By The Numbers Small Victories Two bad years in a row have real estate fund managers counting their blessings—few though they may be. by Barry Vinocur Illustration by Lael Henderson

Kidding aside, real estate fund managers got a whiff of hope in the spring when REITs rallied (see "REITs Behaving Badly," page 12). On March 23 of this year, the Morgan Stanley index was in the red, having posted a year-to-date total return of negative 7.2 percent. By May 12, the index was back in the black, having posted a year-to-date total return of 8.6 percent. By the end of the second quarter, the index had slipped. As of June 30, the Morgan Stanley index had delivered a year-to-date total return of 4.6 percent. Nevertheless, even after giving back much of their second quarter gain, REITs managed to post their best quarter in roughly two years.

Though the spring rally proved fleeting, real estate fund managers continue to argue that sooner or later the gap between the performance of the stocks and the stronger-than-expected property fundamentals for this stage (that is, later) of the real estate cycle will eventually be closed by a rise in stock prices. (More recently, some analysts and portfolio managers have suggested that REITs may once again be demonstrating their tendency to be a leading indicator. If they're correct, rather than being "cheap," real estate stocks may be nearly fairly priced today.) Whether portfolio managers who maintain property-linked stocks are "cheap" are right may be beside the point.

Investors and financial advisors who flocked to REITs following the stocks' meteoric rise in 1996 (the Morgan Stanley index beat the Standard & Poor's 500-Stock Index handily that year, posting a total return north of 35 percent) have all but given up on the stocks' perceived ability to cushion investors against market downdrafts. A number of influential financial advisors have suggested in recent months that having sold performance, real estate fund managers haven't delivered it.

"Had real estate fund managers downplayed the stocks' outperformance in the mid-1990s—when REITs were smokin'—and focused instead on the stocks as a proxy for real estate, fewer of us would have given up on them," said one financial advisor. Harold Evensky, a co-founder and partner at Evensky, Brown & Katz, a Coral Gables, Florida, wealth management firm, said recently that he has stopped using real estate funds as a proxy for real estate in his clients' portfolios. "We're dyed-in-the- wool asset allocators. We believe that real estate belongs in client portfolios. We thought that REITs were a proxy for real estate. We no longer believe that's the case." If REITs aren't a proxy for the direct ownership of commercial properties, what are they? Evensky says he isn't sure. Not yet, at least. His best guess is that REITs are small-cap value stocks. "If we're going to buy small-cap value stocks, we think there are better choices out there."

Another View
Not everyone agrees with Evensky that REITs aren't a proxy for real estate. Not surprisingly, many real estate fund managers continue to press the case that REITs have a low correlation with either stocks or bonds, and, therefore, they have a place in client portfolios if only for their diversification potential. In the short term, they say, any asset class may behave differently than it has historically. "The long-term record is still clear," says one veteran real estate fund manager. "REITs have a low correlation with stocks and bonds." Diversification isn't the only reason to buy REITs. In fact, a number of real estate fund managers say that whether or not one accepts the diversification argument (which they do), REITs are attractive.

In their second-quarter letter to shareholders in Cohen & Steers Realty Shares, their flagship real estate fund, Bob Steers and Marty Cohen wrote that "a healthy U.S. economy and recovering foreign economies bode well for continued demand for goods, services, and, importantly, space in nearly every form of real estate." The founders of Cohen & Steers Capital Management, the country's largest dedicated manager of real estate stocks, added that "while there are increases in the supply of space due to new development, it does not appear to be significantly greater, if at all, than demand in most major markets." Further, they pointed out that REIT industry earnings are growing at approximately a 10 percent annual rate. "This compares well with most other industries in America." Moreover, they noted that "compared to most other public companies, REITs remain undervalued from a price-to-earnings multiple, dividend yield, and price-to-asset value standpoint."

What about the prospect of rising inflation? While upsetting to fixed-income investors and others, Steers and Cohen wrote, the prospect of a strong economy and rising inflation is a major plus for owners of real estate. "Particularly in light of the prevailing tight markets and low vacancy rates, real estate seems poised to resume its role as a prime hedge against inflation. Increasing rental income and replacement cost is further enhancing the asset values of all property owners. To the extent that underlying asset values at all influence REIT share prices—and we believe that they do—the current investment environment is nearly ideal," they noted at the end of the second quarter of this year.

Finally, Steers and Cohen weighed in on the worry that if REIT prices soared, companies would rush to issue equity. "We believe that one of the wild cards in the supply/demand picture for REIT shares, at least for the remainder of the year, is a continued lack of equity issuance. Conventional wisdom is that once share prices recover, companies will rush to sell stock, and that supply will once again depress prices. To the contrary, we expect that most of the major companies will refrain from competing with the private market for property acquisitions and, therefore, will not find it necessary to expand their equity capital bases. Most managements today lament to us the lack of investment opportunities rather than their depressed stock prices. Thus, 1999 may be a year in which opportunistic investing is out of favor simply because there is a shortage of opportunities."

How They Stack Up
As of the end of August (see table on page 58), the majority of the roughly six dozen real estate funds tracked by Realty Stock Review (www.realtystockreview.com) were in the plus column 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.) Three of the four top-performing funds were nondomestic funds (they focus on property-linked stocks abroad). Of the domestic real estate funds, the top performer as of the end of August was Alpine Realty Income and Growth, a relative newcomer (though the fund group is no stranger to the sector, operating two of the longest-standing dedicated real estate funds). Not far behind Alpine's year-to-date return of 6.21 percent were Fidelity Real Estate High Income I, with a 6.05 percent total return, and Ken Heebner's CGM Realty, with a 5.52 percent total return. The average real estate fund, according to data supplied to Realty Stock Review by Lipper, had posted a year-to-date return of 1.38 percent as of the end of August. The industry's largest index fund, Vanguard REIT Index, which tracks the Morgan Stanley REIT Index, delivered a 0.85 percent total return through the end of August.

The Assets Story
The lagging performance of property-linked stocks and, in turn, real estate funds has had a major impact on fund assets. According to data supplied to Realty Stock Review by AMG Data Services in Arcata, California, and Merrill Lynch & Co., as of the end of August, real estate funds had total assets of roughly $9 billion. To put that number into perspective, at the end of the first quarter of 1998, the funds had total assets of just under $12.3 billion.

According to AMG, more than $750 million had been withdrawn (net outflows) from real estate funds through the end of August. Not surprisingly, the second quarter of this year was the best for the funds (as of late August). Just under $25 million was withdrawn from real estate funds in the second quarter. At the same time, the rise in REIT prices during the second quarter sent fund assets up by nearly $1 billion, according to AMG.

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 with 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 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), 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, they mean that at least over the past 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 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. 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 "best fit index for two of the funds shown in the table on page 58—Templeton and Alpine Inter-national—are the Russell 2000 and the MSCI EASEA (Morgan Stanley Capital International Europe, Australasia, South East Asia), according to Morningstar. (The Franklin Real Estate and Templeton Global funds have since merged.) The table on page 60 shows the "best fit betas" and "best fit R2s" for the roughly 30 real estate funds that Morningstar has sufficient data points for to provide the analysis.

To get a better handle on risk when analyzing real estate funds, you should look at standard deviation and Sharpe ratios (see table on page 60). Sharpe ratios are calculated by subtracting the risk-free (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.