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.