By Steve Bergsman
Varied investment strategies guided real estate
mutual funds to overwhelming success in 2003,
but fund managers stress caution for 2004
By any measure, 2003 was another stellar year to invest in publicly traded real estate. All of the leading industry benchmarks soared in 2003 thanks in part to a record level of inflows into publicly traded real estate. The National Association of Real Estate Investment Trust's (NAREIT) Composite REIT Index was up 38.47 percent; NAREIT's Equity REIT Index rose 37.13 percent last year; and the Morgan Stanley REIT Index jumped nearly 37 percent.
Those strong results certainly translated to real estate mutual funds. A quick glance at Lipper's performance ratings for real estate mutual funds in 2003 shows a considerable amount of uniform success. Most of the funds boasted average total returns for the year in the 30 percent to 39 percent range. By comparison, the S&P 500 was up 28.7 percent and the Dow Jones Industrial Average increased 25.3 percent.
Just sticking to the knitting in 2003 meant fund returns stayed relatively aligned with the major benchmarks. However, there were a handful of funds that did better, posting returns in the 40 percent to 49 percent range, plus three funds that sported results way beyond their peers: CGM Realty Fund with a return of 89.71 percent; Alpine U.S. Real Estate Equity Fund, at 81.97 percent; and Alpine International Real Estate Equity Fund, up 55.12 percent.
Portfolio talked with several of the managers of these top- performing funds to determine their 2003 investment strategies and get a sense of their outlook for the sector in 2004.
Exemplary Performance
While REIT stocks were a core component of the leading portfolios, the top performing CGM Realty Fund and Alpine U.S. Real Estate Equity Fund made the same non-REIT bet last year. They felt publicly traded homebuilders would outperform and they over-weighted in this non-REIT sector. To a lesser extent, but still in the over-weighted category, CGM's fund manager Kenneth Heebner and Alpine's Sam Lieber, president of Alpine Funds, invested in lodging companies, some REIT and some non-REIT.
Of Alpine's top 10 holdings in 2003 (about 50 percent of the portfolio), eight were homebuilders and two were lodging companies, La Quinta Properties, Inc. (NYSE: LQI) and MeriStar Hospitality Corporation (NYSE: MHX). While REITs comprised just 22 percent of Alpine's overall portfolio, it did own several strong REIT performers including Chelsea Property Group, Inc. (NYSE: CPG), up 59.38 percent; IMPAC Mortgage Holdings, Inc. (NYSE: IMH), up 60.12 percent; and Senior Housing Properties Trust (NYSE: SNH), up 59.84 percent.
While the strong returns generated by REITs has brought attention to the industry, Lieber is skeptical about seeing the same kind of spectacular returns in 2004. Lieber says the returns seen in 2003 were the result of the market coming out of a really depressed environment and a substantially large amount of capital coming into real estate.
"I don't think REITs or their share prices will collapse, but I don't see a lot of upside potential," Lieber says.
When asked what REIT sector he had the most confidence in, Lieber says, "At this stage of the cycle, growth prospects are certainly solid in the retail sector."
International Success
Alpine's International Real Estate Equity Fund posted the third highest total return in 2003 among the 76 funds ranked by Lipper. This fund is unique in that there are very few funds geared to global real estate companies. The only other international fund of considerable size also made Lipper's list of top 10 real estate funds in 2003—Morgan Stanley's Institutional Europe Real Estate Fund posted a 42.41 percent return. (Morgan Stanley also manages a much smaller Asia real estate fund and that was up 42.76 percent last year.)
Two things occurred last year to make overseas real estate funds great investments, says Theodore Bigman, a managing director for Morgan Stanley and portfolio manager for its REIT funds. First, not only was it a good year for real estate stocks in general, but on top of that there was also about a 25 percent return on local currencies. "Currency made a big difference," Bigman says.
Secondly, European funds got a major boost from the creation of new REIT-like vehicles, Bigman says. At the end of 2002, the French government proposed a REIT-like, tax-efficient structure and the plan was ratified and implemented toward the latter part of 2003. The U.K. also announced it was looking into creating REIT vehicles. The obvious trend line underscored some already strong real estate markets.
