Déjà Vu All Over Again Real estate funds are having their worst year since the industry came of age in the early 1990s. Even after taking September's REIT rally into account, only two of more than 50 funds were in the black for the year as of September 30. by Barry Vinocur

In a recent letter to shareholders of their largest fund, Cohen & Steers Realty Shares, Marty Cohen and Bob Steers wrote that the poor performance of REITs this year reflects "ongoing concern about the overabundance of capital available for real estate in the private market, the maturity of the real estate cycle, and the potential slowing of earnings growth for many real estate companies." Though Cohen and Steers acknowledged those concerns are valid, they were quick to point out that in their view "the drop in REIT share prices more than adequately reflects these issues; 1998 is on track to be the worst year of investment performance since 1990, when REIT prices declined by 15.4%. In that year the real estate bear market began in earnest with declining occupancies and rental rates, plummeting property prices, a credit crunch, and an economic recession."

No one suggests that real estate fundamentals are anywhere near as weak as they were in 1990—not even close. Moreover, as Cohen and Steers state in their letter, there is a widespread feeling among veteran REIT investors that the public market has "overdone" it a bit. Nevertheless, the severe capital crunch (which didn't occur until after Cohen and Steers wrote their letter) and widespread concern about a U.S. recession next year are mitigating factors. Offsetting those concerns, as Cohen and Steers noted, is the widespread view that "the public market is enforcing the type of discipline that many have desired. Further, many companies are adopting rational strategies that should enable them to continue to produce positive results for their shareholders despite what appear to be temporarily adverse market conditions.

Taking Stock
As noted, only two of the industry's 53 funds (unlike Morningstar and Lipper, Realty Stock Review doesn't count each share class as a separate fund) at the end of the third quarter were in the plus column for the year. Dreyfus Real Estate (see Property, September/October 1998) finished the quarter up 7.8%, quite remarkable considering that the average real estate fund was down 16.7%. Dreyfus' trailing 12-month performance was equally impressive, up 13.5% vs. the average real estate fund which was down approximately 16%. The other fund to close out the first nine months of this year in the black was Morgan Stanley Europe Real Estate. Though just under one-year old at the end of the third quarter, the fund posted a 5.2% total return during the first three quarters of this year.

The story for the other 51 funds listed in the table on page 56 was which fund was down the least. Of the funds finishing in the red for the first three quarters of 1998, Cohen & Steers Equity Income fared the "best," down 8.7%. Stratton Monthly Dividend REIT Shares was down 8.8%; the Undiscovered Managers REIT Fund was down 10.5%; and Alpine International Real Estate Equity was down 11.8%. At the bottom of the pack were Morgan Stanley Asian Real Estate Fund, which was down an eye-popping 41.2%; Cohen & Steers Special Equity, down 31.8%; and Alpine U.S. Real Estate, which was down 25.7%.

Though many fund managers said they thought the worst was over for REITs this year, none suggested a dramatic turnaround was likely before year-end. Most said they were resigned to 1998 being a down year for REITs. This would be only the fifth down year since the National Association of Real Estate Investment Trusts, the industry's Washington, D.C.-based trade group, began tracking performance in 1972. Said one fund manager, "The only question left is whether this will be just one of five down years, or whether it will be the worst year on record. Two weeks ago, I would have bet that this wouldn't be the worst year on record. But given the magnitude of the global financial crisis, the credit crunch, and the possibility that the United States could go into a recession next year, I'm no longer willing to make that bet."

Assets Tumble
Lagging performance is taking its toll on fund assets, as well. Though the number of real estate funds has increased sharply over the past year, fund assets (through the end of the third quarter) had declined by nearly 20% (to just over $9.5 billion) since December 31 of last year, according to Realty Stock Review. Though many funds have experienced net redemptions this year, according to AMG Data Services in Arcata, California, through the week ending October 1, real estate fund flows for the year totaled $36.4 million.

The drop in assets is most noticeable at the industry's three largest funds: Cohen & Steers Realty Shares, Fidelity Real Estate, and the Vanguard REIT Index Fund. Cohen & Steers, still the largest fund, has seen its net assets drop by nearly one-third this year, to approximately $2.3 billion as of the end of the third quarter. Fidelity's net assets went down more (on a percentage basis) from just under $2.5 billion at the end of 1997 to just over $1.4 billion at the end of September. Vanguard's net assets went from nearly $1.3 billion at the close of last year to just under $980 million at the end of this year's third quarter. (The decline in assets reflects net redemptions and share price declines.) Though there are some notable exceptions (more on that, in a bit), smaller funds haven't fared a lot better than their larger peers. For example, at the end of last year, UAM Heitman had net assets of $218 million; it had net assets of $134.4 million at the end of September. Templeton Global Real Estate had net assets of $149.1 million at the end of last year; as of the end of September, it had $116 million.

A handful of funds have managed to grow or at least hold their own this year. Franklin Real Estate had net assets of $428.7 million at the end of 1997; it had net assets of $424.3 million as of September 30. Davis Real Estate Fund's net assets went from $291 million at the end of last year to $409.9 million as of the end of September. Brazos/JMIC Real Estate Securities saw its assets go from $59.5 million at the end of 1997 to $87.3 million at the end of September.

Making Sense of the Numbers
When looking at the performance of real estate funds, it's important to keep in mind that though there have been some ups and downs, until this year, REITs hadn't experienced a "bear market" since the sector sprang back to life in 1991. That's important because knowing how a fund performs in down markets is at least as valuable as how it fares with the wind at its back.

Investor concerns about a prolonged stock market correction, or worse, led some real estate fund managers in recent years to claim that their funds would be a "port in a storm." They supported that assertion, in part, with data from the July 1996 mini-market correction, when the S&P 500 dropped by 4.4% and the Wilshire REIT Index rose by 0.1%. More recently, despite the beating REITs have taken this year, some fund managers argued that REITs again proved their "defensive nature," by dropping less than other sectors of the market in August of this year.

Some real estate fund managers have also emphasized their funds' low betas. In fact, Morningstar's data shows extraordinarily low betas vs. the S&P 500 for all real estate funds. But those funds also have R2s that are (or approach) zero (see page 78 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), certified financial planner 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," he wrote. He adds 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? In effect, 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 these funds. (As you might expect, the R2 of 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. But that doesn't mean 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 "best fit" index for two of the funds shown in the above table—that is, Templeton and Alpine International—are the Russell 2000 and the MSCI EASEA (Morgan Stanley Capital International Europe, Australasia, South East Asia), respectively, according to Morningstar. The above table shows the "best fit betas" and "best fit R2s" for more than a dozen real estate funds. Only funds with a track record of at least 36 months are included in the Morningstar-supplied table.

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 above), which is calculated by subtracting the risk free (T-bill) rate from a portfolio's total return and then dividing this by its standard deviation. The resulting fraction can be thought of as return per unit of risk. The higher a portfolio's Sharpe ratio, the better the risk-adjusted performance.