Total returns from real estate closed-end funds slowed significantly in 2005. Last year, the average closed-end fund return was 6.9 percent compared to 28.8 percent in 2004. The ING Clarion Real Estate Income Fund led the pack in 2005 with an 11.3 percent return, according to Lipper rankings. The only other fund to post a double-digit cumulative total return on a NAV basis was the Scudder RREEF Real Estate Fund (10.3 percent). In contrast, a pair of Scudder funds set the pace in 2004, with returns of 36.8 percent and 35.8 percent, respectively.

During 2005, closed-end real estate funds continued to trade at a discount to the NAV, according to John Robertson, managing director for the Scudder RREEF Real Estate funds. “Generally all these funds trade at a 5 percent to 15 percent discount,” he says. As a result, Scudder completed a share buyback program in 2005, an unusual move for most closed-end funds. “Between those two funds we’ve bought back several hundred thousand shares.”

The rising interest rate environment in 2005 compelled Scudder to change its strategy slightly, and if rates continue to rise in 2006, the funds will have to make additional adjustments, says John Vojticek, a managing director with Scudder RREEF. “With the expectation of higher interest rates, we increased the amount of preferred stock modestly,” he explains, adding that the move might not have been necessary because the common stock ended up performing pretty well.

Moreover, Scudder made sure to put in interest rate swaps to protect its 30 percent leverage. “The interest rate swaps eliminate interest rate risk, and those swaps themselves had fairly long durations,” Robertson notes.

Lipper senior research analyst Donald Cassidy blamed rising interest rates for closed-end funds’ overall lackluster performance. “All closed-end funds use leverage, and in 2005, they lost the advantage that comes with borrowing money by using-short term paper,” he says. “The loss of the leverage spread certainly penalized them.”

Because closed-end funds are yield-driven vehicles, the investment choices are somewhat limited, Robertson noted, adding that REITs without high dividends don’t have a place in closed-end funds. Along those lines, many closed-end funds found themselves with extra money to invest in 2005 after several REITs were taken private.

Cassidy says that the top-performing ING Clarion fund made large stock bets in office REITs during 2005 with 9.1 percent of its portfolio held in Arden Realty Inc. (NYSE: ARI), which benefited from news it was being acquired in late 2005.

Robertson says Scudder funds owned three REITs that were bought out by private equity investors—AMLI Residential Properties Trust, Gables Residential and Arden. “Those three REITs had pretty sizeable positions in the fund, about 10 percent to 15 percent of each fund, and we had to reinvest that money. It created a situation where we had to look for additional opportunities.”

Scudder invested the proceeds from the sell-off in student housing companies, which offer stellar yields, Robertson says, adding that hotels were also strongly considered.

Closed-End Fund Rankings

Source: Lipper, A Reuters Company