<PAGE>
- ---------------------------------------------------------
DIRECTORS OFFICERS
Barton M. Biggs Stefanie V. Chang
CHAIRMAN OF THE BOARD VICE PRESIDENT
Chairman and Director, Morgan Stanley Harold J. Schaaff, Jr.
Asset Management Inc. and Morgan Stanley VICE PRESIDENT
Asset Management Limited; Managing Joseph P. Stadler
Director, Morgan Stanley & Co. Incorporated VICE PRESIDENT
Michael F. Klein Valerie Y. Lewis
DIRECTOR AND PRESIDENT SECRETARY
Principal, Morgan Stanley Asset Management Inc. and Karl O. Hartmann
Morgan Stanley & Co. Incorporated ASSISTANT SECRETARY
John D. Barrett II Joanna M. Haigney
Chairman and Director, TREASURER
Barrett Associates, Inc. Rene J. Feuerman
Gerard E. Jones ASSISTANT TREASURER
Partner, Richards & O'Neil LLP
Andrew McNally IV
River Road Partners
Samuel T. Reeves
Chairman of the Board and Chief
Executive Officer,
Pinacle L.L.C.
Fergus Reid
Chairman and Chief Executive Officer, LumeLite
Plastics Corporation
Frederick O. Robertshaw
Of Counsel, Copple, Chamberlin &
Boehm, P.C.
- ---------------------------------------------------------
INVESTMENT ADVISER AND ADMINISTRATOR
Morgan Stanley Asset Management Inc.
1221 Avenue of the Americas
New York, New York 10020
- ---------------------------------------------------------
DISTRIBUTOR
Morgan Stanley & Co. Incorporated
1221 Avenue of the Americas
New York, New York 10020
- ---------------------------------------------------------
CUSTODIANS
The Chase Manhattan Bank
3 Chase MetroTech Center
Brooklyn, New York 11245
Morgan Stanley Trust Company
One Pierrepont Plaza
Brooklyn, New York 11210
- ---------------------------------------------------------
LEGAL COUNSEL
Morgan, Lewis & Bockius LLP
2000 One Logan Square
Philadelphia, Pennsylvania 19103
- ---------------------------------------------------------
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
1177 Avenue of the Americas
New York, New York 10036
- ---------------------------------------------------------
For current performance, current net asset value, or for assistance with your
account, please contact the Fund at (800) 548-7786. This report is authorized
for distribution only when preceded or accompanied by prospectuses of the Morgan
Stanley Institutional Fund, Inc.
[LOGO] MORGAN STANLEY
INSTITUTIONAL FUND, INC.
P.O. Box 2798
Boston, MA 02208-2798
[LOGO] MORGAN STANLEY
INSTITUTIONAL FUND, INC.
U.S. REAL ESTATE PORTFOLIO
FIRST QUARTER REPORT
MARCH 31, 1998
<PAGE>
LETTER TO SHAREHOLDERS
- -------
The U.S. Real Estate Portfolio seeks to provide above average current income and
long-term capital appreciation by investing primarily in equity securities of
companies in the U.S. real estate industry, including real estate investment
trusts ("REITS").
For the three months ended March 31, 1998, the Portfolio had a total return of
- -1.24% for the Class A shares and -1.30% for the Class B shares, compared to a
total return of -0.47% for the National Association of Real Estate Investment
Trusts (NAREIT) Equity Index (the "Index"). For the one year ended March 31,
1998, the Portfolio had a total return of 20.76% for the Class A shares and
20.45% for the Class B shares, compared to 18.87% for the Index. From inception
on February 24, 1995 through March 31, 1998, the average annual total return
PERFORMANCE COMPARED TO THE NATIONAL ASSOCIATION OF REAL ESTATE INVESTMENT
TRUSTS (NAREIT) EQUITY INDEX(1)
- ----------------------------------------------------
<TABLE>
<CAPTION>
TOTAL RETURNS(2)
-----------------------------------------
ONE AVERAGE ANNUAL
YTD YEAR SINCE INCEPTION
--------- ----------- -----------------
<S> <C> <C> <C>
PORTFOLIO--CLASS A............ -1.24% 20.76% 27.63%
PORTFOLIO--CLASS B............ -1.30 20.45 27.85
INDEX--CLASS A................ -0.47 18.87 22.24
INDEX--CLASS B................ -0.47 18.87 23.97
</TABLE>
1. The NAREIT Equity Index is an unmanaged market weighted index of tax
qualified REITs listed on the New York Stock Exchange, American Stock
Exchange and the NASDAQ National Market System, including dividends.
