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Online Extra: "An Interesting Test of Volatility"


Joining the list of 12 newcomers from the real estate sector to BusinessWeek's A-rated fund list is Excelsior Real Estate Fund (UMREX) Manager Joan Ellis. At the helm of the $105 million fund since September, 1997, she has delivered steady performance, with an annualized gain of 13.2% for the past five years. BusinessWeek Personal Business Editor Lauren Young recently spoke to Ellis about rising interest rates, current trends, and apartment investments. Following are edited excerpts of their conversation:

Q: What do rising interest rates mean for the sector?

A: The first half of this year has been an interesting test of volatility. When people began to worry about interest rates rising, you saw a very dramatic sell-off. From Apr. 1, when Morgan Stanley's real estate index closed at 661, it subsequently declined over 18% through May 10 as fears about higher rates were most pronounced. Then the index recovered 16% from that low. Through mid-July, it was still down about 5% from the April peak.

There's going to be a lot of volatility around interest rates, but I think the companies are fairly well-positioned relative to history in terms of their balance sheets. They have fixed a lot of their debt problems.

Q: So how do you run a portfolio knowing such volatility exists?

A: When you think about that backdrop of higher rates, presumably we'll have a better economy. There are certain sectors in real estate that respond more to economics. One is apartments. If you have higher [interest] rates, that's going to mean higher mortgage rates. That's going to make housing less attractive to first-time homebuyers.

So far, housing affordability has been enhanced by lower mortgage rates, and if you've been renting an apartment and you can get a 5%, 30-year fixed-rate mortgage, you'll move out of your apartment and buy a house. If rates hit 7%, that might not be the case. The larger apartment names have done better in the last couple of months, but I still think they're under-owned among REIT [real estate investment trusts] investors.

For example, Camden Properties is a well-managed company. It has exposure to a variety of markets, including the Southwest, but none of the hot, hot ones.

Q: Aside from apartments, are there any other areas you like right now?

A: Another area that has been interest-rate-sensitive and economic-sensitive is the office group. If businesses are hiring more people, they have to put them someplace. Now they're filling up spaces, but at lower rent levels than they were in writing leases three to four years ago. Activity level has improved. Equity Office Properties (EOP) is a top holding in the fund. The valuations are quite reasonable. There's concern some of the companies may not be covering their dividend -- so far most of them have been.

I still have a decent portion of the fund in the retail-related REITs, including malls and shopping centers. I wouldn't completely cut my exposure there because I think they have very good embedded growth.

We do own several companies that are not REITs. We hold some The St. Joe Co. (JOE), which is a traditional real estate operating company. St. Joe owns property in the Florida Panhandle area. They are really a land company that is creating communities in that part of the state, mostly as second homes. They've done a great job creating value for shareholders in that venture.

Q: Are any other trends catching your eye?

A: There does seem to be a little bit more consolidation in this industry. Simon Property [Group] (SPG) acquired Chelsea [Property Group] (CPG) for $4.8 billion in June. In that case, a mall company bought an outlet-center developer. Long-term, I think consolidation is going to be an important theme.

The other near-term theme is that there's a fair amount of transactions now. REITs are selling properties because they think private-market values are so attractive. And, in some cases, they are buying back the shares of their stock.

Q: Do you think real estate has staying power as a long-term investment?

A: There are two different pieces to this. There's actual real estate, and then there's real estate-related securities. While both respond to interest rates and the economy, there's still some favorable dynamics for real estate securities, including real estate investment trusts, because they offer above-average dividends to investors. That continues to be appealing, particularly if people are not completely convinced that the economy is recovering as strongly.


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