John Wenker and Julene Melquist of First American Real Estate Securities Fund

Quick Take: Real estate stocks have prospered over the past few years as interest rates hit historic lows and investors sought out stable, high-yielding REITs to escape the tech melt-down. Now, as interest rates start to ascend, some worry about REITs. The relationship between interest rates and REITs, however, is quite complex.

John G. Wenker and Julene R. Melquist, co-managers of the First American Real Estate Securities Fund (FREAX), believe as the economy improves and real estate occupancy rates eventually rise, any harm from higher interest rates will likely be mitigated by REITs’ higher earnings.

For the one-year period through July, the $433-million fund gained 21.2%, while its benchmark, the Morgan Stanley REIT Index rose 20.6%, and the average real-estate fund was up 21.6%. Over the longer term, the fund climbed 17.3%, annualized, for the three-year period through July, while the peer group rose 16.3%. For the five-year period, the fund gained 16.0%, while the peer group was up 15.3%.

Wenker and Melquist began co-managing the fund in October 1999.

The Full Interview:

S&P: What kind of REITs do you invest in?

MELQUIST: We focus on quality, i.e., REITs with strong managements, growing cash flow, and reasonable valuations. We tend to sacrifice some yield, as lower-quality REITs provide greater yield. The average REIT currently has a yield of about 5.5%, while our fund’s average yield is closer to 4.0%.

S&P: Aside from low interest rates, why have REITs performed so well over the past few years?

MELQUIST: In the late 1990s, REITs were sluggish because their yields were much less than soaring high-tech stocks. When the tech bubble burst in early 2000, REITs became attractive because of their stability and yields. REITs are required to pay out at least 90% of their taxable income to shareholders in the form of dividends. When the Fed started slashing interest rates in early 2001, REITs became even more popular.

S&P: How do interest rates affect REITs?

WENKER: In the short term, REIT returns are hurt by higher interest rates, as in April when long-term rates — the 10-year Treasury bond yield — started rising after a bullish employment report. However, quantitative studies have shown that interest-rate changes have little or no impact on REIT prices over the long term.

MELQUIST: REITs can benefit as interest rates rise. When the Fed raises rates, the economy usually is improving, more people are getting jobs, and occupancy rates for offices and apartments are rising.

S&P: The Morgan Stanley REIT Index fell sharply in April. Was that an overreaction?

WENKER: We think it was a healthy correction. For the 15 months from January 2003 through March, the index surged 54.6% to an all-time high on April 1. At that point, we figured many REITS were trading at 15% to 20% premiums to their respective NAVs. But after the strong jobs report, the index fell about 20% from April 2 through mid-May, leading to more reasonable REIT valuations. Since then, the index rebounded about 15% or so, boosting valuations to about 5% to 6% less than their all-time highs.

S&P: What are your largest holdings?

WENKER: As of June 30: Public Storage (PSA), 4.6%; Vornado Realty Trust (VNO), 4.1%; Boston Properties (BXP), 3.9%; Developers Diversified Realty (DDR), 3.8%; Newcastle Investment (NCT), 3.5%; LaSalle Hotel Properties (LHO), 3.3%; Apartment Investment & Management (AIV), 3.2%; Mills Corp. (MLS), 3.0%; Rouse Co. (RSE), 2.9%; and Simon Property Group (SPG), 2.9%.

MELQUIST: We typically hold 45 to 75 stocks, and we currently have about 60 holdings. The top-ten stocks represent about 35% of the fund’s total assets.

S&P: How large is the universe of publicly-traded U.S. REITs?

MELQUIST: There are about 150 investible REITs. It’s a relatively small industry, less than 0.5% of the S&P 500-stock index.

S&P: What are your top sectors?