From the June 2007 issue of Wealth Manager Web • Subscribe!

June 1, 2007

Real (Estate) Returns

Stan Luxenberg

Real estate funds have enjoyed a remarkable run. During the five years ending in February, the funds returned 23.7 percent annually, outdoing every other domestic category tracked by Morningstar. Is real estate due for a downturn this year? Maybe not. During the first two months of 2007, real estate funds returned 5.3 percent, about five percentage points ahead of the Standard & Poor's 500-stock index. The funds typically invest in REITs (real estate investment trusts) which own commercial properties such as office buildings, apartments and shopping malls. At a time when prices of single-family houses are weakening, rents are rising for many kinds of commercial real estate.

Along with healthy rents, there are several reasons to think that the current real estate upswing could have an unusually long life. For starters, global demand is helping to push up U.S. prices. Investors from Germany and Australia have been leaders in paying record prices for prime office buildings and warehouses. U.S. prices, while not cheap, are lower than comparable figures in markets like London.

Low global interest rates are also helping to fuel the move to real estate. To appreciate the importance of low rates, consider that a prime office building in the U.S. may provide a buyer a yield of 5 percent--a modest return. But an Australian investor can borrow at 2 percent in Tokyo and invest the money to earn 5 percent in New York. That's a profitable transaction, and on top of the income, the investor stands to enjoy capital appreciation if the building's price rises.

The move to real estate began after stock markets collapsed in 2000 and 2001. Long considered a slow-moving investment, real estate suddenly looked relatively solid. While the prices of Internet high-flyers plunged to zero, prime office buildings held their values. Besides providing nice returns, real estate offers compelling diversification. When the S&P 500 lost 9.1 percent in 2000, the average real estate fund returned 32.0 percent.

Which real estate vehicle is likely to offer the best ride now? To find the top choice, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alphas must also exceed category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The search reduced the field from 199 selections down to 48. A top finisher was Alpine International Real Estate, but we eliminated that strong choice because we wanted to focus on domestic funds. Other contenders included First American Real Estate Securities and Cohen & Steers Realty Shares. Finally, we gave the title to Phoenix Real Estate Securities A, which had strong returns and a domestic focus.

Phoenix achieved its record by sticking with big, strong companies. The fund aims to find growing companies that seem positioned to continue improving for years. "We are not interested in buying troubled companies that may sell at a discount," says portfolio manager Michael Schatt. "We want experienced managements with good assets."

The fund typically holds REITs in a mix of sectors, including malls, warehouses, hotels, offices and apartments. A big holding is Simon Property Group, an owner of regional malls. Schatt says that Simon is the premium choice in its industry. The company owns 324 properties, including many high-end malls that record high sales per square foot. Besides collecting rents, Simon derives income from providing advertising space in the malls. The company is beginning to grow overseas, opening new sites in China. Schatt says that Simon's size gives it clout with retail chains. "They can negotiate top rents from chains that want to have the best locations," he says.

Another holding is ProLogis Trust, a major owner of warehouses. At a time when global trade is creating more demand for efficient distribution space, ProLogis has been leading the industry. The company builds big facilities that are designed to save time for truckers, a key issue for shippers facing global competition. Because the warehouses have many loading docks, trucks can quickly transfer their cargo to forklifts that stack the goods on high racks. "ProLogis has been building state-of-the-art warehouses near ports and airports, places where cargo shipments are growing rapidly," says Schatt.

The portfolio manager prefers REITs that focus on strong local markets. A favorite holding is Vornado Realty Trust, which owns office buildings mainly in New York City and Washington, D.C. Vornado has properties in key downtown locations. Because land is expensive and construction regulations are tough in both cities, competitors would have a hard time building new offices and stealing market share from Vornado. "There are few empty sites in midtown Manhattan," says Schatt. "Because of the scarcity, the value of Vornado's properties should continue rising."

Another holding with properties in New York and Washington is Archstone-Smith Trust, an owner of apartments. Demand for apartments remains strong in the two cities. Archstone-Smith does not rest on its laurels. The REIT continually reviews its portfolio, which includes 267 apartment complexes. Archstone sells the weakest properties and uses the proceeds to invest in more promising projects. By constantly buying and selling, the REIT aims to increase earnings and provide the strong returns that attract growth-oriented investors like Phoenix Real Estate Securities.

Stan Luxenberg (sluxenberg1@nyc.rr.com), Wealth Manager's "Best of Breed" columnist, is a New York-based freelance business writer and a regular contributor to the magazine.

Reprints Discuss this story
This is where the comments go.