Real Estate Funds Find Smooth Sailing in 2005, Managers Navigate For Similar Returns in 2006
By
Jennifer D. Duell
Real estate investors who ducked for cover in 2005 were kicking themselves for listening to all the negative hype, while those who stayed the course were rewarded with another strong year of income and capital appreciation. This year, many industry experts are forecasting improved real estate fundamentals and yet another good year for REITs and real estate mutual funds.
“We were one of the few bulls on record about real estate in 2005,” says James Corl, chief investment officer for Cohen & Steers Capital Management Inc. “At the beginning of 2005 the real estate markets were still in recovery. It’s quite clear that one and two years from now, occupancy rates and rental rates will be higher. We do see 2006 being similar to 2005 in that there will be a forward progression of fundamentals.”
For the sixth year in a row, the NAREIT Composite and Equity REIT Indexes outperformed the major market indexes in 2005 with a gain of 8.3 percent and 12.2 percent, respectively. Most industry experts are forecasting similar returns for 2006.
The strength of the listed real estate market in 2005 boosted real estate mutual fund performance. The 2005 cumulative total return for real estate funds was 11.75 percent, according to Lipper. Real estate funds’ performance exceeded the overall average U.S. mutual fund return of 6.7 percent, but was a sizeable dip from real estate funds’ 2004 average total return of 32.1 percent.
Of the 86 distinct real estate funds tracked by Lipper (not including clone funds), 65 produced double-digit total returns in 2005. And 76 funds, or 88 percent, outperformed the U.S. mutual fund average total return for the year.
Top Funds
CGM Realty Fund was the top real estate mutual fund performer in 2005 with a 27.0 percent total return, according to Lipper. The fund, which can invest up to 35 percent of its assets in equity or fixed-income securities of companies outside the real estate industry, held a number of coal and copper stocks, as well as homebuilder stocks, which performed well during the year. In fact, of the fund’s top 10 holdings as of Sept. 30, 2005, five were REITs, four were energy companies and the other was real estate advisory firm CB Richard Ellis Group Inc. CGM, headed by Kenneth Heebner, was also the top-performing fund when tracked by annualized total return over the two and three-year periods and ranked second for the five-year period.
“CGM has a much broader investment mandate than most real estate funds,” points out one real estate fund manager. “Heebner has the flexibility to invest in stocks that most real estate fund managers would be fired for.”
With a completely different allocation strategy, E.I.I. International Property Fund, established in July 2004, was the second-best performing real estate mutual fund in 2005, with a total return of 21.4 percent. The fund, headed by lead manager James Rehlaender, invests at least 80 percent of its assets in non-U.S. real estate companies, preferably REITs. The company’s top holdings include major property companies in Europe, Asia and Australia.
With a portfolio including many of the largest U.S. REITs, Morgan Stanley’s Institutional U.S. Real Estate Fund ranked third in 2005 with a total return of 17.7 percent. Portfolio manager Ted Bigman’s 10-year-old fund also ranked in the top 15 according to total returns for the two, three and five-year periods.
The top five mutual fund rankings were rounded out by the Alpine Equities International Realty Fund (17.3 percent) and the Van Kampen Real Estate Securities Fund (16.6 percent). The Alpine International Fund, launched in 1989 by Samuel Lieber, is the granddaddy of all global real estate funds (see sidebar). The Van Kampen fund, also headed by Bigman, concentrates on U.S. real estate companies but can allocate up to 25 percent of its holdings to international securities.
As mentioned, the CGM Realty Fund posted the highest annualized total returns over the one, two and three-year time periods. Over the last five years, the top performing fund has been Lieber’s Alpine U.S. Real Estate Equity Fund, posting a 29.2 percent annualized total return. The fund also ranked second in annualized total returns over the three-year period. However, the fund has seen its standing dip over the last two years as its homebuilder holdings have struggled.
Office Outperforms in ’05
Unless discussing an index fund, it is oversimplifying to say that real estate fund managers simply rode another strong year from the industry to their healthy fund returns. After all, there was a wide range of returns posted by the funds and a variety of strategies used by the top managers. However, there were some common traits among those leading funds.
Although nearly every sector boasted some star stocks in 2005, many funds forecasted strong performance in the office sector and allocated accordingly. Cohen & Steers, for example, expected select office REITs to experience higher occupancies and increased rental rates. As a result, the Cohen & Steers Realty Fund invested roughly 26 percent of its capital in office REITs such as Kilroy Realty Corp. (NYSE: KRC), Maguire Properties, Inc. (NYSE: MPG) and SL Green Realty Corp. (NYSE: SLG). The allocation paid off as returns for these three REITs ranged from 29.1 percent for Maguire to 59.3 percent for Kilroy.