2. Total returns for the Portfolio reflect expenses waived and reimbursed, if
applicable, by the Adviser. Without such waiver and reimbursement, total
returns would be lower.
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
- ------------------------------
THE PERFORMANCE RESULTS PROVIDED ARE FOR INFORMATIONAL PURPOSES ONLY AND SHOULD
NOT BE CONSTRUED AS A GUARANTEE OF THE PORTFOLIO'S FUTURE PERFORMANCE. PAST
PERFORMANCE SHOWN IS NOT PREDICTIVE OF FUTURE PERFORMANCE. INVESTMENT RETURN AND
PRINCIPAL VALUE WILL FLUCTUATE SO THAT AN INVESTOR'S SHARES, WHEN REDEEMED, MAY
BE WORTH MORE OR LESS THAN THEIR ORIGINAL COST.
of the Class A shares was 27.63% compared to 22.24% for the Index. From
inception on January 2, 1996 through March 31, 1998, the average annual total
return of the Class B shares was 27.85% compared to 23.97% for the Index.
The first quarter of this year was a difficult one for the REIT industry. There
appear to be several key issues that concerned investors and dampened returns.
At the end of January, the Clinton administration put forth several proposals in
its new budget that were specifically addressed at the REIT industry. In
addition, the continued strength in the U.S. equity market has led the non-
dedicated real estate investors to add funds to the broad market as opposed to
the REIT sector. Finally, many observers are now calling for more moderate
returns in the sector given the progress that the U.S. real estate market has
made in the cycle and the notion that the stocks already reflect much of the
good news expected from the properties.
Despite ending the quarter with only a modest decline, the REIT market had three
distinct phases. In January, the market declined modestly in the face of a
fairly somber equity market in which the various equity indexes provided mixed
results. However, from the beginning of February through mid-March, the market
faced a steep decline, falling almost 4%. These results appeared more dramatic
in the face of a soaring equity market. The REIT market finally showed a
recovery through the second half of March predominantly due to market calls by
several key sell-side equity strategists who highlighted the fact that the
relative average multiple of the S&P 500 versus the REIT market had achieved its
greatest level of divergence. Based on a top-down analysis of earnings, the S&P
is trading at a multiple that is 1.9 times greater that the REITs and on a
bottom-up analysis that figure is 1.75 times. This compares to average premiums
of 1.5 and 1.3 times for the top down and bottom up comparison throughout most
of 1997.
The legislative issues prompted a great deal of debate and concern over the REIT
market. Based upon our
2
<PAGE>
discussions and subsequent actions by Congress in March, we believe that the aim
of the proposals is not to attack the fundamental structure of the REIT
industry, rather the purpose is to limit abuses or inefficiencies available
within the existing guidelines. Washington's stated preference is to work with
the REIT community to solve these issues.
The issue that generated the greatest interest surrounded the grandfathered
paired share REITs and thus only affects four public companies (and soon to be
five based on Simon DeBartolos group's acquisition of Corporate Property
Investors as described below). As we discussed last quarter, the paired share
REITs had attracted a great deal of attention by virtue of their rapid growth
and Starwood's prolonged battle with Hilton over ITT. The current proposal
grandfathers the paired share REITs for all existing transactions, but going
forward all new acquisitions must be compliant with the current REIT rules, thus
eliminating their advantage in making acquisitions beyond the March cutoff date.
One area that was not addressed by a specific proposal is the paper clipped
structure (which we discussed last quarter) which attempts to mirror the paired
share structure through the creation of an additional C-corporation with a
similar Board and management team. The potential for abuse was evidenced in the
purchase of a public gaming company by Crescent Real Estate (as discussed
below), which plans to place the assets at the REIT and the operating company at
the paper clip. The key economic driver of the transaction is the elimination of
taxes. Once again, the current message is that if a structure is deemed to be
abusive then we may expect new proposals to shut down a REIT's ability to
execute this strategy.
The exciting merger and acquisition environment that we discussed last quarter
continued into the first quarter. The merger environment includes a continuation
of friendly takeovers but two new variations include friendly takeovers of
companies operating in other businesses as well as mergers of equals. A
representative merger of equals transaction is the merger of Avalon Properties
(an owner and developer of Northeast and mid-Atlantic apartments) with Bay
Apartment Communities (a significant owner and redeveloper in the San Francisco
bay area and other Pacific markets) to form Avalon Bay Communities. This new
company will be comprised of all of the senior management of the two companies
and plans to be the dominant player focusing on in-fill multifamily markets. In
addition, there was the announcement of the combination of Security Capital
Pacific (a multifamily owner in the Pacific) with Security Capital Atlantic (a
multifamily owner in the Southeast) to form Archstone Communities--a branded
national operator.
