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Real Estate Funds Cash Out, But Only Briefly

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With the wisdom of hindsight, many investors are vigilantly watching for signs of the next technology-like market crash in the real estate sector. After Morgan Stanley’s MSCI US REIT index reached an all-time peak of 885 on August 2, some investors worried as stock prices seesawed mostly down, hitting a low of 783 on October 13.

During that period, Standard & Poor’s noticed that three real estate mutual funds had reported cash levels above 10% as of August 31, 2005, based on the latest figures available in our database for 234 funds. Because mutual funds typically aim to be fully invested, we asked several managers if these cash hoards were defensive plays against an expected future crash. Or, more optimistically, were the managers building arsenals for use in a buying opportunity?

In this case, holding a lot of cash did not mean that these portfolio managers were expecting a bust. Michael Winer, manager of the Third Avenue Real Estate Fund Third Avenue Real Estate Value Fund (TAREX) said the 12.79% cash level in his fund in late August was not unusually high. Last June, cash had represented 28% of assets. “We consider ourselves fully invested when under 10%, but we have been over that because of growth of the fund,” he said. “It’s a function of our ability to put money to work as fast as it was coming in.” Due to rapid inflows of new cash, the $2.86-billion deep value fund was closed to new investors on July 1, though it might be reopened if cash levels again drop below 10%.

Winer said he was avoiding stocks of companies building condominiums, especially in overheated markets like South Florida and Las Vegas. But the other income-producing, largely commercial sectors in which his fund invests — multi-family housing, office buildings, industrial, hotels — look “very solid,” he said. Winer described the pullback in real estate investment trust (REIT) stock prices that began in August as a “great opportunity to add to holdings.” A year ago, he began buying U.K. property companies, and more recently Hong Kong firms. About 13% of the fund’s assets are now invested in real estate companies outside North America. In terms of diversification, this move makes sense to Standard & Poor’s, which finds that property stocks are less correlated internationally than traditional equities or bonds in general.

Alex Peters, portfolio manager of the $760-million Franklin Real Estate Securities Fund/A (FREEX), admitted that the fund’s 16.5% cash level in August was higher than normal. “I was having trouble finding opportunities at that point,” he said. Peters stressed that this position was due more to his bottom-up investment style than to any macroeconomic call. The fund doesn’t have a targeted cash level. Peters said he is somewhat wary of apartment REITs at present, because they “have held up the best, and have the furthest to fall” in the event of a downturn. But he feels that retail and mall stocks, which represent his fund’s largest holdings, could best weather such a turn.

Although Robert Gadsden’s $640.3-million Alpine Realty Income & Growth Fund/Y (AIGYX) had 10.46% cash in late August and nearly 12% in late July, the fund “basically doesn’t have a cash position” at present, Gadsden said. During the summer, the fund took some profits by trimming back health care and other REITs. “We weren’t eager to invest it at that point, because we didn’t like the valuations,” Gadsden said. Since then, customer redemptions, and new stock purchases by the fund as shares dropped further, have dissipated the cash hoard.

Though Gadsden sees improving fundamentals in all property types, he is particularly bullish on lodging, apartment, and office REITs. Higher-end hotels are seeing little additional inventory and are able to raise prices, he said. Office REITs are a “mixed bag,” due to leases signed after the commercial market passed its 1998-2000 highs, Gadsden said. But he expects the coastal regions in which his fund’s office REITs are concentrated, specifically Southern California, New York, and Washington, D.C., to enjoy rising rents of potentially 10%. Gadsden also confesses to lowered expectations. “We’re expecting returns in the real estate and REIT groups to be more in keeping with traditional real estate returns, not in the 30% rate you’ve seen over the last couple of years,” he said. “There’s a tension between rising interest rates but improving cash flow.”

While these portfolio managers aren’t expecting an imminent crisis in commercial real estate, a caveat mentioned by Gadsden is that interest rates are the wild card. “As long as interest rates don’t accelerate significantly, we think the improvements in the economy ought to benefit real estate companies, speaking broadly,” Gadsden said. If financing becomes more expensive and other investment alternatives more attractive, less money will flow into real estate. As of November 11, the Morgan Stanley REIT index had recovered to 845.

Raymond Mathis, an equity analyst covering REITs for Standard & Poor’s, is generally bullish on the sector. He points out that REIT stocks typically have lower volatility than those in a broader index because their dividend yield can never be negative. (By law, REITs must pay at least 90% of their earnings as dividend.) “Over time, those dividends accumulate until you’ve been paid back,” Mathis said. “Even if a company is insolvent, it’s unlikely to implode because the shares represent claims on hard assets.”

In an October 2005 study, (“Listed Property and REITs — A Compelling Case for Popularity”), Standard & Poor’s found that from 1994 to 2004 more than two-thirds of the growth in the property sector came from REITs. We generally see property stocks, defined as those held in companies deriving more than 60% of revenue from real estate development, management, rental, and/or direct investment in physical property, as offering greater liquidity and transparency than directly owned real estate, while reducing volatility in an investment portfolio. This asset class offers the potential capital gains of equities, along with a steady income stream similar to that of bonds.

Nonetheless, like all sector funds, those dedicated to real estate are mandated to invest in a specific area of the market, whether it outperforms or sputters. As Winer put it, “The market could be overvalued, but we invest in companies we think are undervalued.” In addition, investors should consider how much exposure they already have to a given sector in core, broad-based funds. Notwithstanding careful stock picking, Standard & Poor’s generally recommends limiting sector funds to no more than 5% to 10% of an overall fund allocation.


Cash as % of assets*

Year-to-Date Return (%)

3-Year Annualized Return (%)

5-Year Annualized Return, Annualized (%)

Expense Ratio (%)

Alpine Realty Income & Growth Fund/Y (AIGYX)






Franklin Real Estate Securities Fund/A (FREEX)






Third Avenue Real Estate Value Fund (TAREX)






*As of 8/31/ has more mutual fund news from Standard & Poor’s available here.