Real Estate Offers a Way to Diversify

Is the old mantra “location, location, location” really that critical to investment success in real estate?

The Vanguard Group thinks not.

The big no-load fund outfit in Valley Forge, Pa. ([800] 662-7447) has unveiled a new fund that thumbs its nose at the conventional wisdom. Vanguard is stuffing the portfolio with real estate securities with little regard for the properties they hold. The fund does not even have a portfolio manager, in the traditional sense.

Naturally, the new product is an index fund. It buys the same stocks included in the Morgan Stanley REIT index, which counts 90 companies with operations around the United States.

REITs, or real estate investment trusts, are special companies that own or operate apartment, office, industrial and other types of properties, often specializing by property type or geographic area. These firms come with several unusual twists, including an exemption from having to pay corporate income taxes and a tendency to pay above-average dividends.

If you’re looking for relative bargains in today’s pricey stock market, real estate mutual funds are a good place to start, as they have been serious laggards over the last couple of years.

Over the 12 months ended March 31, for example, the funds returned just 20% on average, compared with 31% for the typical small-stock fund, according to Lipper Analytical Services in Summit, N.J.

Over the last five years, they did even worse on a relative basis, gaining 56% compared with 119% for the latter group.

Small-stock funds are a reasonable yardstick for comparison, considering that REITs include some of the tiniest public companies around.

Real estate has been stuck in a holding pattern in recent years, as the industry has struggled to work off excess capacity created during boom times in the 1980s.

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Why would you want to hold a real estate fund in the wake of such disappointing performance? Diversification provides the answer.

Increasingly, real estate is being viewed as a core asset class in which well-diversified investors should have at least a small stake. Real estate goes through its own boom and bust cycles. As a tangible asset, it traditionally has done well during inflationary periods, when stocks and bonds languish.

“Most financial assets react negatively to higher inflation,” says Derek Sasveld, a consultant at researcher Ibbotson Associates of Chicago. “Real estate will help cushion some of that.”

While millions of Americans have exposure to real estate through their homes, most do not own enough properties to have anything resembling a diversified portfolio. But they can buy a piece of the action in a real estate mutual fund for a couple of thousand dollars or less.

“If you already have an otherwise diversified portfolio, you might consider adding a real estate fund as a core holding,” says Cebra Graves, an analyst at researcher Morningstar Inc. of Chicago. But he suggests limiting such a stake to 5% or 10% of your investment assets.

Sasveld prefers direct real estate investments for people who can afford to own multiple properties. He’s skeptical of real estate funds and REITs because he believes their prices still move too closely in sync with the broad stock market to be considered true diversifiers.

But because most such funds have been around only a few years or less, nobody really knows how they will fare in a highly inflationary environment.

Another problem for real estate funds has been their relatively high expense. The typical portfolio charged 1.6% in annual management fees and operating costs in 1995, according to Morningstar. That compares with expenses of 1.4% for stock funds generally. (Fund expenses erode shareholder returns.)

By trimming research costs and realizing other economies, Vanguard hopes to pass along savings to shareholders. The company expects that its REIT Index Portfolio will carry costs of just 0.35% a year.

The Vanguard fund is off to a good start, having attracted more than $30 million since a May 13 launch.

“We’ve had a lot of interest from investment advisors,” says John J. Brennan, the company’s president.

Brennan adds that the recent introduction of the Vanguard REIT Index Portfolio is not a prediction on the company’s part that real estate will take off any time soon. Still, he considers the timing significant in that the REIT market has only recently grown sufficiently large to be able to support a broad-based index portfolio.

But is Vanguard’s index approach the right one for real estate companies? REITs, after all, tend to be small firms that are not carefully followed by Wall Street analysts. That means shrewd fund managers should be able to spot exceptional bargains.

Vanguard is hoping that the cost savings and broad diversification of its fund will more than make up for any stock-picking deficiencies.