A Safer House in Real Estate Funds


By Amey Stone During most of the bear market of the past two years, mutual-fund investors found shelter in real estate. Through the end of June, the average real estate fund was up 13% year-to-date and had a 12% three-year annual return. Those numbers are in stark contrast to the average diversified equity fund's 11% drop this year and 3% annual loss for the last three years through the end of June.

However, in July real estate funds started acting like the rest of the market. They're typically less volatile than most stocks, simply because real estate prices, stabilized by hard assets like land and buildings, don't fluctuate as much as stock prices. But in July, investors were reminded that the real estate investment trusts (REITs) that most funds invest in are stocks themselves. In the past month, real estate funds have fallen 6%, while the average diversified stock fund fell about 7%.

CAUGHT IN THE DROP. Nonetheless, for investors seeking a way to help cushion their portfolios against the market's recent bone-jarring volatility and diversify away from big-name blue chips, the recent dip actually makes real estate funds a better opportunity than before. The sector fell not because of any worsening of real estate fundamentals -- which should improve as the economic recovery takes hold -- but because it was caught up in the broad market sell-off.

Another reason for the drop: Many general equity funds, which had moved into real estate to stabilize their portfolios in recent years, sold those stocks in July to meet a sudden rush of redemptions (fund managers typically choose winners to unload), says Steven Brown, portfolio manager of Neuberger Brown Real Estate Fund (NBRFX).

Even though real estate stocks have rallied back in the past week, many are still selling at a discount to the value of their underlying holdings, says Michale Winer, portfolio manager of Third Avenue Real Estate Value (TAREX). By the end of June, the sector was starting to look a little pricey, he says.

LESS AIR. But REITs are now selling at about 9 times earnings and have yields near 8%, which is near the bottom the sector reached in 1999, when real estate stocks were out of favor, says Brown (for more, see this video Q&A with Brown).

"The recent correction has probably taken the air out of some of the highfliers across the board," agrees Alan Papier a mutual-fund analyst for Morningstar, the fund-rating services. He gives credit to the commercial real estate industry for doing a good job matching the supply with demand in recent years, which has kept the real estate market healthy throughout the economic slump.

Real estate funds can generally be divided into those that emphasize high current income and those that look for growth. For example, Winer's fund invests primarily in real estate operating companies, which don't cast off dividends but instead reinvest their earnings. This gives them more opportunity to grow than pure REITs, which must distribute at least 90% of their earnings as a dividend.

"VERY GOOD STRATEGY." Third Avenue Real Estate's yield is among the lowest in the group -- just 1% in the past 12 months, vs. 4% for the average real estate fund, according to Morningstar. But it's one of Papier's favorites because of its steady long-term results. It has gained 15% a year for the past three years, putting it in the top 5% of all real estate funds. Year to date, it's up 2%.

In contrast, Stratton Monthly Dividend REIT Shares (STMDX) is all about providing an above-average dividend to investors each month. Co-manager Jim Beers seeks out REITs that yield 6% and higher. "Over the last year and a half, that has proved to be a very good strategy since the higher yielding REITs have outperformed some of the lower yielding REITs," he says. The fund is up an average of 14% for the past three years and climbed 9% this year.

Many fund managers make big bets in certain subsectors of the industry, which can hamper their results if they bet wrong. For example, apartment REITs have been floundering this year as falling mortgage rates have enabled many more renters to buy homes, lowering occupancy rates and opportunity for rent increases.

WORTH CONSIDERING. Security Capital U.S. Real Estate (SUSIX), which is still one of Papier's favorite funds in the sector, loaded up on apartment REITs this year with large holdings in AvalonBay Communities (AVB), Post Properties (PPS), and Archstone-Smith (ASN). Year-to-date, the fund is up just 1%. But Papier says its volatility has not been excessive, and its management has the depth and experience that makes it worth considering. Its five-year average annual return is 8%, putting it in the top 4% of real estate funds over that time period.

Papier also likes Morgan Stanley Institutional U.S. Real Estate (MSUSX), which is available in many 401(k) plans. It, too, has focused on apartment and office REITs to its detriment this year but has solid long-term results. The fund, which had 59 holdings at last count (a large number for a real estate fund), is up 2% this year but has a five-year return of 7%, in the top 15% of real estate funds.

For his fund, launched in May this year, Brown is emphasizing real estate stocks that buy regional malls, like General Growth Properties (GGP) and CBL & Associates Properties (CBL), since they benefit directly from retail's boost by strong consumer spending.

"NO GUARANTEE." He's also emphasizing industrial properties to take advantage of climbing demand as the economy recovers. His top picks there include ProLogis Trust (PLD) and CenterPoint Properties Trust (CNT). Another favorite is Vornado Realty Trust (VNO), a diversified REIT with major office holdings in New York City and Washington.

Given the piddling returns available on money-market funds and short-term bonds, it's not surprising that many investors seeking higher yields are venturing into real estate funds. Stratton's Beers warns investors -- as the first few weeks of July proved well -- that with real estate funds, unlike CDs, "there's no guarantee, and they do fluctuate."

But for investors who are looking for an alternative to the volatility of stock funds, real estate funds, with their relative stability and high yields, should offer a welcome haven from the markets' stormy seas. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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