Property
 

F E A T U R E S
 
By The Numbers
A Topsy-Turvy Year for Real Estate Funds
Most real estate funds have underperformed the Morgan Stanley REIT Index thus far in 2001. Here’s why that may not be as bad as it sounds.

by Barry Vinocur

You no doubt have heard the old saw, “You cannot eat risk-adjusted returns.” Well, what about relative returns? After spending back-to-back years (1998-1999) in the investment doghouse, real estate investment trusts roared back last year. The strong performance of the Morgan Stanley REIT Index in 2000—it posted a 26.8 percent total return—only shone more brightly when stacked up against the broader market’s dismal showing last year. The Standard & Poor’s 500-Stock Index was down 9.1 percent; the Nasdaq Composite finished in the red as well, down an eye-popping 39.2 percent.

Property-linked stocks are having their ups and downs this year, though they’re not nearly as volatile as the broader market. In late August, the Morgan Stanley REIT Index—a total return index—was up 15.2 percent. Since then, the stocks have given back some of those gains, as concerns about the economy have intensified. When we went to press, the widely followed benchmark of REIT performance was up approximately 7 percent, year-to-date. For the second year running, the Morgan Stanley REIT Index was well ahead of broader market benchmarks, such as the S&P 500, which was down nearly 19 percent, and the Nasdaq Composite, which was down roughly 36 percent.

Industry veterans argue that concerns over the economy are overshadowed by REITs’ relatively high and stable dividends. “The 10-year is yielding 4.4 percent; the Fed funds rate is at its lowest level in nearly four decades after the Fed cut short-term rates for the ninth time this year; the yield-focused investor doesn’t have a lot of choices,” said one investor. REITs, he argues, fit the bill. “The issue isn’t so much stock price volatility as it is dividend security. Most retirees will live with a bit of price volatility if they believe the dividend is rock solid. They figure if they are buying strong companies, prices will bounce back; they have seen that happen. Besides, stock price is their children’s concern. They hope the dividend will increase over time, but their No. 1 issue is whether the dividend is safe. If they can get comfortable with that concern, then REITs become a great place to invest their money.”

How secure are REIT dividends in the post-September 11 world? As we noted in our Sept./Oct. issue (see “Rock Solid: The REIT Dividend Story” on page 20), the best available data suggest across-the-board—with the exception of the hotel REITs (see “Bleak Outlook for Lodging Sector” on page 8 in this issue)—dividends are secure.

How secure? In an October 3 note, the REIT Research Team at UBS Warburg wrote, “We believe the dividends on the stocks under our coverage are generally secure as we head into a recession. On average, our universe can lose an average of 12 percent in occupancy before dividends are at risk. This would be an unprecedented occupancy drop in light of historical performance.”

(Download Real Estate Mutual Funds Table)

Since most investors aren’t able to “stress test” the earnings models of dozens of REITs, we suggest zeroing in on a few key variables. The first is a company’s dividend coverage ratio (DCR), which is calculated by dividing the estimate for a company’s adjusted funds from operations (AFFO) per share by its current dividend. The higher a company’s DCR, the more sustainable its current dividend. (The table on pages 66-71 shows the current dividend and AFFO estimates for more than 100 REITs and non-REIT real estate operating companies.) In other words, “dividend safety” is closely tied to DCR.

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The second question to ask is, “How highly levered is the company?” We’ll focus first on financial leverage. In a recent note on dividend coverage ratios, the REIT Research Team at Merrill Lynch & Co. noted, “Investors need to remember that dividends are paid from real cash (not GAAP earnings), and therefore we focus on each REIT’s cash flow (not earnings) to determine the sustainability of dividends.” AFFO is equal to a REIT’s cash flow.

Steve Sakwa and his fellow Merrill Lynch analysts added that the DCR for the companies in their coverage universe is 134 percent, which implies that the average REIT generates $1.34 of cash flow to support $1.00 of dividends. “Given that the average REIT is approximately 45 percent levered implies that the preleveraged cash flow figure (i.e., the net operating income) would need to decline by approximately 15 percent for the average dividend coverage ratio to reach 100 percent, an unlikely event despite the current economic slowdown.”

Operating leverage also figures in the mix. Given the short-term nature of hotel leases (guests check in and out every day), the current extremely soft lodging fundamentals, the fact that hotel REITs are generally more highly financially levered than other companies, and their high degree of operating leverage, lodging REITs are a much higher risk proposition vis-à-vis dividend sustainability than, say, regional malls, which historically have demonstrated very stable cash flows.

Two final points before moving on. First, though some subsectors within the universe are more insulated from the economy’s ups and downs in the short-term, such as office buildings, which generally have long lease durations, property-linked stocks are far from immune to events such as a recession. Though the general consensus seems to be that real estate markets are unlikely to soften enough to jeopardize the overwhelming majority of nonlodging REITs’ dividend coverage, the depth and breadth of the recession are factors to keep an eye on.

Second, as noted earlier, financial leverage is important when assessing dividend sustainability. A highly levered company’s DCR is less sustainable than a company with the same DCR that has lower leverage, so focusing solely on DCR isn’t enough. Though there are a variety of ways to gauge leverage, Realty Stock Review (this magazine’s sister publication) relies on several metrics, the most important being fixed-charge coverage ratios (see Glossary on page 78; fixed-charge coverage ratios for roughly 100 property-linked securities can be found in the table on pages 66-71).

Valuation Concerns
Given the run-up in REIT prices over the past roughly 18 months, it’s reasonable to ask whether the stocks are overvalued. Such questions are never easily answered to everyone’s satisfaction. For one thing, agreeing on valuation metrics is far from straightforward. Most analysts and investors, however, generally agree the two most valuable metrics when analyzing REITs are forward AFFO multiples and premiums/(discounts) to net asset value, or the estimated private market value of the company’s real estate.

