Real Estate Funds: Beyond the Bubble

For the past five years, mutual funds investing in various types of real estate securities have turned in a stellar performance, while housing prices in many metropolitan markets have skyrocketed. For the five-year period through May 31, real estate funds returned, on average, an annualized 19.4%, versus an 0.6% gain for the average domestic stock portfolio. The S&P 500 actually declined 1.9% over that period.

Despite growing anxieties over a housing bubble, some portfolio managers predict that real estate funds will remain insulated, or even thrive, should house prices fall back to Earth.

The sector's top-performing fund, the $526-million Alpine U.S. Real Estate Equity Fund/Y (EUEYX), is concentrated in homebuilder stocks. Managed by Samuel A. Lieber, this portfolio topped all real estate mutual funds for the one-, three- and five-year periods ended May 31, 2005. (see table below).

The correlation between the housing market and homebuilding stocks is "pretty strong, but not always evident," said Lieber. While homebuilders benefit from rising home prices, Lieber attributed the sub-sector's 586% cumulative five-year stock price appreciation to having been "significantly undervalued" in 2000. Additionally, homebuilders today are "dramatically better companies, and they will not go into the red if there's a slowdown," he said.

Lieber doesn't regard homebuilder stocks as overvalued because these companies have expanded their market shares and margins. Five years ago, shares were trading at just a 4.5 price-earnings (P/E) ratio; now they're at a 8.5 P/E, according to Lieber. He thinks they should be selling for 11 times earnings, given that they've historically traded at two-thirds of the S&P Index average P/E, which amounted to 17.1 as of May 31.

With demand for homes outstripping supply, Lieber thinks that housing markets could survive a drop in price. He expects stock prices to dip slightly, and would likely buy more shares if they do. Lieber is so bullish on homebuilders that one of his firm's private funds is composed entirely of such stocks.

Because condominiums are in greater supply and more of a commodity than individual homes, Lieber believes that a "temporary scare" could occur in that market. However, because mortgage risk has been widely spread through securitization, it would likely "mitigate" the risk of default in the sub-prime market (15% of all mortgages) and among over-stretched homeowners who lose their jobs.

David Wyss, chief economist at Standard & Poor's, believes we are unquestionably in the midst of a housing boom. "When real interest rates are low, housing always has a boom, and then when interest rates go up, it has a bust," he observed. "Homebuilder stocks will definitely follow suit" if the housing market softens, he said. But the "multiplicity of ways of financing a house means that housing is not quite as sensitive to financial markets," he said. "It still counts, but not as much as it used to."

Wyss doesn't expect home prices to decline nationally, though they might stop rising. "I think you do have some local markets that are overpriced," he said. "But, historically the only time we've seen prices decline significantly is when there's a loss of employment in an area -- like Texas in the mid-'80s, and the Northeast in the late '80s."

Real estate investment trusts (REITs) follow a different trajectory in the real estate universe. In some cases, REITs have benefited indirectly from the residential housing boom, but their returns are generally driven by a different set of fundamental factors -- those of commercial real estate.

James Corl, co-manager of the $78.6-million Cohen & Steers Realty Focus Fund/Instl (CSSPX), sees "very little" correlation between what happens in the housing market and how REITs perform. "REITs invest in income-producing property -- office, industrial, warehouses, retail space, and multi-family apartments," he said, adding that these four areas represent 80% of the value of the commercial real estate sector.

"Income-producing types are owned by investors, who buy and sell based on income stream," he said. In contrast, owner-occupied homes are purchased for habitation, depending on what the owner can afford. There's an implied return in home ownership, based on the rent that one would otherwise pay, but it's theoretical and not the primary purpose of buying, he said.

Corl's fund invests exclusively in commercial properties, including REITs and "C corporations" that own and manage property. Both businesses offer advantages -- REITs don't pay taxes on their net income, but must pay out 90% of it in the form of dividends to shareholders and are restricted as to how fast they can trade or sell assets. C corporations must pay 35% tax on net income, but do not face the same restrictions on selling and trading.

The Cohen & Steers fund has never held homebuilder stocks, Corl stated, because their "volatility profile is very different" from what his investors expect. "Homebuilders are really traders -- they buy land, sell lots, or put up houses and sell them," he noted. "The holding period is brief. REIT stocks have high income, with stable long-term leases underpinning their income streams."

The income generated by REITs has been somewhat constrained due to the soft U.S. economy and weak demand for commercial space in the wake of the tech bubble and recession. However, things have picked up since mid-2004. "We're in the very early stages of a real estate recovery," Corl said. "Retail is close to peak occupancy. Across the country, the occupancy level, which bottomed last year, started to go up." Conversely, the vacancy rate is now about 17% nationally, he said, leaving a lot of room for growth. When the vacancy rate last hit bottom, in 2000, it was about 7% to 8%.

Corl sees the greatest chance for growth in hotel and office properties, as well as in manufactured homes. REITs generally are now "inexpensive relative to the broader market, by virtue of their growth and dividend yield, and are trading at small premiums" compared with where they might be at this point in the economic cycle, he indicated.

Raymond Mathis, one of three analysts covering REITs for Standard & Poor's Equity Research, is also bullish on the real estate sector, especially retail and lodging, and regards them as somewhat defensive if the housing bubble bursts. "Prices within commercial real estate have appreciated, but they've come back to the long-term trend line," he said. "They're not out of whack, and they have strong fundamentals."

Mathis likes the fact that REIT dividend payouts can never be negative. "It goes a long way to decreasing volatility in your investment portfolio," he said. "And you don't have the agency risk -- the risk that the company is going to retain profits and spend it on whatever they feel like. If they want to expand the company, they have to ask permission to issue more shares."

