By Art Gering

Fund flows continue to pour into the industry, but what does this mean for REITs and is this growth sustainable?

To the real estate mutual fund industry, for which the fund flow cup has either been full or empty, this year's record-setting results have to be heartening. Through Dec. 4, $4.2 billion had flowed into real estate mutual funds, according to AMG Data Services, surpassing the previous annual record of $4.1 billion set in 1997. In all of 2002, $3.4 billion came in.

The cash that has flowed into the industry in 2002 and 2003, in part the result of broader market tumult, has many REIT observers warily pondering whether the money is permanent, or "sticky." After all, $2.9 billion was drained from funds from the second quarter of 1998 to the end of the first quarter of 2000, according to data compiled by Citigroup Smith Barney's senior REIT analyst Jonathan Litt. But real estate mutual fund flows reversed course thereafter and have posted positive flows in 12 of the past 14 quarters, leading many to believe that something bigger than changing investor appetites is taking place.

"The big question is whether the increased attractiveness of real estate and REIT stocks is simply a short-term phenomenon in response to low interest rates and a lack of confidence in growth stocks following a gut-wrenching bear market or whether it's a secular trend," notes Ralph Block, a former principal with Bay Isle Financial and the current head of Essential REIT Publishing.

Some industry analysts believe that a more informed retail investor has emerged in the market and that this group will be able to sustain positive fund flows at some level. It's difficult to say with complete certainty, but the better informed investor universe appears to grasp what REITs are. Those investors are looking for stable and realistic returns from their portfolios and are motivated by the looming financial demands of retirement.

The effects of positive fund flows have rippled throughout the industry, stimulating debate among analysts, portfolio managers and investors on a number of related topics. For instance, what portion of fund flow activity can be attributed to investors chasing performance? And what can be inferred from fund flows, anyway?

Additionally, some analysts question whether positive fund flows will slow as fixed-income investments begin to look more attractive in a rising interest rate environment. It's a fair matter to consider, as REIT dividend yields fell while industry indexes climbed in 2003.

"Investors are warming up to the idea of investing in REITs and may be concluding that the industry is not as cyclical as it has been in the past," says Dan McNeela, fund analyst at Morningstar Associates. He notes that stable REIT dividend yields, currently around 6 percent, stand out in a low interest rate environment and REITs have maintained profitability through the bear market that sent major indexes reeling.

REITs Gain Higher Profile

Perhaps the profile of REITs in the public consciousness was elevated to a new stature when Carmela advised Tony that they should look into "these things called REITs" in a 2002 episode of "The Sopranos." No one is claiming a Sopranos effect on the industry, but many are saying that the financial planning community has successfully pushed the attributes of REIT investing to their retail investor clients over the past few years.

Bruce Brittain, a certified financial planner and the manager of research and investments for Brittain Financial Advisors, says the tech frenzy that fueled the late 1990s bull market encouraged unrealistic hopes of great riches for retail investors.

"They kept hearing about the dot-coms that were going to take their small savings and make them multimillionaires," Brittain says. "The greed bug bit a lot of people and they lost sight of building a solid foundation (in their portfolios)."

Individual investors have come to their senses and now have a better understanding of what level of returns are reasonable to expect and what REITs can do for their portfolios, Brittain adds.

"The capital that has been coming in lately has been buying REITs because of their attributes as an investment," according to Jim Trowbridge, portfolio manager of the AIM Real Estate Fund. "We have a more stable investment base today than we had in 1993 and 1994. A lot of individuals are saying they want real estate in their portfolio."

Draw of Dividends

Legislation paring the tax on dividends has had significant meaning for REITs, although the new law did not directly impact most of the dividends from the individual companies. Nonetheless, dividend-paying stocks are gaining more notoriety than before and are developing a wider appeal for the investing public.

Some mutual fund companies are even preparing dividend-focused mutual fund offerings. One such fund, the Scudder Tax-Advantaged Dividend Fund, will invest in a mix of dividend-paying stocks, high-yield bonds and REIT shares, according to a published report in The Wall Street Journal.

The focus on dividends intensifies and gathers importance as the U.S. population ages. Current income becomes a more crucial aspect of investment portfolios for older individuals.

"Baby boomers, the largest class of U.S. investors, are positioning what's left of their portfolios for safety and yield," says Stephanie Krewson, senior vice president at BB&T Capital Markets. "REITs are a likely beneficiary of these fund flows."

		Impact of Interest Rates Because REITs are viewed as a yield play, some analysts worry what might occur when interest rates, as measured by the 10-year U.S. Treasury, rise.

Baby boomers comprise the segment of the U.S. population born from 1946 to 1964. According to the U.S. Census Bureau, baby boomers numbered 82.8 million in 2000, or 29.4 percent of the population. In 2010, their ranks are expected to drop to 75.2 million, or 25 percent of the population.

At the end of 2003, baby boomers will be aged from 39 to 57 years. Some of the oldest will have already retired while greater numbers will be fast approaching retirement age.

"Demographics favor income-oriented investments," Trowbridge says, adding that the importance of dividend income to an aging population has emerged as a factor capable of sustaining additional positive fund flows into real estate mutual funds. "Demand for real estate securities will increase."

Flavor of the Month

If the "rational" money is supporting positive fund flows into real estate mutual funds, there is also a segment of the investing public that does not behave as rationally. The so-called "hot" money is simply eager to get in the game with whatever is the current favorite sector of the month.

Bob Gadsden is a portfolio manager of Alpine Management & Research LLC's U.S. Real Estate Equity Fund, which Morningstar reports has returned 66.6 percent year-to-date through mid October and 62.4 percent over a one-year period. The fund, which invests in a combination of publicly traded REITs and homebuilders, has also produced a 32.2 percent return over three years. Gadsden acknowledges the fund has probably attracted new investors solely because of the high returns it has produced.

