arden Realty Group.......................................... 177,300 3,956,006 4.76
Crescent Real Estate Equities Co. .......................... 153,400 3,873,350 4.66
Forest City Enterprises -- Class A.......................... 172,700 3,626,700 4.36
*Crescent Operating.......................................... 454,700 3,182,900 3.83
*American Retirement Corp. .................................. 191,500 2,980,219 3.58
First Industrial Realty Trust............................... 110,500 2,817,750 3.39
Prime Group Realty Trust.................................... 123,500 2,068,625 2.49
*Wellsford Real Properties................................... 218,900 2,038,506 2.45
TrizecHahn Corp. ........................................... 96,500 1,809,375 2.18
*Alexander's................................................. 23,300 1,788,275 2.15
Meditrust Corp. ............................................ 48,200 822,413 0.99
*Hospitality Worldwide Services.............................. 218,400 682,500 0.82
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TOTAL EQUITIES (Identified cost -- $101,322,321)...... 78,279,490 94.16
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PRINCIPAL
AMOUNT
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COMMERCIAL PAPER
Aluminum Company of America, 5.60%, 10/01/98................ $1,492,000 1,492,000 1.79
Avnet, 5.60%, 10/01/98...................................... 2,000,000 2,000,000 2.41
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TOTAL COMMERCIAL PAPER
(Identified cost -- $3,492,000).................... 3,492,000 4.20
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TOTAL INVESTMENTS (Identified cost -- $104,814,321)............... 81,771,490 98.36
OTHER ASSETS IN EXCESS OF LIABILITIES............................. 1,362,713 1.64
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NET ASSETS (Equivalent to $21.78 per share based on 3,817,306
shares of capital stock outstanding)........................... $83,134,203 100.00%
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* Non-income producing security.
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
FINANCIAL HIGHLIGHTS'D'
SEPTEMBER 30, 1998 (UNAUDITED)
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NET ASSET VALUE
TOTAL NET ASSETS PER SHARE
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NET ASSET VALUE:
Beginning of period: 12/31/97................................ $135,934,404 $ 32.25
Net investment income.................................. $ 2,080,713 $ 0.49
Net realized and unrealized loss on investments........ (47,293,481) (10.69)
Distributions from net investment income............... (1,245,699) (0.27)
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Capital stock transactions:
Sold............................................. 42,060,275
Distributions reinvested......................... 1,046,299
Redeemed......................................... (49,448,308)
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Net decrease in net asset value.............................. (52,800,201) (10.47)
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End of period: 9/30/98....................................... $ 83,134,203 $ 21.78
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'D' Financial information included in this report has been taken from the
records of the Fund without examination by independent accountants.
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COHEN & STEERS SPECIAL EQUITY FUND, INC.
OFFICERS AND DIRECTORS
Robert H. Steers
Director and Chairman
Martin Cohen
Director and President
Gregory C. Clark
Director
George Grossman
Director
Jeffrey H. Lynford
Director
Willard H. Smith, Jr.
Director
Elizabeth O. Reagan
Vice President
Adam Derechin
Vice President and
Assistant Treasurer
William Goodwin
Assistant Secretary
KEY INFORMATION
INVESTMENT ADVISER
Cohen & Steers Capital Management, Inc.
757 Third Avenue
New York, NY 10017
(212) 832-3232
SUB-ADMINISTRATOR AND TRANSFER AGENT
Chase Global Funds Services Co.
73 Tremont Street
Boston, MA 02108
(800) 437-9912
CUSTODIAN
The Chase Manhattan Bank, N.A.
One Chase Manhattan Plaza
New York, NY 10081
LEGAL COUNSEL
Dechert Price & Rhoads
1775 Eye Street, NW
Washington, DC 20006
NASDAQ Symbol: CSSPX
Website: www.cohenandsteers.com
Net asset value (NAV) can be found in the daily mutual
fund listings in the financial section of most major
newspapers under Cohen & Steers.
This report is authorized for delivery only to
shareholders of Cohen & Steers Special Equity Fund, Inc.
unless accompanied or preceded by the delivery of a
currently effective prospectus setting forth details of
the Fund.
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STATEMENT OF DIFFERENCES
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The dagger symbol shall be expressed as........................... 'D'
