Real Estate Funds Defy Housing’s Gravity

By JACK DUFFY

THE housing market may be facing a prolonged dip in prices, but for real estate mutual funds the problem is very different: prices that have climbed so much that they may not be sustainable.

It may seem surprising, but while home sales have slumped and foreclosure rates have risen in recent months, real estate funds, which typically invest in commercial property and multifamily housing, have boomed.

The 251 domestic real estate funds tracked by Lipper have returned 55.7 percent over the past two years, on average, compared with 31.2 percent for diversified equity funds. According to Morningstar, real estate funds returned 6.1 percent in the first quarter, compared with a 5.1 percent average gain for all stock funds.

Real estate funds have been able to outperform the average general equity fund in part because they did so much worse in the most severe part of the downturn. During the heart of the financial crisis, some commercial real estate investments lost two-thirds of their value in less than six months. Some real estate funds ended 2008 with losses of more than 50 percent.

“It’s been a huge snapback from a drop that was way overdone,” said Robert W. Gadsden, manager of the $112 million Alpine Realty Income and Growth fund, which returned 9.24 percent in the quarter, making it the top-performing real estate fund among those tracked by Lipper.

Real estate funds tend to concentrate their investments in real estate investment trusts, or REITs, which own office, industrial, apartment, health care and other types of income-producing properties. REITs were one of the hardest-hit sectors when the credit markets seized in the fall of 2008, as investors feared that they wouldn’t be able to refinance their debt and that a wave of corporate bankruptcies would cause vacancy rates in their office properties to soar. From Sept. 30, 2008, to March 6, 2009, the MSCI United States REIT index plummeted 66 percent. Mr. Gadsden’s Alpine Realty fund ended 2008 down 50.2 percent, according to Bloomberg.

“There was extraordinary fear in the market, and people did not see the positives, like the diversification in REIT portfolios as well as their long leases and long debt agreements,” said Mr. Gadsden, whose recent top holdings have included REITs like the Simon Property Group, the mall owner, and Vornado Realty Trust, the big office landlord.

As REITs began to regain access to the credit markets, however, that fear began to dissipate, prompting a relief rally that has been supported by an almost perfect mix of market conditions, fund managers say. Those conditions have included very low interest rates, depressed property prices, lots of available capital and a lack of supply of new office and apartment space.

“We have seen occupancy rates and rental rates going up in many markets,” said Joseph R. Betlej, co-manager of the $428 million Ivy Real Estate Securities fund. “And that is because construction lenders turned off the spigot in 2007, and today we are faced with a lack of new supply.”

Ivy Real Estate Securities returned 5.7 percent in the first quarter after a 28 percent gain in 2010. Mr. Betlej’s recent top holdings have included Simon Property; HCP, a REIT that invests in health care properties; and Equity Residential, the big United States apartment owner.

The perfect mix that allowed REITs to shine so brightly has prompted some analysts to warn, however, that they could now be overvalued and that investors who continue to pour money into real estate funds might wind up getting burned. After all, some analysts say, gains made when the Federal Reserve is making extraordinary efforts to keep interest rates near zero might be hard to replicate as the economy grows and inflation and interest rates start to rise.

Investors added $4.15 billion to real estate funds in the first quarter, according to EPFR Global, an analysis company based in Cambridge, Mass.

“I would argue that there are more risks than benefits in REITs at these prices,” said Ryan Leggio, an analyst at Morningstar. “If interest rates go up, they are going to be in a world of hurt.”

Rising rates make it more expensive for REITs to finance their property assets and to make acquisitions. With most of their income coming from longer-term leases, higher financing costs also can’t be quickly passed on to tenants. REITs, by law, also must return 90 percent of their income to shareholders as dividends, making them attractive to yield-hungry investors. Higher interest rates would make other investments, like bonds and even bank certificates of deposit, more competitive.

The average dividend yield for REITs soared to more than 10 percent during the financial crisis, while yields of 10-year Treasury notes fell to near 2 percent. At the end of the first quarter, the dividend yield for equity REITs, which own commercial property and constitute the bulk of the market, was 3.46 percent, virtually the same as 10-year Treasuries.

Real estate fund managers acknowledge that higher interest rates could take some steam out of the commercial property market, but they say REITs will not be hurt much if any increase is modest and gradual.

“If rates are rising because of inflation, real estate has historically been viewed as an inflation hedge and a store of wealth,” said David M. Lee, manager of the $2.9 billion T. Rowe Price Real Estate fund.

Mr. Lee, whose fund gained 6 percent in the first quarter after a gain of nearly 30 percent in 2010, said REITs could keep pace if rising rates were accompanied by stronger job growth. “We need jobs, jobs, jobs,” he said. “We are dealing with a physical product that needs to be filled.”

One bright spot, he said, is likely to be apartment REITs, which are benefiting from strong rental demand as homeownership rates decline because of the foreclosure crisis. “We perhaps made too much of an effort in the past to put people in homes they could not really afford,” he said. “As more people recognize that homeownership is not a sure thing, you will have more renters by choice.”

Among Mr. Lee’s top holdings are two large United States apartment owners, Equity Residential and AvalonBay Communities.

MANAGERS say the most favorable environment for real estate funds — and the REITs in which they invest — would be an economy that improves enough to create more jobs but not enough to prompt major worries about inflation.

“If borrowing costs stay attractive while vacancy rates and credit ratings continue to improve — that would be the ideal,” said Mr. Gadsden of the Alpine Realty fund. “The best thing for REITs going forward is a Goldilocks scenario of not too hot, not too cold.”