“In 2005, we made the most money on our stock selection in office,” Corl says.
Similarly, the Oppenheimer Real Estate Fund held a number of regional office REITs including Boston Properties Inc. (NYSE: BXP) and Corporate Office Properties Trust (NYSE:OFC), according to Scott Westphal, managing director of securities for Cornerstone Real Estate Advisors, which advises the Oppenheimer fund.
Boston Properties posted a one-year return of 34.9 percent, while Corporate Office Properties posted a one-year return of 34.6 percent. Those strong returns helped Oppenheimer achieve a total return of more than 14.0 percent in 2005, according to Lipper.
“We were excited about office REITs, especially those with buildings in urban markets like New York, D.C. and Los Angeles,” says Steve Brown, managing director and portfolio manager for Neuberger Berman Inc. “As we entered 2005, we thought a lot of the office REITs looked inexpensive relative to other classes and many were trading at a discount to NAV. We also thought there were good supply-demand characteristics that would create increases in occupancy.”
The fund’s focus on the office sector allowed it to out-perform the benchmark with a return of 13.1 percent, according to Lipper. SL Green, Maguire and Trizec Properties, Inc. (NYSE: TRZ) were among the fund’s 10 largest holdings, as of Nov. 30, 2005.
For 2006, however, a number of fund managers are less optimistic about office REIT performance. In general, they feel that the market has recognized the improved operating performance and the value will not be as high in 2006.
However, there will be some standouts in the office sector. Joe Betlej of Advantus Capital Management still likes Brandywine Realty Trust (NYSE: BDN). “The purchase of Prentiss Properties has diversified its growth amongst five core markets,” says Betlej, who sub-advises the Ivy Real Estate Fund.
Apartment Appeal
Funds with stakes in residential REITs in 2005 found success with coastal owners such as AvalonBay Communities Inc. (NYSE: AVB), BRE Properties Inc. (NYSE: BRE) and Essex Property Trust, Inc. (NYSE: ESS).
“The apartment markets have been favorably impacted by condo conversions,” says Kelly Rush, managing director of portfolio management for Principal Global Investors. AvalonBay, for example, posted a 2005 return of 33.5 percent, while BRE Properties gained 20.3 percent and Essex posted a return of 18.5 percent.
But this year, some managers feel that the glow from apartments is gone. “From a valuation point of view, it’s hard to get as excited about apartments because it seems like they priced in all the good news,” says Rick Imperiale, portfolio manager of Forward Uniplan Real Estate Investment Funds and author of “Real Estate Investment Trusts—New Strategies for Portfolio Management.” “A lot of the pricing for the premium apartment owners like AvalonBay or Archstone-Smith (NYSE: ASN) has something to do with condo conversions, which has been factored in (to the pricing).”
However, Betlej isn’t ready to sell off his apartment stocks just yet. “The apartment sector may seem overpriced, but it has the potential for tremendous earnings growth,” Betlej says. “We’re just now turning the corner on market fundamentals, and we see strong prospects.”
Neuberger Berman’s Brown also maintains confidence in the sector. In particular, Brown thinks apartments in the coastal areas will continue to do well in 2006 because of the price differential between renting and buying a home in these markets. “We’re looking at apartments as being the stars for 2006,” Brown says.
Hot on Hospitality
If there is one sector most fund managers agree upon in 2006 it is lodging. Nearly every fund manager Portfolio spoke with is looking to the lodging sector for the highest returns in 2006. “We love hotels,” Corl says. “They were one of our favorite property types in ’05 and will be this year as well.” He points to the lack of new development within the sector, as well as the fierce competition for land. “There aren’t too many hotels being built at the precise moment in time when demand is accelerating,” he says.
In 2005, Starwood Hotels & Resorts (NYSE: HOT) was a positive contributor to Fidelity Investments’ Strategic Real Return Fund, according to fund manager Sam Wald. “We honed in on the relative valuation for Starwood, which the market did not properly give credit,” he says. Wald added that the fund was overweighted with Starwood as it became more attractive throughout 2005, but he’s mum on Fidelity’s stance for Starwood and other hotel stocks in 2006.
Not all hotel stocks were strong performers in 2005, though. For example, Alpine’s U.S. Fund, which had a return of 11.1 percent, was impacted negatively by its investments in hotels, according to president Sam Lieber.