Of the three major real estate markets, U.S., Europe and Asia, Bigman predicts the big winner in 2004 will be Asia. "Hong Kong and Japan are the two most exciting markets. They are basically trading back at 1997 levels and a little bit of consumer confidence will get them going again," he says.
Asia is an asset replacement story, Bigman adds. "It will be more volatile, but Asia could really be the one market to reproduce the returns of 2003," he says, adding that he has more conservative expectations about the U.S. market in 2004.
On a sector basis, Bigman says he is more negative than most investors and analysts on office, but more favorable on hotels. Still, the Morgan Stanley Institutional U.S. Real Estate Fund held major positions in Equity Office Properties Trust (NYE: EOP) and Starwood Hotels & Resorts Worldwide Inc. (NYSE: HOT). In 2003, Morgan Stanley's domestic real estate fund did well with a smaller sector, manufactured housing, which had some takeover activity. For 2004, Bigman is keen on another smaller REIT sector, self-storage.
Index Fund Worships Efficiency
There was one other anomaly in the top performing real estate funds. The fourth best fund on Lipper's list is ProFunds Real Estate UltraSector, which jumped 49.87 percent. The difference between ProFunds and the other top performing real estate funds is that it is a leveraged index fund, benchmarked against the Dow Jones Real Estate Index.
What gives ProFunds real estate its zest is the leveraging, which is 1.5 times the performance of the index on a daily basis. So, if the index is up 1 percent, then the fund moves up 1.5 percent. Last year, the Dow Jones Real Estate Index was up 32.45 percent for the year.
"We are simply tracking the index," explains William Seale, chief investment officer of
ProFunds Advisors LLC. "The reason we do this is because we worship at the shrine of efficient markets, and we don't believe over the long-haul that an active manager would be able to outperform the benchmark index they are trying to capture. My thesis is, that as long as we have low-interest rates, real estate will be a good investment."
However, count Seale among the many fund managers who doesn't expect 2004 to be as rosy as 2003. Seale estimates returns will be in the 15 percent to 20 percent range, which he exclaims is still "a dandy return."
Does Past Indicate Future?
As noted, the majority of the top 10 performing real estate funds last year experienced returns that fell in the 40 percent to 49 percent range, handsomely beating all real estate indices. The fifth and sixth leading funds fell at the top end of that scale. Cohen & Steers Special Equities Fund posted a return of 46.89 percent and Strategic Partners Real Estate Securities Fund posted a 45.13 percent return. The latter belongs to Prudential Investment's Strategic Partners fund family, but is managed by James Hoffmann at Wellington Management.
While Hoffmann was reluctant to comment about the fund's strategy, Prudential Real Estate Investors (PREI) had a lot to say about the REIT markets in its 2004 U.S. Market Outlook. Considering how well the Strategic Partners real estate fund did, PREI takes a very cautionary approach to the coming year. Its 2004 U.S. Market Outlook reports, "strong capital flows and generally weak property market and operating fundamentals raise concerns about REIT valuations over the next 12 months."
The report's concerns stemmed from a historical perspective of the industry. PREI's Outlook notes that REIT share prices tumbled more than 22 percent in 1998, the last year following back-to-back years of healthy capital inflows. The sharp decline in 1998 came despite healthy and steadily improving property markets and REIT operating fundamentals.
"Today, after nearly three years of rising share prices and weakening property market and operating fundamentals, REITs look expensive by almost any historical measure," according to PREI's Outlook.
James Corl of Cohen & Steers Capital Management Inc. also thinks it's important to take a historical look at REIT performance before prognosticating about 2004. He's just not as fretful as Prudential.
Corl wears two hats at Cohen & Steers: a senior vice president and the co-portfolio manager of the Cohen & Steers Specialty Equity Funds. From his perspective, REIT total returns for 2004 will probably fall in the 18 percent to 20 percent range.