Generally, we are not highly supportive of mergers of equals. The stated
advantages are heavily reliant on being big--which may result in a marginally
better unsecured debt rating and an increased equity float. We question whether
these modest advantages are outweighed by the management risks involved in the
integration of two companies, the ability to effectively manage the larger
entity as well as the added pressure to grow a larger company.
The hotel sector featured two deals involving mergers of a REIT and a C-Corp. to
form a REIT which will own the combined entity's assets and a C-Corp. (the
"paper clip") which will lease and manage the assets. In the first transaction,
CapStar Hotels (a C-Corp. focused on renovating and reflagging full service
hotels) merged with American General Hospitality (a REIT with a similar business
plan). This transaction is the model paper clip in which senior management will
participate in each company. The other deal involved Bristol Hotels (a C-Corp.
focused on upgrading Holiday Inns) and Felcor Suites (a REIT focused on
converting hotels to Embassy Suites). This transaction differs in that Felcor
will own all of the assets and Bristol will lease all of the assets but there is
no effective paper clip. These transactions are the result of the efficiency of
owning real estate assets (and particularly hotel assets) in the REIT structure.
Further evidence of this advantage is highlighted by the conversion of Rouse (a
national owner of regional malls) from a C-Corp. to a REIT and the current plan
that Host Marriott (a national owner of Marriott Hotels) will convert at the
beginning of next year.
3
<PAGE>
Meditrust Corporation's acquisition of LaQuinta Hotels and Crescent's purchase
of Station Casinos were interesting both because they involved REITs purchasing
public C-Corps for very hefty premiums over the companies' prevailing stock
price and because in each case the economics of the deal were justified to a
significant degree by the tax savings. In addition, these deals involved
companies moving into an asset class in which they do not have any experience.
Specifically, for Meditrust, one of the paired share REITs, their entry into the
hotel business appeared to be the result of pressure on the company to justify
paying over $200 million to attain the paired share structure last year.
Crescent, which has opted for a multi-property strategy, entered the casino
business at a hefty multiple through the use of the paper clip structure.
The other half of the acquisition story involves the purchase of significant
private companies and private assets by the public REITs. Significant
transactions included Simon DeBartolo Group agreeing to purchase both Retail
Property Trust and Corporate Property Investors, two private REITs that own
large portfolios of regional malls. These transactions ensure that Simon remains
the largest regional mall REIT. Trammell Crow Residential, a private operator,
sold their Midwestern business to a joint venture composed of Avalon Properties
and Amli Residential, their Florida business to Merry Land and Investment, their
West Coast business to BRE Properties and their Pacific Northwest operations to
Avalon Properties. In the West Coast office market, two potential REIT IPOs were
squashed when Arden Realty agreed to purchase Layton Belling (which had already
filed a prospectus with the Securities and Exchange Commission) and Spieker
Properties acquired Transpacific Development Company. On the large private asset
acquisition front, Simon teamed up with Macerich Company to buy the IBM regional
mall portfolio, Boston Properties purchased the Prudential Center in Boston and
we are awaiting the naming of the winning bidder in the auction of the
Embarcadero Center in San Francisco. These transactions provide evidence of the
continuing trend of high quality assets moving from private hands into the
public markets.
We have previously discussed the reopening of the market for initial public
offerings given the arbitrage between valuations in the private markets and the
public markets. This quarter featured an initial public offering by Cabot
Industrial Trust, which, like AMB Property Corporation, is a former pension fund
advisor turned REIT. The other large IPO was by Capital Automotive REIT, which
intends to be a consolidator in the ownership of automotive dealerships. This
IPO marked the continuance of a trend of new assets moving into the REIT format.
Other planned REITs for new asset types in the second quarter include another
prison REIT, a timber REIT and a REIT focused on the ownership of student
housing.
As is customary at the beginning of each calendar year, analysts predict total
returns for the upcoming year. In a report that received significant attention,
a sell-side analyst downgraded the REIT sector from an outperformer to a market
performer. The key thesis behind this adjustment relates to increasing amounts
of capital driving the business toward its peak. These capital inflows have
created cap rate compression (in other words increased prices achieved by
sellers) and thus lower returns from new investments and also provide financing
for new construction which inhibits future gains in occupancy and rental rates.