“Hospitality is one sector where we underperformed, although that’s the place where we think we need to be in 2006,” he explains, adding that there has not been significant new hotel supply since late 2002.
“The best value in the real estate market today is hotels,” Betlej says. “Hotels are in a very nice position to achieve very strong revenue growth. Occupancies are running at high levels and there’s not a lot of supply.” The Ivy Real Estate Securities Fund has been investing in hospitality and will continue to do so in 2006, he notes.
In particular, Betlej likes Hilton Hotels (NYSE: HLT), which recently announced a merger with Hilton Group PLC, its international operating arm. With the merger, Hilton has one of the largest international hotel portfolios.
Principal is another fund banking on some hospitality from lodging stocks in 2006. However, Rush says that he is more focused on upscale hotels in CBDs where there is very little construction activity and increasing land prices. “They’ve got more operating leverage, and in an accelerating environment they can have
greater margin improvements as related to services,” Rush says.
Principal started moving away from interest-rate sensitive REITs to invest in hotels in 2005. “As we enter in 2006, the largest overweighting is in retail and hotel, but we also recognize the need to stay nimble and that we may need to make changes,” Rush says.
Retail Shows Resilience
Principal’s fund has been overweighted in retail for several years. “Retail has been the one property type that had really demonstrated strength,” Rush says, adding that about 34 percent of the fund’s investments at the end of 2005 were in retail REIT stocks. “Retail won’t last forever, but we’re not ready to make a change yet.”
Imperiale contends that retail is a strong bet for 2006. “Everyone is waiting for the consumer to collapse, but I think that large and super-regional mall operators will have a strong year. Most retailers are looking for strong locations, and there’s only so much high quality space available.”
Last year, General Growth Properties, Inc. (NYSE: GGP), Simon Property Group (NYSE: SPG) and Taubman Centers, Inc. (NYSE: TCO) showed some strong NOI growth, although funds that owned stock in The Mills Corporation (NYSE: MLS) suffered a valuation hit. General Growth, for example, achieved a one-year return of 38.3 percent, with Simon following at 29.6 percent and Taubman at 23.7 percent. In contrast, Mills dropped 24.5 percent.
Betlej, for example, says his fund trailed the benchmark in 2005 because it was underweighted in large-cap stocks like Simon. Those funds that owned significant shares in Mills, however, were definitely hurt by that specific stock. “Our biggest negative was our stock selection in the mall sector, where we were slightly overweighted,” Corl says. “We owned a lot of Mills, which was a bad stock selection in ’05. They were a good play in ’03 and ’04, but the story fell apart in ’05.”
More Optimism for ’06
Coming off another positive year, real estate fund managers are excited about REIT performance in 2006. “We’re foreseeing pretty decent conditions in 2006 because we’re comforted by the fact that private equity supports public real estate,” Rush says.
The REIT privatizations in 2005 gave most real estate funds a boost by inflating certain companies’ returns. And, there’s no reason to think that real estate funds won’t benefit from another wave of acquisitions this year, Brown says. “There’s still a number of REITs that are trading at a discount to NAV in the office, shopping center and hotel sectors,” he contends.
REIT valuations were a source of significant debate in 2005, and concerns over net asset value will continue into 2006. “The thing to consider is that REIT valuations are not as attractive today because the discount to NAV is much thinner than it was in years past,” says Matthew Emmert, lead advisor with The Motley Fool. “If you’re not going to get some level of discount, I don’t think we can expect the same level of performance that we’ve had over the past several years.” He predicts: “In 2006 we will find that only a few funds will provide outstanding returns.”
“The $64,000 question is the direction of private real estate,” says Morgan Stanley’s Bigman. “We think there will be modest capital value growth, which gives us reason to think that the sector could continue to have favorable performance. We’re not as convinced that we’ll get double digits in 2006, though.”
The majority of the managers are confident the overall economy will continue to gain strength and help support the real estate economy. Corl of Cohen & Steers says given the economy’s current path he is sticking with cyclical property types in 2006.
Cornerstone Real Estate Advisors’ Westphal agrees with Corl that the economy could ride through 2006 with good GDP, which means continued growth for hotel, office and apartments.
As always, there will be unexpected factors that impact both the economy, real estate market and, in turn, real estate fund performance. But having built a track record of solid performance, real estate fund managers seem well positioned to navigate whatever may come.
Jennifer D. Duell is a freelance writer based in Fort Worth, Texas.
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