"If you look at all the years when REITs performed at 30 percent or better in the history of the sector since the 1970s, every one of those 30 percent years was followed by a 15 percent to 25 percent year without exception," he says.
Corl maintains that 2004 will not be a "bubble-bursting" year for REITs. "The economy is getting better, earnings growth rates are getting better and real estate fundamentals are getting better. As a result, REIT growth will be higher in 2004 than in 2003 and higher in 2005 than 2004—the foreseeable future for the investing universe. As long as those numbers keep accelerating across the industry, the stocks are not going to go down."
Cohen & Steers offers a number of REIT funds, but the Special Equity fund had the best performance in 2003 thanks to a strategy of less diversification (only about 35 positions). The top 10 investments comprise roughly 50 percent of the portfolio. These include (in descending order): Vornado Realty Trust (NYSE: VNO); Taubman Centers Inc. (NYSE: TCO); Boston Properties, Inc. (NYSE: BXP); Post Properties, Inc. (NYSE: PPS); Alexandria Real Estate Equities, Inc. (NYSE: ARE); AvalonBay Communities, Inc. (NYSE: AVB); The Rouse Company (NYSE: RSE); The Mills Corporation (NYSE: MLS); Sun Communities, Inc. (NYSE: SUI); and Host Marriott Corporation (NYSE: HMT).
On a sector basis, Corl thinks 2004 will prove to be a difficult environment for health care REITs, and he's also pessimistic about strip shopping centers. On the other hand, Corl thinks office, multifamily and self-storage REITs will be ramping up in 2004.
Too Early Can Mean Too Bad
Sector plays are common among REIT investors, but at least one fund manager warns investors not to jump into a sector too early. Joseph Betlej, vice president, investment officer and portfolio manager for
Advantus Capital Management Inc., manages the Ivy Real Estate Securities Fund (which returned 41.71 percent in 2003) for Waddell Reed Financial Inc. As an example, he points to the number of real estate fund managers that moved into the office and multifamily sectors last year, expecting a rapid turn around on fundamentals—which never happened.
"We didn't jump on the bandwagon early on with apartments or office," Betlej says. "A lot of people think REITs are much like other parts of the market where you have to be in fairly early in order to take advantage of the market. We have a tendency to believe the weighting [should be figured] once you can see the whites of their eyes."
Where Betlej did overweight was retail, particularly regional malls—a sector he still likes for 2004. In particular, he will maintain his holdings in General Growth Properties, Inc. (NYSE: GGP) and The Rouse Company.
Betlej made some small bets in 2003 on homebuilders and lodging, both of which increased his fund's returns nicely. He also owned two health care REITs, Ventas, Inc. (NYSE: VTR) and LTC Properties, Inc. (NYSE: LTC) that did well.
One sector that doesn't turn up on the overweight list of too many fund managers is industrial, but Betlej feels there could be some undiscovered opportunities that arise there in 2004.
While Betlej cautions against jumping into a sector too early, there is also risk in waiting too long. Phoenix-Seneca Equity Income Fund did well in 2003 by investing in mortgage REITs and mortgage finance companies—a strategy investment manager David Shapiro says he will maintain in 2004.
However, Shapiro admits he missed the window of opportunity for lodging companies and now thinks it's too late to jump in. "They had a great run (in 2003) and I missed it," he says. "I just don't see it as a play in 2004."
Like many of his colleagues, Shapiro maintains his underweight position on office REITs. "I don't see how office companies will do well in 2004," he says. His outlook for the multifamily sector is a little more optimistic, but his picks in that sector are selective only favoring companies that operate in land-constrained areas like Archstone-Smith (NYSE: ASN).
Only time will tell how realistic the expectations made by Shapiro and all the fund managers will be and whether or not we will see a wide range of real estate funds posting returns in excess of 40 percent again. Coming off a record year for performance and capital inflows in the REIT industry in 2003, there are a large number of investors waiting anxiously alongside them.
Steve Bergsman is a regular contributor to Portfolio based in Mesa, Ariz.
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