Secondary issues include the idea that REIT pricing has become more efficient
and the uncertainty created by the changes in the regulatory environment for
REITs may dampen funds flow. Several analysts rebutted this downgrade by
demonstrating that REITs have not been as cheap relative to the broad equity
market during the modern REIT era as measured by relative earnings multiples (as
described above). We do not believe that the two arguments are mutually
inconsistent. It is true that it will be difficult for REIT returns to match
those returns provided in the previous three years, which have averaged almost
25% per year. However, REITs do provide an investment in a separate asset class,
which provides diversification to an investor. With regard to the property
markets, we continue to see evidence of an emerging recovery in the area of new
construction of real estate. We believe that a number of major asset classes
have moved to equilibrium (defined by new supply being equal to the demand for
new
4
<PAGE>
space). Specifically this includes the apartment, industrial and self-storage
markets. We see limited evidence of oversupply at this point except for the
limited service hotel business as well as multifamily markets in parts of the
Southeast and Southwest. We continue to monitor the supply in both the office
and upscale full-service hotel markets but believe that they are still not in
equilibrium. However, certain suburban office markets are moving quickly toward
equilibrium.
The largest change to the Portfolio was increasing our exposure to the office
sector, particularly those companies focused on assets in central business
district ("CBD") locations and Southern California. This decision was a result
of both our belief that these markets are better protected from oversupply and
from opportunistic purchases when the stocks declined. In the hotel sector we
replaced our exposure to mid-market and extended stay hotels with companies
focused on urban, upscale hotels, due to concerns of overbuilding. In addition,
we reduced exposure to the health care REITs because we believe they have
received the bulk of the benefit from the reduction in interest rates. Finally,
we did take the opportunity during the decline in REIT stock prices to move a
number of larger cap companies into the Portfolio. These companies feature
strong management but traditionally had traded at premiums that were too
significant to their underlying asset value to be included in the Portfolio.
Given the compression in cap rates (i.e., increase in prices) throughout the
country in virtually every asset class, it is becoming clear that it will be
difficult for REITs to add value purely through spread investing. This evolution
places the onus on management to create value by operating their assets better
and, on an external growth basis, the focus will be on redevelopment and
ground-up development of assets. Although a select few companies have created
significant development pipelines, a large number have been reluctant to engage
in development particularly because it is difficult to receive value for this
strategy within the context of an investor base that focuses on Funds from
Operations (both development and the ownership of land will depress current
earnings). We believe that there will be a new emphasis by investors to search
out those companies that create value through development. Based on our
valuation methodology, we analyze each company's development value and include
it within our Net Asset Value model. As a result, the Portfolio currently
contains exposure to companies with significant development or redevelopment of
CBD office, suburban office, Class A multifamily, and regional mall properties.
Russell C. Platt
PORTFOLIO MANAGER
Theodore R. Bigman
PORTFOLIO MANAGER
April 1998
5
<PAGE>
INVESTMENTS (UNAUDITED)
- ----------
MARCH 31, 1998
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- --------------- ----------
<C> <S> <C>
COMMON STOCKS (94.6%)
REAL ESTATE (94.6%)
DIVERSIFIED (6.3%)
336,800 Pacific Gulf Properties, Inc. REIT $ 7,725
200,500 Pennsylvania REIT 4,912
654,898 Wellsford Real Properties, Inc. 9,496
----------
22,133
----------
HEALTH CARE (4.0%)
404,300 Nationwide Health Properties, Inc.
REIT 10,107
96,100 Omega Healthcare Investors, Inc.
REIT 3,748
----------
13,855
----------
LODGING AND RESORTS (9.2%)
132,200 CapStar Hotel Co. 4,586
547,900 Host Marriott Corp. 10,376
401,200 John Q Hammons Hotels, Inc., Class
A 3,159
262,637 Starwood Lodging Trust REIT 14,035
----------
32,156
----------
INDUSTRIAL (2.2%)
383,100 Prime Group Realty Trust REIT 7,662
----------
OFFICE/INDUSTRIAL (1.7%)
151,500 Bedford Property Investors, Inc.
REIT 2,926
111,000 Reckson Associates Realty Corp. 2,928
----------
5,854
----------
OFFICE (28.4%)
104,924 American Office Park Properties 2,833
723,700 Arden Realty Group, Inc. 20,625
335,100 Beacon Capital Partners, Inc. 144A 6,702
38,200 Boston Properties, Inc. 1,344
147,300 Brandywine Realty Trust REIT 3,508
425,454 Brandywine Realty Trust REIT 144A 10,131
905,700 Brookfield Properties Corp. 14,466
473,800 CarrAmerica Realty Corp. REIT 14,214
456,227 Equity Office Properties Trust
REIT 13,972
592,200 Great Lakes, Inc. REIT 11,437
5,500 Prentiss Properties Trust REIT 144
----------
99,376
----------
OTHER (0.6%)
589,684 Atlantic Gulf Communities Corp. 2,138
----------
RESIDENTIAL APARTMENTS (16.2%)
267,100 Avalon Properties, Inc. REIT 7,746
447,000 Bay Apartment Communities, Inc.
