How Low Can You Go?

With credit markets jittery and the economy on the lip of recession (or in recession, depending upon whom you ask), real estate funds have plummeted. During the 12 months ending in January 2008, the category lost 21 percent. Should investors stay clear of real estate funds until the outlook brightens? Not necessarily. Some signs indicate that the funds could be nearing a bottom. “The markets have fallen too far,” says Michael Winer, portfolio manager of Third Avenue Real Estate Value. “The current prices for most companies do not reflect the real value of the assets.”

To appreciate the bullish case, first recall that real-estate funds invest primarily in REITs (real-estate investment trusts) and public companies that own commercial properties, including offices, warehouses, apartments and hotels. Like all stocks, REIT shares tend to anticipate the future, falling when trouble is on the horizon, and rising before a recovery becomes obvious. The current downturn in REIT shares started in January 2007, well before newspaper headlines began trumpeting problems in credit markets.

REIT bulls compare the current slide to the previous two downturns, which occurred in the late 1980s and the late 1990s. In each case, the stocks dropped nearly 24 percent before hitting bottom. After reaching a trough, the shares quickly retraced their steps, recovering most of their losses in a matter of months — and before the fundamental performance of real estate improved markedly. In the current downturn, REIT shares have already lost 24 percent.

There is no guarantee that the red ink won't continue. But bulls point to several indicators that the shares are fairly priced. Yield may be the most reliable measure of value. Many investors buy REITs for their high-dividend yields. During the past two decades, REITs have yielded on average 1.2 percentage points more than 10-year Treasury bonds. As the market for REITs soared several years ago, share prices rose and yields fell, hitting a low of 3.4 percent in January 2007, according to the National Association of Real Estate Investment Trusts. That yield was 1.4 percentage points lower than Treasuries — a record spread — and an indication that REITs had become relatively expensive sources of income. Since then, share prices have dropped, and yields climbed, hitting 5.3 percent on January 31, 2008, 1.7 percentage points above Treasuries.

To be sure, the rising yields could indicate that investors foresee further weakening in real estate performance. But so far property prices have declined only slightly in the major markets where many REITs concentrate their investments. With construction of new buildings slowing, analysts do not expect that prices will be substantially depressed by oversupplies of space. “Demand should remain healthy for offices and warehouses in the big coastal cities,” says Frederic Leffel, senior vice president of Savills Granite LLC, a New York-based real-estate investment-banking firm.

A Diversification Source — Still

Whether or not markets have touched bottom, investors should hold some real estate for diversification, argues Richard A. Ferri, CEO of Portfolio Solutions, an investment advisor in Troy, Mich. REITs sometimes rise when the S&P 500 is falling, and real-estate shares have delivered double-digit returns over long periods. Ferri puts 10 percent of his portfolios into real-estate funds. “We rebalance the portfolios, and hold the allocation steady,” says Ferri. “When real-estate shares were rising, we were selling. And now that REITs are down, we are buying to get our positions back to 10 percent.”

For a steady fund, consider T. Rowe Price Real Estate. Portfolio manager David Lee holds a diverse collection of solid REITs. Once he buys a stake, he typically holds for four years or longer. “We try to pick the long-term winners and hold them for the long-term,” he says.

Big portfolio holdings include Simon Property Group and General Growth Properties, dominant owners of regional malls. A favorite office holding is Vornado Realty Trust, which owns upscale properties in Manhattan.

Another fund that focuses on blue chips is Oppenheimer Real Estate. “We prefer strong REITs in growing markets,” says portfolio manager Scott Westphal. The fund's biggest holding is ProLogis, a premier owner of warehouses and industrial properties. The REIT is poised to continue growing because it owns facilities near ports and airports, locations that are getting a boost from rising global trade. ProLogis is also expanding into fast-growing foreign markets.

Bottom fishers may prefer Third Avenue Real Estate, which looks for shares selling at deep discounts. Besides buying REITs, portfolio manager Michael Winer also seeks companies that own land or real estate. His aim is to spot businesses that can exploit their undervalued assets. Though he seeks bargains, Winer sticks with solid businesses. “We only invest in companies that have strong balance sheets and management teams that have track records for creating value,” he says.

A long-time holding is St. Joe Company, which owns 850,000 acres of land in Florida. St. Joe is building residential communities on some of the land and selling off parcels to other developers.

For additional diversification, some investors should consider international real-estate funds. While prices of foreign REITs have recently dropped along with their U.S. counterparts, global markets do not always move in lockstep. Because many foreign economies are growing faster than the U.S., overseas real-estate shares could outpace American REITs in the future.

To hold stakes in Europe, Japan, and the emerging markets, consider Alpine International Real Estate. The fund seeks companies that stand to benefit from growing demand. Lately, portfolio manager Samuel Lieber has been setting his sights on Brazil. A favorite holding is Gafisa, a homebuilder that targets middle-class customers. “The consumer economy is growing in Brazil,” he says. “For the first time, people are using credit to buy homes.”

Another overseas choice is Fidelity International Real Estate. The fund looks for solid assets selling at discounts. Recently, portfolio manager Steve Buller has been finding tempting targets in the United Kingdom. “The U.K. companies trade at a 20-percent discount to our estimate of their net asset values,” says Buller.

Buller is also shopping in Hong Kong where he is finding companies that are benefiting from the rapid growth in China. Such fast-rising real estate holdings can be an attractive addition for investors looking to diversify their portfolios with stocks that are tied to the Asian boom.

DOWN BUT NOT OUT

Real-estate funds that should bounce back.