For Mathis, there's a correlation between the share prices of homebuilding stocks and REITs, but their fundamentals "move in opposite directions." So, when the number of housing units built exceeds the number of new households formed, rents fall and apartment REITs suffer. This scenario has been in place for several years.

Nonetheless, apartment REITs' net asset values have boomed. "They've been offered exorbitant sums of money by condominium converters for their apartments," Mathis explained. "Even though the fundamentals are terrible and they're making less money from continuing operations, they're able to extract one-time gains by selling their properties to condo converters." This practice obviously limits future earnings capacity, he added.

Mathis doesn't see a bubble in commercial real estate. Still, should events precipitate a rapid sell-off, he believes REITs would be somewhat insulated. "The 1031 tax exchange rule is probably going to put brakes on that," he said. "A lot of people have sold properties over the years and rolled over the gains into new properties. They cannot sell and extract their profits without getting a huge hit from the IRS. So they're not going to sell," he projected.

For Robert McMillan, who also covers the sector for Standard & Poor's, REITs can help individual investors diversify their asset classes and geographical exposure. "It's not common for the average investor to get exposure to real estate, unless you're Donald Trump or have a lot of money to buy real estate," he said. "Not only that, but a REIT can diversify around the country."

McMillan looks favorably upon such REIT names as Simon Property Group Inc. (SPG), General Growth Properties Inc. (GGP), and CBL & Associates Properties Inc. (CBL). "Their business is to buy, own, and operate malls, and they are benefiting from robust sales," he said. "Their occupancy levels are high, and their rental rate growth is pretty good." He sees retail REITs providing the sector's strongest growth prospects for the next couple of years.

For his part, Lieber sees REITs as overvalued. However, as their fundamentals continue to improve, he might consider moving more assets into them in about 18 months, he said. REITs currently constitute just a fraction of the Alpine U.S Real Estate Equity Fund's portfolio, compared with 30.9% for lodging stocks and 53.2% for homebuilders, as of March 31.

Despite the general bullishness toward real estate, most of our experts voiced concerns about unpredictable events that could affect the overall sector, though none foresees calamity.

Wyss sees housing speculation as only a "minor concern," though he is bothered by the proliferation of risky "creative banking" products, such as interest-only adjustable-rate mortgages (ARMs). With the average home selling for 3.1 times average household income (versus 2.6 times historically), Wyss expects that ratio will fall as mortgage rates eventually rise. "If mortgage rates go up gradually, housing prices will flatten out while income catches up," he said. "But if they jerk up, then those prices will have to drop."

Some homeowners with ARMs might not be able to meet their mortgage payments. Wyss sees the major metropolitan areas in the Northeast, along with the West Coast and Florida, as being the most vulnerable to this scenario, while housing prices elsewhere are "still pretty realistic."

For Corl, a slowdown in housing price appreciation would be "fantastic" for the apartment sector by encouraging more new families to rent rather than buy. At the same time, by reducing the "wealth effect" that has been buoyed by "cash-out refinancing," it could cut into retail sales and dampen REITs in that sector.

Mathis is cautious about REIT funds that are overexposed to weak income-producing or inflated property markets like San Francisco, San Jose, Houston, Dallas, Austin, and Denver. But such information can be difficult for the average investor to obtain. "They would have to know each REIT in the mutual fund's portfolio," he said. Mathis also advises avoiding "larger-cap names not covering their dividend from cash flow from operations," such as Equity Office Properties Trust (EOP), Crescent Real Estate Equities Co. (CEI), and Apartment Investment and Management Co (AIV).

Taking a broader view, Lieber points out that the current account deficit gives U.S. policymakers "less of a cushion" to counteract a weakening economy, a rapidly falling dollar, or spiking interest rates, should any of these events occur. Also, job losses could lead to mortgage defaults, though the distribution of risk would soften the impact. "But if the scale is bigger, you've got more problems," he said. "A bust in housing would blow the economy."

TOP 5 Real Estate Funds, One-Year Period*

Fund Name S&P Star Ranking Return (%) Expense Ratio (%)
Alpine U.S. Real Estate Equity Fund/Y (EUEYX)

5

49.9

1.31

PIMCO Funds: Real Estate Real Return Strategy/D (PETDX)

N.R.

40.4

1.24

ProFunds: Real Estate Ultrasector/Inv (REPIX)

1

40.3

1.55

Strategic Partners Real Estate Securities/A (PURAX)

5

36.7

1.58

CGM Realty Fund (CGMRX)

3

35.8

0.96

TOP 5 Real Estate Funds, Three-Year Period*

Fund Name S&P Star Ranking Annualized Return (%) Expense Ratio (%)
Alpine U.S. Real Estate Equity Fund/Y (EUEYX)

5

34.0

1.31

CGM Realty Fund (CGMRX)

3

31.3

0.96

Strategic Partners Real Estate Securities/A (PURAX)

5

25.8

1.58

Cohen & Steers Realty Focus/Instl (CSSPX)

5

25.3

1.43

AIM Real Estate Fund/A (IARAX)

5

23.1

1.65

TOP 5 Real Estate Funds, Five-Year Period*

Fund Name S&P Star Ranking Annualized Return (%) Expense Ratio (%)
Alpine U.S. Real Estate Equity Fund/Y (EUEYX)

5

33.8

1.31

CGM Realty Fund (CGMRX)

3

27.8

0.96

Cohen & Steers Realty Focus/Instl (CSSPX)

5

24.4

1.43

Strategic Partners Real Estate Securities/A (PURAX)

5

22.9

1.58

Alpine Realty Income & Growth Fund/Y (AIGYX)

5

21.8

1.25

Contact Bob Keane with questions or comments at: .

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