REIT 16,595
<CAPTION>
VALUE
SHARES (000)
- --------------- ----------
<C> <S> <C>
472,600 Essex Property Trust, Inc. REIT $ 16,216
93,900 Irvine Apartment Communities, Inc.
REIT 2,958
299,510 Security Capital Atlantic, Inc.
REIT 6,290
279,300 Walden Residential Properties,
Inc. REIT 7,052
----------
56,857
----------
RESIDENTIAL MANUFACTURED HOMES (6.2%)
560,552 Chateau Communities, Inc. REIT 16,676
137,200 Manufactured Home Communities,
Inc. REIT 3,550
42,900 Sun Communities, Inc. REIT 1,491
----------
21,717
----------
RETAIL STRIP CENTERS (8.2%)
580,200 Burnham Pacific Property Trust
REIT 8,485
460,800 Federal Realty Investment Trust
REIT 11,318
176,300 Pan Pacific Retail Properties,
Inc. REIT 3,856
2,200 Ramco-Gershenson Properties Trust
REIT 45
186,400 Regency Realty Corp. 4,928
----------
28,632
----------
RETAIL REGIONAL MALLS (9.4%)
382,400 CBL & Associates Properties, Inc.
REIT 9,369
1,296,400 Taubman Centers, Inc. REIT 16,934
203,600 Urban Shopping Centers, Inc. REIT 6,719
----------
33,022
----------
SELF STORAGE (2.2%)
271,900 Shurgard Storage Centers, Inc.,
Series A REIT 7,647
----------
TOTAL COMMON STOCKS (Cost $308,925) 331,049
----------
PREFERRED STOCKS (0.8%)
OFFICE (0.0%)
33,150 Great Lakes, Inc. REIT 144A --
----------
RETAIL STRIP CENTERS (0.8%)
80,600 First Washington Realty Trust,
Series A REIT 2,672
----------
TOTAL PREFERRED STOCKS (Cost $2,257) 2,672
----------
</TABLE>
6
<PAGE>
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- --------------- ----------
<C> <S> <C>
CONVERTIBLE PREFERRED STOCKS (0.5%)
OTHER (0.5%)
107,021 Atlantic Gulf Communities Corp. $ 1,084
75,765 Altantic Gulf Communities Corp.,
Series B 767
----------
TOTAL CONVERTIBLE PREFERRED STOCKS (Cost $1,828) 1,851
----------
<CAPTION>
NO. OF
WARRANTS
- ---------------
<C> <S> <C>
WARRANTS (0.5%)
INDUSTRIAL (0.4%)
184,843 Meridian Industrial Trust, Inc.,
REIT, expiring 2/23/99 1,432
----------
OTHER (0.1%)
112,509 Atlantic Gulf Communities Corp.,
Class A, expiring 6/24/04 127
112,509 Atlantic Gulf Communities Corp.,
Class B, expiring 6/24/04 127
112,509 Atlantic Gulf Communities Corp.,
Class C, expiring 6/24/04 127
----------
381
----------
TOTAL WARRANTS (Cost $300) 1,813
----------
<CAPTION>
FACE
AMOUNT
(000)
- ---------------
<C> <S> <C>
CORPORATE BOND (1.0%)
OFFICE (1.0%)
$ 2,934 Brookfield Properties Corp. 6.00%,
due 2/14/07 (Cost $2,278) 3,352
----------
SHORT-TERM INVESTMENT (2.8%)
REPURCHASE AGREEMENT (2.8%)
9,659 Chase Securities, Inc. 5.60%,
dated 3/31/98, due 4/01/98, to be
repurchased at $9,661,
collateralized by U.S. Treasury
Bills, due 6/11/98, valued at
$9,964 (Cost $9,659) 9,659
----------
<CAPTION>
VALUE
(000)
----------
<C> <S> <C>
TOTAL INVESTMENTS (100.2%) (Cost $325,247) $ 350,396
----------
OTHER ASSETS AND LIABILITIES (-0.2%)
Other Assets 4,733
Liabilities (5,300)
----------
(567)
----------
NET ASSETS (100%) $ 349,829
----------
----------
CLASS A:
NET ASSETS $328,086
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 21,595,264 outstanding $0.001 par
value shares (authorized 500,000,000 shares) $15.19
----------
----------
CLASS B:
NET ASSETS $21,743
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 1,436,582 outstanding $0.001 par
value shares (authorized 500,000,000 shares) $15.14
----------
----------
</TABLE>
- ----------------------------------
REIT -- Real Estate Investment Trust
7
