Fall 2000
	Cover Story Doing the REIT Thing Western Properties’ Brad Blake and Bradley’s Tom D’Arcy put their shareholders first. Now they’re looking for work. Company Spotlight Failure to Communicate The "REIT Story" is a good one. Unfortunately, many companies haven’t done as good a job as they should have in telling it. Sector Spotlight Critical Conditions Opportunities among the healthcare REITs, but be careful out there. The New Economy Plugged In Making Money in the Internet Age Tracking The Market Bye, Bye Bear Market Blues After two of the worst years in their 40-year history, REITs have staged a strong comeback. By The Numbers Much Better, Thank You Real estate fund managers may never live down the 1998-99 bear market, but at least these days they can go out in public. Washington Wire Legislative Relief No legislation in the roughly 40-year history of REITs had the potential to alter the landscape more dramatically than the recently enacted REIT Modernization Act. Investment Basics Just How Safe Are REIT Dividends, REALLY? Yield-conscious investors drawn to REITs by their "rich" yields need to look beyond what’s printed in the stock tables of their daily newspapers. Investment Insight Opposites Attract It didn’t come as a surprise to portfolio managers at LaSalle Investment Management that REITs soared when tech stocks hit the wall this past spring. Investment Fundamentals NAV Growth: A Meaningful Performance Yardstick Growing FFO and enhancing shareholder value are not always one and the same. Focusing on NAV growth is a better, though not perfect, alternative suggests Green Street’s Mike Kirby and Jon Fosheim. Editor's Note The Journey Continues ... Parting Shot Wrestling With Net Asset Value The Penobscot Group’s Frederick S. Carr Jr. questions whether the market is telling investors that NAV is irrelevant. Newsline Urban To Be Acquired By Rodamco For $3.4 Billion Investor's Guide Questions Back Issues Feedback

by Barry Vinocur
Illustration by Dave Cutler

fter two of the roughest years you could imagine, real estate fund managers joke that they can finally go out in public without having to wear bags over their heads. "There were times last year when I was standing in front of the mirror shaving and thinking it might be easier to cut my jugular vein and bleed out all at once rather than face another year of slowly bleeding to death," said a longtime veteran of the REIT wars.

Was it really that bad? You bet it was. Though no one realized it at the time-isn’t that the way it always is-the REIT market peaked back in the fall of 1997, when the Morgan Stanley REIT Index closed at 367.35 on October 6. Like the rest of the financial markets, REITs suffered through the rest of the fall and into the winter, living through the Russian debt crisis and the angst known as Long Term Capital Management. The situation went from bad to much worse early the next year. In rapid-fire succession, the Clinton administration took aim at REITs-making several proposals, most notably that the tax-advantaged paired REIT structure be scuttled. If that weren’t enough, investors turned their backs on REITs as the rest of the market soared, and concerns about overbuilding and REITs overpaying for properties came to the fore.

It all took a toll. In 1998, REITs finished down nearly 17 percent, one of their worst finishes ever. Last year, despite two Warren Buffett-induced rallies, REITs finished in the red again. Taken together, the two years added up to the worst stretch in a quarter century.

Real estate fund managers felt the downdraft two ways. Not only didn’t investors or financial advisors want to hear about REITs, but their funds were also hemorrhaging cash. On top of the falloff in assets from dropping prices, just over $1 billion was pulled out of real estate funds last year alone (see below), according to AMG Data Services in Arcata, California.

By the end of last year, fund managers were hanging their hopes on a "tech wreck." If two Warren Buffett-induced rallies didn’t do it, perhaps Nasdaq hitting the wall would. (There was some evidence to suggest that would be the case; see "Opposites Attract" on page 63 in this issue.) As it turned out, this past spring’s Nasdaq meltdown did the trick (see "Bye, Bye Bear Market Blues" on page 36 in this issue).

Talking Strategy
In the depths of their depression last year, some fund managers began searching for special situations. Though making money by betting, for instance, on REIT takeovers hasn’t done much to boost returns in the past, some fund managers thought it might be different this time. That didn’t happen. On the other hand, a number of deals-from going-private transactions to mergers-have been announced since REITs rebounded this past spring. A number of those deals have been very positive for shareholders.

Fund managers also cite several liquidation/going-private transactions as signaling a positive industry trend. Two frequently cited deals were the acquisition of Bradley Real Estate by a private REIT and the decision to liquidate Pacific Gulf Properties (see "Doing the REIT Thing" on page 14 in this issue).

Another strategy, albeit a very controversial one, came under fire last year. Several analysts (see "Plugged In" on page 32 in this issue) have suggested that property-linked stocks that derive significant revenues from tech-related activities, such as providing broadband access and other Internet-related services to tenants, might see their multiples expand as investors broaden their quest to find new avenues to capitalize on the Internet-driven e-commerce/e-business revolution.

As promising as those tech-related ventures may be, some industry veterans were highly critical of fund managers who they contended were "reaching" in order to drive their returns and thereby distinguish their funds from the pack. An article in The Wall Street Journal earlier this year questioned whether "such risky stocks" belong in what the article contended are traditionally conservative real estate funds. Some of the same critics also questioned the wisdom of office owners accepting warrants on a dot-com venture in lieu of rent (a practice that in the wake of this past spring’s Nasdaq meltdown is no longer in vogue).

