From the June 2008 issue of Wealth Manager Web • Subscribe!

Are REITs a blue light special?

Let's face the facts: The subprime mortgage meltdown, the credit crunch, asset write-downs and the looming economic recession have resulted in increased volatility, financial market turmoil and a sharply lower financial sector. And real estate is bearing the brunt!

While there is no denying that the residential housing market is currently weak and may have a lasting impact on the economy, what about the commercial real estate market? For our first Wealth Manager column on separate account managers and the universe in which they operate, we decided to look at the commercial real estate market--most often represented in portfolios by REITs. Of course, real estate itself is a relatively volatile asset class that--even in the best years--can experience drops of 10 percent or more. Market mavens note that in the 13 months from January 2007 to February 2008, the category was excessively punished--down 27.5 percent. Since that negative peak, the yield on the Dow Jones Wilshire REIT Index has risen from just under 3.5 percent to a hefty 4.9 percent--more than the yield on U.S. Treasuries and the trailing 12-month rate of inflation. By avoiding the credit dislocation thus far, commercial real estate fundamentals are generally positive. But while the commercial subsector has shown itself to be substantially different than the residential subsector, the market has reacted as though the two are very similar.

In order to capitalize on both the current market valuations and the yield advantage, wealth managers might consider investing with a real estate manager with a fundamental asset valuation methodology and a secondary emphasis on current income. One such separate account manager is Adelante Capital Management, a boutique investment firm in Oakland, Calif. that specializes in real estate investing. The firm began as Lend Lease Real Estate in 1993 and was purchased by its own lead portfolio manager, Michael Torres, in 2004. Adelante currently manages $4.4 billion in real estate investments for institutional and retail clients.

Adelante's relatively concentrated portfolio typically consists of 25 to 35 REITS and other real estate securities. Its conservative investment philosophy centers on the current (and future) market value of each REIT's holdings.

Adelante's research process starts with an assessment of the real estate held by each REIT candidate. The firm prefers to invest in the core sectors of the real estate market including office, retail, and apartment properties where they have the most expertise and competitive advantage, avoiding specialty sectors such as manufactured housing and factory outlets. Adelante prefers quality, seasoned REIT management teams with histories of success in both operations and acquisitions. The final step in Adelante's research process is a tour of many of the individual properties to review on-site conditions and operations. This review is then used to modify the estimated value of each particular REIT's property portfolio.

Adelante's conservative, value-oriented and fundamental investment process naturally leads the portfolio to outperform the Wilshire REIT Index and its peer group by the widest margins during down markets. There have been just two calendar years out of the last 10 in which the index has delivered negative returns, and Adelante's total return strategy outperformed in both of those years by more than 700 basis points. In fact, the portfolio has beaten the index in eight of the last 10 calendar years, and the two shortfalls were by less than 1 percent. While short-term focused investors may be afraid of current market conditions and volatility, sage investors with a three- to five-year horizon may be well rewarded by acquiring these quality, managed real estate assets at today's discounted prices.

J. Gibson Watson III (watson@primacapital.com) is president and CEO of Prima Capital, a Denver-based firm that conducts objective, institutional-quality research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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