"That seems to be the nature of the beast," Gadsden relates. "If you're performing, you get your fair share. If you put up knockout numbers, you get more than your fair share."

David Fick, managing director of Legg Mason Wood Walker, agrees that there is definitely a "herd mentality" in the investment community. "There are investors who chase performance. You see it time after time," he says.

And the performance of REITs that some investors are chasing has been impressive. Through late October, specialty-real estate funds, as Morningstar classifies dedicated real estate funds, had delivered year-to-date returns of 28.5 percent, the seventh best performance among 20 classes of equity funds. The returns of real estate mutual funds also stand up well over three and five-year timetables (see table on page 48).

Performance of Real Estate Mutual Funds
Period	Return	Rank
YTD	28.5%	7
One year	35.5%	6
Three year	16.6%	1
Five year	13.3%	2
Note: All returns are through Oct. 21, 2003. Rank refers to real estate funds' placement among 20 classes of equity mutual funds Source: Morningstar Associates

The problem with "hot" money, many point out, is that it typically doesn't stick around. Some REIT observers fear the next sector providing outrageous returns, like tech stocks did in the late '90s, could siphon money from real estate. But the tech-heavy Nasdaq Composite Index is up more than 40 percent through October 2003 and money continues to come into real estate, providing fodder for those who insist much of the recent money is indeed in for the long term.

What Does the Data Mean?

Every Wednesday, AMG reports fund flows data. When REIT analysts and industry commentators report whether the results are up or down from the preceding week, the meaning and usefulness of fund flow data is revealed.

"They're kind of like the University of Michigan Consumer Confidence Survey," says Barry Vinocur, editor of Realty Stock Review, and one of those who tracks fund flows.

		More Funds Greater Flows An examination of fund flows raises a lot of interesting questions.

Indeed, if anyone wants to find out which way the wind is blowing in the REIT world, check out the fund flow data. During the eight-month period from the second quarter of 1998 to the first quarter of 2000, encompassing the last REIT bear market, $2.9 billion retreated from REIT funds and the NAREIT Composite Index fell from 1,115.00 to 1,017.95. The index bottomed out at 1,008.65 on March 14, 2000.

Beginning in the second quarter of 2000, the early days of the tech collapse and the onset of the REIT bull market, and continuing through the end of the third quarter of 2003, approximately $7 billion flowed into the sector. From its nadir on March 14, 2000, the NAREIT Index has nearly doubled, climbing to 1,971.87.

Based upon this information, Krewson and others contend fund flows data are a coincident indicator of investor sentiment. The numbers, however, only faintly reflect real estate fundamentals. Even though flows are positive and have been increasing, most observers would agree that property performance has deteriorated since the second quarter of 2000.

Other Capital Sources

For all that the numbers purport to say about investors' views on REITs, mutual funds represent only one of several ways capital comes into the industry. For example, the fund flow data from AMG and other sources fails to account for closed-end fund activity, an important source of capital for the REIT industry, Vinocur and others point out.

New REIT closed-end funds raised $4.3 billion through the end of October 2003, according to Vinocur. Two additional funds were registered in September: the USA REIT Fund and Cohen & Steers' REIT and Utility Income Fund.

Also, there is no easy way to track the amount of institutional money coming into the industry through vehicles such as separate accounts. "Our estimates suggest that for every dollar that's flowing into mutual funds, there's probably a minimum of $2 or $3 flowing in from institutions," Vinocur says.

Unlike institutional fund flow data, information on mutual fund flows is widely disseminated and reported. By examining it, or at least heeding it, analysts, investors and REIT commentators are able to corroborate the anecdotal accounts of investment activity shared among industry insiders. These accounts become credible when supported with numbers.

The amount of money coming in may be encouraging initial public offerings by prospective REIT management teams. Through the end of October 2003, five such offerings had been brought to market.

Krewson reports several well-run private firms are considering going public. "I think we'll see a lot of the demand for REIT shares absorbed by these and other new REITs," she says. "Hopefully, Wall Street will be disciplined enough to try and stick with the better management teams that go public because they should, rather than because they can."

		Correlations grow stronger Real estate mutual fund flows have become more positively correlated to the S&P 500 since 2001, when the first REITs were added to the index, according to Stephanie Krewson, a senior vice president at BB&T Capital Markets.

Legg Mason's Fick says the industry could use the additional capacity provided by new companies. Currently, there is a lot of capital chasing a limited market capitalization and float, he maintains. "The float is a lot less than what is implied because a lot of people buy the shares and hold them," he says.

Karen Knudson, portfolio manager and principal for Scudder RREEF, adds that publicly traded real estate firms hold only a small portion of the total value of all commercial real estate. "It feels like we could penetrate a little more and support a larger publicly traded real estate market," she says.

Institutional and retail investors should like more choices of companies to invest in, but eventually concerns emerge over whether the money can be put to work. Ralph Block, for one, warns of the downside of excessive capital flows learned from earlier capital booms.

"We saw then that a number of new, unproven companies with faulty strategies and inept management may take advantage of the free-flowing capital, make lots of promises to shareholders and fail to deliver," he says. "If this should happen, the credibility of the entire industry could be affected."

As money pours into the industry through mutual funds and from institutional sources, perhaps no less than credibility is at stake. New investors have bought into the REIT story of stable dividends, beneficial diversification and modest growth. Any failure by REITs to fulfill these expectations could reverse the flow of funds, perhaps significantly.