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This year's big winner in the stock market has been commercial real estate: a surge of 12.8% at the average mutual fund investing in real estate investment trusts (REITs). That's the group's sixth double-digit gain in seven years.
But the very success of real estate raises the specter that a correction is due. In addition, the Federal Reserve has its hands around the economy's neck, trying to wring the exuberance out, and landlords go broke when the economy faints.
At least two factors argue in favor of real estate, though. The first is that recessions have become shorter and milder in recent decades, as the Fed gets better at calibrating its actions.
"The Fed is increasing rates in an effort to engineer a steady-growth economy, and commercial real estate can thrive exceptionally well in that (environment)," says David Lee, manager of T. Rowe Price Real Estate (TRREX).
Secondly, a mountain of cash has been building up on the sidelines amid today's chaotic markets, and some of it is destined to cascade through the property sector.
"Our belief is that there is in excess of $100 billion of capital, including leverage, that's waiting to be invested in commercial real estate," says Barry Vinocur, publisher of REIT Wrap, a daily e-mail newsletter focusing on the group. The total capitalization of the REIT sector is only $341 billion.
I have long been an advocate of real estate funds for income investors, and I own one in my model portfolio of exchange-traded funds. But I'm increasingly bullish on a role for real estate in an equity fund portfolio. I think it's likely that REITs will outperform the stock market for at least the next three to five years, and probably longer.
Property diversity
REITs are a small marketplace, consisting of little more than 140 companies, all of whose shares combined are worth less than one year of sales at ExxonMobil (XOM, news, msgs). They are also fractured among more than a dozen sub-sectors, some of which behave in contradictory ways."When you talk about REITs, you're really talking about 13 different property types, and each of these different property types, at any moment, may be reacting to the economy in a different fashion," says Michael Schatt, senior portfolio manager of Phoenix Real Estate Securities (PHRAX).
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The big three groups are office and industrial properties, which account for 27.5% of the sector's market capitalization; retail, 26.0%, and residential, 17.2%, which is almost entirely multifamily housing.
Currently, the retail component is weakest, especially among low-price merchants like Wal-Mart Stores (WMT, news, msgs), whose customers are discouraged by high gasoline prices. These REITs are up between 3% and 10% this year.
The strongest are offices and apartments, each with gains in the neighborhood of 20%. They reflect two ways in which commercial real estate reacts to higher interest rates.
Office rents are booming both because employment remains very strong and because rising rates discourage developers from putting up new buildings. Apartments are strong because they have the shortest leases -- six to 12 months -- and therefore landlords can raise rents as fast as rates go up.
I prefer actively managed real estate funds because they can tilt toward the groups with the best prospects and away from those the market is shunning. But in practice some index funds have done as well as the best actively managed funds.
| Fund | Manager tenure in years | Expense ratio | Avg. return, 3 years | Avg. return, 5 years |
|---|---|---|---|---|
Vanguard REIT Index (VGSIX) | 10.2 | 0.21 | 25.6 | 18.9 |
n/a | 0.35 | 28.5 | 20.5 | |
T. Rowe Price Real Estate (TRREX) | 8.7 | 0.85 | 29.3 | 21.1 |
Cohen & Steers Realty Shares (CSRSX) | 15 | 0.97 | 30.2 | 20.7 |
Phoenix Real Estate Securities (PHRAX) | 8.4 | 1.3 | 25.8 | 20.6 |
Notes: As of June 30, 2006. n/a=Not available; team managed. *=Adjusted for sales load for Phoenix fund.
Sources: MSN Money, Morningstar Inc.
The biggest REIT fund is Vanguard REIT Index (VGSIX), which tracks the MSCI U.S. REIT Index. Part of its success is due to its extraordinarily low expense ratio of 0.21%.
Phoenix's Schatt, on the other hand, has to overcome expenses of 1.30% annually to earn a dime, but he has succeeded. Lee of T. Rowe Price has a much easier job, having to earn just 0.85% each year before shareholders start to make money.
I'm considering adding the T. Rowe Price fund to my personal portfolio in the amount of between 5% and 10% of total assets. (I have my largest retirement account with Price.) Among the many advantages of real estate is that it tends to move independently of the forces that drive stock and bond prices.
Extra returns, no extra risk
If you owned a classic stock-and-bond mutual fund like Vanguard Balanced Index (VBINX), you would have earned average annual returns of 4.5% over the past five years with a standard deviation, or risk level, of 7.82.If instead you had limited that fund to 90% of your portfolio and devoted the other 10% to Vanguard REIT Index, your return would have increased to 5.9% and your risk level would have been unchanged at 7.82. Increasing returns without increasing risk is investing's Holy Grail.
Part of the property group's dramatic gains in recent years has been due to more and more investors climbing aboard after discovering its risk-return advantages. Fresh demand for property has driven the average yield of a REIT down to 4.1% currently from 4.7% at the end of 2004, as its price has risen.
It's not surprising that even sophisticated investors are only now discovering REITs. The modern REIT era didn't begin until November 1991, when Kimco Realty (KIM, news, msgs) went public. Lacking even two decades of data, today's market has no "historical average" against which it can be compared.
But the mammoth booms and busts that characterized commercial real estate in the pre-public era have disappeared, at least so far, as professional corporate managers have taken over the business. Public REITs are more diversified than private landlords, as well as better managed.
Vinocur expects REIT total returns to moderate in coming years to an average of 8% to 9% annually, half in dividends and half in capital gains. That's more than I expect the stock market to deliver, which is one more reason I think real estate belongs in my portfolio, and possibly yours.
At the time of publication Timothy Middleton didn't own any securities mentioned in this article. Middleton is the author of "The Bond King: Investment Secrets From PIMCO's Bill Gross," and the former mutual funds columnist of The New York Times. He works from home in Short Hills, N.J.
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