The current economic environment complicates these analyses because so many of the data points used to derive these metrics are in rapid flux. There are two points to keep in mind. First, the REIT bear market of 1998-1999 left the stocks “cheap.” So, while prices have run-up since late 1999/early 2000, the stocks are still below their peak valuations seen in late 1997/early 1998. Though industry veterans generally agree those valuation levels were overdone, the forward AFFO multiple for the companies in Merrill’s coverage universe (see the bar graph on page 44), as of late-September of this year, was 9.7, well below the average for the period 1993-2001 of 10.8.

Second, in late 1997-1998 real estate stocks were changing hands at roughly a 30 percent premium to net asset value, the highest premium since Green Street Advisors in Newport Beach, California began tracking the data more than 10 years ago (see graph on page 75). As of early October, Green Street reported the property-linked stocks in its coverage universe were trading at a slight discount (-0.45 percent) to their net asset value estimates.

Put simply, though it will be a while before companies are able to get a good handle on their numbers for next year—let alone 2003—the best available data suggest that heading into the fourth quarter of 2001, REITs were attractively valued relative to historic benchmarks, even taking into account the economic slowdown.

Funds Flows
In spite of strong returns last year and solid returns for many real estate funds this year through the end of the third quarter, fund managers didn’t see the assets in their funds swell. According to AMG Data Services in Arcata, California, after experiencing net redemptions of roughly $1.3 billion in 1998 and another $1.3 billion in 1999, dedicated real estate funds saw net inflows last year of $528 million. Though inflows are preferable to the alternative, fund managers are surprised more money didn’t come into the sector through their funds. Through late September of this year, AMG reported $392 million flowed into dedicated real estate funds.

There’s no way to know why investors didn’t turn to real estate funds last year. Some industry veterans speculated investors were reluctant to pour money into a sector that had disappointed them so badly the two prior years. Others suggested it took a while for investors to realize Nasdaq wouldn’t simply “snap back” as it had done before.

Whatever was responsible for the lack of significant inflows into real estate funds last year, a lot of fund managers thought this year would be a different story. Several fund managers said they had expected flows to pick up as investors who focus on yield backed away from utilities. Heading into the fourth quarter of 2001, the hoped-for inflows had yet to materialize.

If individuals aren’t embracing the sector, it appears that institutions are. Industry veterans report that a number of pension funds and other institutions either have Requests for Proposals (RFPs) out for real estate securities managers or are already evaluating potential candidates. Though industry veterans say the process has been slowed by the tragic events on September 11, all said they expect the institutions to press ahead with the search process. How much money are we talking about? The number bandied about is $2 billion, with up to another $1 billion possible in the first half of next year.

Surveying the Landscape
When the bell rang on December 29 to end trading for 2000, real estate fund managers were feeling mighty good. According to data supplied to us by Lipper Inc., the average real estate fund posted a 25.2 percent total return in 2000, outperforming not only the broader market benchmarks by a wide margin but also the average diversified stock fund. Results through the third quarter of this year were good, though not eye-popping like last year. Again, according to Lipper, through the end of Sept-ember, the average real estate fund posted a 4.3 percent total return.

Of the nearly five dozen real estate funds tracked by Realty Stock Review, roughly only a dozen outperformed the Morgan Stanley REIT Index through the first three quarters of 2001. (Unlike Lipper and Morningstar, Realty Stock Review doesn’t count each share class as a separate fund. Realty Stock Review totals the assets of all share classes, and that data are used to track fund growth over time.) Changes in fund assets incorporate not only fund flows but changes that occur as a result of rising stock prices.

A couple of notes about the performance of real estate funds through September 30, 2001. First, though we and others use the Morgan Stanley REIT Index to track the performance of REITs, it’s by no means the benchmark used by all fund managers. Some fund managers, for instance, consider their benchmark to be the Wilshire Real Estate Securities Index, or the NAREIT Equity REIT Index, or one of the other REIT indices (see “Tracking the Market for Publicly Traded Real Estate Stocks” on page 76). Second, so far, 2001 has been a topsy-turvy year for the stocks. Whereas the large-cap names shone most brightly last year, this year most of the stellar performers have been smaller-cap, higher-yielding stocks. Put another way, many of this year’s standouts are stocks off-the-beaten path of many fund managers.

When analyzing real estate funds, there are a number of factors to take into account. Chief among those is manager tenure, the fund’s risk profile, turnover ratio, the fund’s holdings, and its track record. Though its tempting to chase the “hot hand,” mutual fund investors should know why that hand is so “hot” before jumping head first into a fund. For instance, this year some real estate funds have loaded up on less-liquid, small-cap names or on high-yielding and high-flying mortgage REITs. In the hands of pros, these may be workable investment strategies, but investors should keep in mind that as a fund’s assets swell, it will become increasingly difficult for a manager to make a small-cap strategy work as well without substantially increasing risk. Likewise, though mortgage REITs seem every few years or so to have their day in the sun—frequently when rates are falling—it is very difficult to find mortgage REITs that have posted stellar returns over extended periods.

Two final points: (1) Real estate funds come in all shapes, sizes, and flavors today. As a result, it’s important to “know a fund’s strategy” before making an investment. (2) In addition to the funds listed in the table on page 43, there are a number of closed-end funds, as well as a growing number of exchanged-traded funds, or ETFs, that focus on property-linked securities.

The top five performing real estate funds at the end of the third quarter of this year were: (1) Kensington Strategic Realty Fund (22.9 percent total return); (2) Spirit of America (22.3 percent total return); Stratton Monthly Dividend REIT Shares (14.8 percent total return); Third Avenue Real Estate (11.9 percent total return); and Cohen & Steers Equity Income Fund (11.2 percent total return).

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