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David Lee of T. Rowe Price Real Estate Fund

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Quick Take: This year may go down on record as one of the worst for U.S. and global equity markets, with the vast majority of stocks and sectors deep in the red so far. The real estate sector, however, has been a bright spot. While REITs themselves don’t typically deliver huge returns, they can provide a cushion in a declining market environment with their high dividend yields as well as capital appreciation.

T Rowe Price Real Estate Fund (TRREX), a strong performer in the sector, gained 10.9% for the 12-month period ended July 31, 2002, while sector funds on average fell 20%. For the three-year period ended July 31, the portfolio edged out its peers, rising 13.7% annualized, versus a gain of 12.4% for the average real estate fund. The Wilshire Real Estate Securities Index, which is the fund’s benchmark, gained 8.9% for the one-year period, and 13% for the three-year period ended in July.

David Lee, who has managed T. Rowe Price Real Estate fund since its inception in October 1997, generally favors large-cap companies in mainstream real estate sectors like apartments, retail and office properties. As of June 30, the portfolio had about $113 million in assets comprising 38 stocks.

The Full Interview:

S&P: What kind of stocks do you look for?

LEE: We typically like to invest in real estate companies that have strong balance sheets, strong portfolios, and that are operating in vibrant markets. We have a bias toward management teams that are `value creators’ — that is, they add value by consistently growing net asset values on a per share basis. Most of our holdings are highly-liquid, large-cap names in mainstream segments of the industry.

Although we like the substantial dividend yields provided by REITs, our investment approach is more balanced. We like to focus on total return, combining distributions with capital appreciation. We have the flexibility to own stocks that are not `purely’ real estate stocks, like homebuilders, health care REITs and mortgage REITs, but we tend not to invest there. On a risk-adjusted basis we don’t find them attractive investments.

S&P: Why do you keep the fund so concentrated?

LEE: There are hundreds of REIT stocks in the U.S. to choose from, but we like to make meaningful bets on our favorite holdings. Despite the concentrated nature of the portfolio, I think we are sufficiently diversified. Our holdings themselves comprise a highly varied portfolios of assets.

S&P: In the first half of 2002, real estate stocks performed very well, while most of the overall market plunged. Why did the REIT sector do so well?

I think investors were attracted to the dividends and high yields that REIT stocks provide, as well as their cash-flow characteristics and the contractual nature of these businesses. However, fundamentals in the real estate industry are actually weakening — REITs are not immune to the downturn in the overall economy, but they can provide a bit of a buffer from a weak economy.

Our fund gained about 12.8% in the first half, while the S&P 500 dropped 13.2% and the NASDAQ Composite plunged nearly 25%.

Our fund’s performance in the first half of the year was buoyed by superb returns from our retail holdings, particularly mall operators like Simon Property Group (SPG) and General Growth Properties (GGP), which have benefited from relatively robust consumer spending.

S&P: What are the fund’s largest holdings?

LEE: As of June 30: Equity Office Properties (EOP), 7.1%; Vornado Realty Trust (VNO), 4.9%; Simon Property Group (SPG), 4.0%; Equity Residential (EQR), 4.0%; Boston Properties (BXP), 3.9%; ProLogis Trust (PLD), 3.6%; Avalonbay Communities (AVB), 3.4%; Regency Centers (REG) 3.3%; Camden Property Trust (CPT), 3.1%; and Weingarten Realty Investors (WRI), 3.0%. These ten stocks represented 40.3% of the portfolio’s total assets.

S&P: What are the fund’s largest sectors?

LEE: As of June 30: Apartment/residential, 21.3%; Office, 20.3%; Shopping Centers, 10.1%; Regional Mall, 8.8%; Industrial, 8.7%; Diversified, 7.2%; Office & Industrial, 6.4%; Manufactured Housing, 4.4%; Lodging & Leisure, 4.4%; and Self Storage, 2.4%.

S&P: The REIT sector seems to have sold off a bit since the end of June. Has this made it more attractive to you as a buyer?

LEE: The sector has sold off because the economic doldrums in the country have deepened. This is clearly a troubling sign. However, as the stocks have corrected some, their valuations relative to their net asset values have indeed made them more attractive buys.

S&P: Can you describe two of your recent stock purchases?

LEE: In the first half of 2002, we bought initial positions in United Dominion Realty Trust (UDR) and Essex Property Trust (ESS). Both are apartment operators.

United Dominion is a well-established nationwide apartment REIT which hired a new chief executive, Thomas Toomey, in February of last year. Toomey has an excellent track record and was formerly at Apartment Investment and Management Co. (AIV). Before buying United Dominion, however, we wanted to see that the company could deliver some strong quarterly performances under his stewardship, which it did. We think Mr. Toomey will be able to increase the operational efficiencies from United Dominion’s portfolio of assets.

Essex Property is a company we have long admired, but we didn’t purchase the stock until its price came under some pressure earlier this year as the real estate market on the West Coast weakened. Essex has a heavy presence in California and the Pacific Northwest.

S&P: Tell me about ProLogis Trust. They’ve done very well this year — the stock is up about 25% year to date.

LEE: ProLogis Trust is a REIT that operates a global network of industrial distribution facilities. They are a highly proficient developer of industrial properties, and they are also earning management fees through some of their institutional partnerships. ProLogis is unique in that it has significant business operations overseas. They are already well-established in Europe and they’ve recently launched a division in Japan. It’s quite unusual for an American real estate company to have operations overseas.

S&P: Your top holding as of June 30, Equity Office Properties, has been sluggish this year.

LEE: The company hasn’t done well because the office sub-sector as a whole has had it tough this year with declining fundamentals. But we like the company’s management team and portfolio of assets. In addition, last year Equity Office acquired Spieker Properties, a deal that made it the largest merger in REIT history. But Spieker has a large exposure to the San Francisco-San Jose market, which has been under some pressure, thus hurting the performance of Equity Office’s stock.

Incidentally, our exposure to Equity Office is actually an underweight position relative to our benchmark, the Wilshire Real Estate Securities Index.

S&P: Do you favor one region of the U.S. over another?

LEE: We like real estate companies that operate in areas that provide high barriers to entry. This condition tends to exist on either coast. As a result, we have heavy exposure to companies operating in places like New York, Boston, California and Florida.

S&P: What do you sell?

LEE:. We will sell a holding when there is a change in our original investment thesis, when our confidence level management’s strategy declines, or when we can find a more attractive substitute for the portfolio. We have a moderate turnover, however, generally below 50% annually.

S&P: Can you cite two stocks you recently sold off?

LEE: We sold off JP Realty — but that occurred only because the company was acquired at a premium by General Growth Properties in an all-cash takeover. We made a substantial profit on JP Realty.

A more convention sale was Alexandria Real Estate (ARE), a company that supplies space and facilities to life sciences businesses. Although the stock has performed well this year, up about 25% in the first half of 2002, we became increasingly concerned about the prospects of its tenant base, given the problems in the life sciences industry. We felt that Alexandria’s stock price had not taken this into account, so we eliminated it. However, we still like their management team very much.

S&P: What is your outlook for the real estate sector?

LEE: One subject we are concerned about is the potential lack of demand in property space. While supply levels are falling, we need to see a steady increase in demand for the REIT sector to flourish — and higher demand is predicated on a stronger US economy.


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