Holding REITs the Right Move--Last Year, That Is

For most people, investing in real estate means buying a home and hoping the price rises over time. But with today’s low inflation and moderate buyer demand, that can take awhile.

So mutual fund investors might have been surprised last year to see real estate funds clobber the return on S&P; 500-index funds by more than 15 percentage points, especially after a lackluster 1995, when they trailed the same index by almost 27 percentage points. This year, real estate once again trails the S&P.;

Consider 1996 an anomaly.

“The easy money was made last year,” said Kevin McDevitt, an analyst with mutual fund tracking firm Morningstar. “It was one of the best years ever, because REITs were selling at a discount to their underlying properties, and this year they are selling at a premium.”

Real estate investment trusts, the investment base of most real estate mutual funds, are companies whose main assets are pools of income-producing properties--office buildings, apartments, hotels, etc.--that are put into trusts. The stock is then sold on stock exchanges.

An advantage REITs have over conventional businesses is that if they pay out 95% of their income to shareholders, there is no corporate income tax. (In that way they are similar to mutual funds, which make similar payouts for the same reason.) That dividend payout, which often ranges from 4% to 7% annually, according to fund managers, constitutes the main reason many individual investors buy REITs directly. The potential for appreciation of the stock is a lesser reason.

Between the dividend and the appreciation, “normally we are talking about low- to mid-teen growth returns because they are a long-term investment,” said Kim Redding, who manages the American Century Real Estate Fund, a fund mainly for institutions until last year, when it was merged into the retail American Century fund family so it could grow faster.

“We had an extraordinary run the last half of last year, then things stalled this year,” said Martin Cohen, a partner in Cohen & Steers Capital Management, a New York firm that runs the Cohen & Steers Realty Shares Fund--at $2.6 billion, the industry’s largest.

Part of that big run-up last year was a reaction to the summer bear market in technology stocks, said Barry Greenfield, manager of the $2.2-billion Fidelity Real Estate Fund, the industry’s oldest at 11 years. “The sell-off in tech stocks happened, and the big players at aggressive-growth funds started buying REITs. It was like a big debutante ball with all these new players coming out,” he said.

The newfound interest in REITs among equity funds and Wall Street traders was in large part because of growth in the size of the REITs, which had been--and still are, by Wall Street and mutual fund definitions--small- to micro-capitalization stocks.

But in 1996, Greenfield said, 21 REITs hit the billion-dollar mark and several hit the $2-billion to $4-billion level. “The pension guys, who preferred to own real estate directly because REITs had been too small for them, suddenly switched,” he said.

The ensuing demand pushed up prices--and mutual fund returns along with them. But in April, the pension funds began selling, and the REIT market and REIT funds took a beating from which they are just beginning to recover.

Despite the kickup in value of REITs, the real estate mutual fund category is still tiny. The $8 billion in real estate funds is less than one-half of 1% of the $2 trillion in stock funds. And more than half that is contained in only three of the 38 real estate funds--Cohen & Steers, Fidelity Real Estate Fund and Vanguard’s new REIT Index Fund, which took in about $900 million in its first year.

Consider also that the total capitalization of the REIT industry is about $100 billion, considerably less than that of General Electric, for example. Greenfield expects the REIT market to triple in about 20 years.

Not all real estate funds invest exclusively in REITs. Some also own the stock of independent real estate-related companies. For example, Longleaf Partners Realty, a Memphis, Tenn.-based mutual fund, holds IHOP Corp. in its portfolio. Where some see only a chain of pancake restaurants, others look at IHOP as a real estate business because of all the locations it controls.

Other real estate-related companies include home builders, development businesses, construction companies and lumber companies.

Those funds differ from ones that invest almost entirely in REITs, said Morningstar’s McDevitt, because they lack the cushion of the high-dividend flows from REITs, and their value often coincides more with the actions of the overall stock market and interest rates.

You might think real estate would be highly interest rate-sensitive, dropping on rate increases. After all, real estate lending is sensitive to rate hikes. But higher interest rates can also help the funds by slowing development of new projects and reducing competition with existing buildings that might be held in a REIT fund.

If rates rise, of course, it’s also possible investors will sell REITs and seek higher-yielding investments.

It is important for investors who tend to jump on last year’s winners to remember that even real estate fund managers consider 1996’s stellar performance to be an exception.

Cohen, like other fund managers, suggested holding only 5% to 10% of your portfolio in these funds, if you want them at all.