As Real Estate Sags,
REITs Cool Down
VIVIAN MARINO / New York Times 7oct2007
ALL the skeptics and naysayers may have finally gotten it right: the long-running rally in real estate funds seems to have run out of steam.
For the last few years, market analysts and some seasoned money managers had been predicting that the highflying mutual funds, which amassed colossal returns for much of the decade, would soon falter, yet the funds continued to surge as demand for commercial real estate remained strong.
Now a slump in real estate investment trusts, or REITs — companies with portfolios of properties like office buildings and hotels, which make up the bulk of most funds’ holdings — has bumped the sector from the top of all fund categories. The weakness in REITs has been attributed partly to profit-taking, as well as the credit crisis, which makes it harder for private equity firms to continue acquiring REITs, and, in the process, to drive up share prices. In 2006 alone, REIT shares shot up 34.4 percent, on average, according to the National Association of Real Estate Investment Trusts. They ended the third quarter up just 2.6 percent, though off 3.5 percent for the first nine months of the year. (Mortgage REITs, meanwhile, posted average negative returns of 28.15 percent for the quarter and 42.5 percent for the first nine months.)
For the quarter, real estate funds posted a 1.7 percent return, on average, and for the first nine months of the year, an average negative return of 2.9 percent, according to Morningstar, which tracks mutual funds.
The funds — which soared 34.4 percent, on average, in 2006, compared with a 15.6 percent rise in the Standard & Poor’s 500-stock index — are still well ahead for the three-year period, returning 18.1 percent, and five-year period, returning 21.6 percent, annualized.
But some market analysts think that the sector’s heady days may be over for a while, just as the fortunes for REITs have reversed. “It’s been almost unbeatable in the last few years; the trajectory of the returns obviously isn’t sustainable,” said Andrew Gogerty of Morningstar. “I wouldn’t be surprised to see this continue for some time,” he said of the slump.
Others weren’t so sure. Tom Roseen, a senior research analyst at Lipper, another fund tracker, agreed that the funds, and REITs in particular, had risen too far, too fast. “It was the only classification in the last seven years that could actually claim to have had positive performance each year in the whole equity universe,” he said. But he said that REITs, along with real estate funds, could rebound in the near term — they were already improving in recent weeks — because the economy was generally healthy and many property categories were fundamentally sound. “The numbers still look O.K. — occupancy rates are not bad, earnings are fairly strong,” he said. “It could be a good buying opportunity at this point.”
Investors, though, have been selling more than buying. The flow of money out of real estate funds totaled $4.048 billion this year through the third quarter, according to AMG Data Services, the first net redemptions in eight years. By comparison, AMG Data said, $5.008 billion flowed into the funds for all of 2006.
STILL, there were some bright spots in the real estate sector during the quarter. Funds that branched out into other investments, including real estate companies overseas, fared far better than those that stuck with home-grown REITs.
Cohen and Steers Asia Pacific Realty, for example, rose 7.55 percent for the quarter, and 20.71 percent for the first nine months. Its top holdings include the Japanese developers Mitsubishi Estate, the Mitsui Fudosan Group and Hongkong Land Holdings.
“There are a lot of opportunities overseas; economies are stronger,” said Samuel A. Lieber, the chief executive of Alpine Woods Capital Investors. His Alpine International Real Estate Equity fund was strong for most of the year, returning 12.7 percent for the first nine months, though it ended the third quarter up only 0.7 percent.
Among Mr. Lieber’s favorites is the large Hong Kong real estate company Midland Holdings, because, he said, “We think the residential market in Hong Kong will pick up.” He also likes Cyrela Brazil Realty, one of Brazil’s largest residential real estate developers. “They started the excitement in Brazil back in September 2005,” he said, with an initial public offering.
A notable success story for the third quarter was the CGM Realty fund, which had a return of 11 percent; it was up 27.24 percent for the first nine months. The fund loaded up on global mining companies like Rio Tinto of Britain and BHP Billiton of Australia, reflecting a broader definition of real estate by the fund manager, Ken Heebner. Mining companies made up 59 percent of the portfolio during the third quarter.
Mr. Heebner also trimmed the fund’s REIT holdings to around 29 percent from 81 percent at the start of the year. He still holds ProLogis, one of the world’s largest owners of distribution facilities; Douglas Emmett, an owner of office buildings and apartment properties in Los Angeles; and Digital Realty Trust, a owner of technology-related real estate. He considers all of them “niche companies.”
“I introduced a program to sharply cut back on REITs; it appeared to me that the valuations were too excessive,” he said, noting, too, that the rise in REIT share prices had been derived in part from a takeover frenzy by private equity firms.
REIT mergers and acquisitions reached record levels last year, with 23 announced transactions totaling $106.15 billion in value, including the assumption of debt, according to the research company SNL Financial. While takeover activity continued through into this year, it came to a near standstill in the third quarter, with only two announced deals, totaling $1.55 billion in value, SNL Financial said. (For the first nine months, there were 17 deals totaling $65.29 billion, the company said.)
“Just as we saw a housing bubble, I think there was a private equity bubble,” Mr. Heebner said. “They were using extreme leverage in purchasing.”
Private equity firms, he said, are feeling the reverberations from the credit squeeze that swept through the subprime mortgage market after the fallout in housing. Many financial institutions are more reluctant these days to provide loans for private equity buyouts.
“It looks to me like the L.B.O. business is going to come to a screeching halt,” Mr. Heebner said of the leveraged-buyout deals that have made headlines in recent months. “You won’t see as many deals announced.”
BUT Theodore R. Bigman, a managing director of Morgan Stanley who also manages its real estate mutual funds, said that those highly leveraged investors would probably be replaced by more traditional buyers who were less reliant on debt, like pension funds and foreign investors. (His funds include the Morgan Stanley Institutional Global Real Estate fund, up 3 percent, which has a large concentration in Asian companies.)
“There is still a wall of capital that wants to invest in real estate,” Mr. Bigman said. “Those investors were frustrated most of the last 6 to 12 to 18 months losing bidding situations to leveraged buyers.”
It could take awhile, though, for the commercial market to readjust. More often than not, he said, property owners are not in a rush to sell, especially at lower prices. “The process of real estate getting repriced,” he said, “will probably be slow.”