Aging Bull

After stagnating in 1999, real estate funds soared. During the next seven years, the fund category returned 21.8 percent annually, according to Morningstar. Now some advisors worry that the real estate rocket ship is due to crash. But there are good reasons to continue holding the funds. For starters, the fundamental performance of commercial real estate appears sound. Rents are rising for apartments,

After stagnating in 1999, real estate funds soared. During the next seven years, the fund category returned 21.8 percent annually, according to Morningstar. Now some advisors worry that the real estate rocket ship is due to crash. But there are good reasons to continue holding the funds.

For starters, the fundamental performance of commercial real estate appears sound. Rents are rising for apartments, offices and warehouses. That is good news for real estate funds, which primarily hold real estate investment trusts (REITs), companies that own portfolios of commercial properties. In addition, money is flooding into commercial real estate. Though prices of single-family homes may be weakening, pension funds and other big buyers are bidding ferociously for quality office buildings and warehouses. Big institutions see real estate as a solid income source: While the price of a stock can go to zero, a prime office building is likely to hold at least some value.

Institutional Cash

The flow of pension money into prime properties is not likely to end any time soon. After Wall Street collapsed in 2000, many pensions re-examined their asset allocations and decided to switch a few percentage points of total portfolios from stocks to real estate. This move represented a shift of billions of dollars. The giant funds typically take several years to accomplish a change in assets, and many have not yet reached their new target allocations. In a survey by the Pension Real Estate Association, about one-third of large pensions aim to keep at least 10 percent of their assets in real estate. But only 12 percent of the funds have reached their intended goal. “With lots of money still coming into the property markets, real estate funds have a good chance of producing double-digit returns this year,” says Amos Rogers, portfolio manager of SSgA Tuckerman Active REIT fund.

Along with their return potential, real estate funds can serve as powerful diversifiers. This became obvious as the 1990s bull market ended. While the S&P 500 dropped 9.1 percent in 2000, real estate funds gained 27.0 percent. “I like to keep at least 5 percent of a client's assets in real estate — just for the diversification,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Waltham, Mass.

Some of the most effective diversification can come from global real estate funds, which hold foreign and domestic stocks. In many cases, real estate depends on local market conditions. So property prices may be rising in Paris when they are falling in San Francisco. A top global performer is Alpine International Real Estate. Portfolio manager Samuel Lieber looks for solid real estate companies that have been overlooked by the crowd. Currently, he is interested in Norway. The country suffered through a real estate slump earlier in the decade. But now the economy is turning around as oil revenues prop up consumer and government spending. A favorite holding is Norwegian Property, which owns high-quality office buildings in Oslo and other cities. “This is a very solid company that produces a nice dividend,” says Lieber.

Another international choice is ING Global Real Estate. The fund holds solid companies in the U.S. and abroad. Portfolio manager Christopher Reich is particularly interested in companies with strong growth prospects. He is currently focusing on Japan, a country that is just starting to recover from 15 years of soft real estate markets. “We still see some Japanese companies trading at discounts, even though rents are finally starting to rise,” says Reich.

He particularly likes Mitsubishi Estate, a big owner of office buildings in Tokyo. Although Japan's population is not growing, Tokyo continues to expand as people leave outlying areas in search of better jobs in the city.

Goldman Sachs Real Estate focuses on U.S. companies, but the fund still provides significant diversification. The relative predictor of an investment's performance is 31.0, suggesting that the correlation with the S&P 500 is much lower than what an investor would get with a typical domestic equity fund. Goldman Sachs favors REITs in growing markets. The fund particularly likes apartment REITs in the Northeast and California. “In those areas, prices of single-family homes are so high that apartment landlords have room to raise rents,” says portfolio manager Collin Bell.

A recent holding was AvalonBay Communities, a REIT that owns high-quality apartments in New York, Washington, D.C. and Southern California. The REIT has been able to improve earnings by selling weak units and building in strong markets.

To own a broad portfolio, consider SSgA Tuckerman Active REIT. The fund buys companies that own high-quality properties and can grow faster than peers. Portfolio manager Amos Rogers seeks REITs in every major sector, including offices, apartments, retail and industrial. Once he buys a stock, Rogers typically holds the shares for several years.

A big holding is ProLogis, an owner of high-quality warehouses. “With global trade increasing, the demand for warehouses is growing steadily,” says Rogers.

SSgA also owns Simon Property Group, a REIT that owns high-end regional malls. Because it invests in strategically located properties around the country, Simon has bargaining leverage to seek high rents from national chains, says Rogers.

Another diversified domestic choice is T. Rowe Price Real Estate. Portfolio manager David Lee works methodically, buying companies that seem likely to grow for years. Once he buys, Lee rarely sells. The fund has an annual turnover rate of only 18 percent.

Lee is keen on apartments. Demand is growing as the children of the baby boom generation leave college. “With mortgage rates rising in recent years, young people are being forced to postpone buying single-family homes,” says Lee.

Apartment holdings include Archstone-Smith Trust, a REIT with properties in New York and other major cities. The company faces limited competition, since it is difficult to build new units in crowded urban areas.

Besides delivering solid capital gains, the T. Rowe Price fund pays a dividend of 3.6 percent. That kind of income can tempt clients to consider a real estate fund.

This Must Be the Place

These soaring real estate funds may reach greater heights.
Fund Ticker 1-Year Return 3-Year Return 5-Year Return Maximum Front Load Category % 5-Year Rank
Alpine International Real Estate EGLRX 38.7% 30.4% 29.5% 0% 3
Goldman Sachs Real Estate A GREAX 34.3 26.7 23.9 5.50 40
ING Global Real Estate A IGLAX 40.4 29.7 26.3 5.75 7
SSgA Tuckerman Active REIT SSREX 36.0 28.8 24.6 0 28
T. Rowe Price Real Estate TRREX 36.8 29.9 25.0 0 23
Source: Morningstar
Returns through 12/31/06.
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