Though both are valid issues to consider, the evidence in support of any widespread risk taking by fund managers or property owners was lacking. Yes, there were isolated instances in which, for instance, a REIT that owns office space had set aside an amount of space (frequently this is equivalent to what property owners term structural vacancy, or that small amount of space that typically remains vacant for any one of a variety of reasons even during the best of times) to be leased to start-up Internet-driven ventures. At the same time, companies such as Spieker Properties were going in the opposite direction. Spieker required more money upfront (cash or a letter of credit) from many dot-comers, and, in some instances, it ended up with warrants not as a means of lowering rental costs, but rather as a "sweetener" to lock up the deal.

Finally, though there was anecdotal evidence that a handful of fund managers might have been sprinkling some dot-com-related stocks (primarily companies seeking to capitalize on wiring buildings for broadband, or companies delivering real estate-related information via the Net), there was no evidence to suggest the practice was widespread, nor, more importantly, that fund managers were throwing caution to the wind. (At the end of every quarter, this magazine’s sister publication Realty Stock Review surveys fund managers concerning their top holdings. The survey for the period ended December 31 of last year turned up only a few dot-com-related plays in the top 10 holdings of the funds that completed their survey forms.)

One fund that played the dot-com card-and profited last year-was Cohen & Steers Special Equity. (The fund has suffered this year.) However, that fund is one of three offerings from New York-based Cohen & Steers Capital Management, and the fund’s strategy is to push the envelope-within reason-by investing outside the list of "usual suspects" for real estate fund managers. Last year, Cohen & Steers Special Equity not only was the best-performing real estate fund but also outperformed the Standard & Poor’s 500-Stock Index.

How They Stack Up
As of the end of August (see table on page 47 ), only two of the nearly 70 real estate funds tracked by Realty Stock Review (www.realtystockreview.com) were in the red for the year. (Unlike Morningstar and Lipper, which count each share class as a separate fund, Realty Stock Review totals the assets in the various share classes of each fund and counts it as one fund.)

The average real estate fund, according to data supplied to Realty Stock Review by Lipper, posted a negative 1.8 percent total return last year. As of the end of August of this year, the average fund, again according to Lipper, was up roughly 17.5 percent.

Roughly two dozen funds, as of the end of August, were up more than 20 percent. The best performers were Kensington Strategic Realty Fund (up nearly 26 percent), Third Avenue Real Estate (up nearly 25 percent), and Alpine Realty Income and Growth (up just over 24 percent). The worst-performing fund, as of the end of August, was Cohen & Steers Special Equity (down 4.4 percent). The industry’s largest index fund, Vanguard REIT Index, which tracks the Morgan Stanley REIT Index, was up 18.4 percent through the end of August.

The Assets Story
The lagging performance of property-linked stocks and, in turn, real estate funds (as noted) had a major impact on fund assets (see the table on page 46). According to AMG Data Services in Arcata, California, $1.3 billion flowed out of these funds last year. Over the roughly two years from February 1998 through early March of this year, real estate fund assets went from $12.5 billion (February 1998) to $7.6 billion (as of March 2 of this year). This year fund flows have been positive, though not eye-popping (see "Bye, Bye Bear Market Blues" on page 36 in this issue). Just under $500 million had flowed into real estate funds during the first eight months of this year.

It’s worth noting that tracking mutual fund flows isn’t the be all and end all that some folks suggest it is. After all, though the number of real estate funds has soared in recent years, the assets in those funds have never amounted to even 10 percent of the REIT market’s equity capitalization. That said, fund flows shouldn’t be dismissed. Tracking fund flows is a barometer of investor sentiment and, though it may be far from a super scientific indicator, it’s the best benchmark out there.

Perspective
Over the years, some real estate fund managers have chosen to emphasize their funds’ low betas. In fact, if you compare the betas of real estate funds vs. the Standard & Poor’s 500-Stock Index’s beta, you find an extraordinarily low beta. But those funds also have R2s that are (or approach) zero (see page 86 for definitions of terms) when calculated based on the S&P 500.

In his book, Wealth Management: The Financial Advisor’s Guide to Investing and Managing Client Assets (Irwin Professional Publishing, 1997), Harold Evensky discusses the use of beta and its interrelationship with R2, or the coefficient of determination. "It’s of no value to measure the risk of a portfolio by its beta, if the beta is based on an inappropriate market." Evensky added that his firm looks for another "best fit index" if R2 falls below 75.

What do the low betas and R2s of real estate funds vs. the S&P 500 tell you? Put simply, that at least over the last several years, there’s been a very low-if any-correlation between the performance of the S&P 500 and the performance of real estate funds. (As you would expect, the R2of the Vanguard 500 Index Trust is 100, which tells you that all of that fund’s risk can be explained by the risk of the S&P index.) Put another way, the risk associated with real estate funds cannot be explained by the risk in the S&P 500. That, however, doesn’t imply that property-linked stocks, or the funds that invest in them, aren’t "risky."

When analyzing domestic real estate funds, Morningstar uses the Wilshire REIT Index as the "best fit index." The table on page 48 shows the "best fit betas" and "best fit R2s" for the 40 real estate funds for which Morningstar has sufficient data points to provide the analysis.

To get a better handle on risk when analyzing real estate funds, you should look at standard deviation, as well as Sharpe ratios (see table on page 48), which is calculated by subtracting the risk-free (that is, T-bill) rate from a portfolio’s total return and then dividing this by the portfolio’s standard deviation. The resulting fraction can be thought of as return per unit of risk. The higher a portfolio’s Sharpe ratio, the better its risk-adjusted performance.

Print Friendly Version