Skip to Content
The Short Answer

Is the Time Right for Real Estate?

Real estate is a good diversifier, but now's the time to trim, rather than add to, a position.

Mentioned: , ,

Fears that the residential real estate bubble will soon deflate have sent the stocks of many prominent homebuilders, such as  Toll Brothers (TOL),  Centex (CTX), and  Pulte Homes  (PHM), reeling in recent months. On the other hand, both institutional and retail investors are piling into commercial real estate via real estate investment trusts (REITs) and real estate operating companies (REOCs). (REITs and REOCs, which make up the majority of most real estate mutual funds, generally own commercial properties such as shopping malls, apartment complexes, office buildings, and hotels.) For example, two of the more popular real estate mutual funds,  Fidelity Real Estate Investment (FRESX) and  T. Rowe Price Real Estate (TRREX), have together taken in nearly $2 billion in assets over the past year. If fear and greed govern financial markets, fear seems to be surrounding the residential homebuilders, while greed seems to be gripping commercial real estate.

We think investors adding commercial real estate to their portfolios are on the right track, but they should be careful not to overdose on the asset class right now. We'll keep our focus on REITs for this article, because that's what most mutual funds own, though we'll highlight a fund at the end that owns REOCs, too.

History of an Asset Class: From Frog to Prince
Not so long ago, real estate investors shunned REITs because, as stocks, they displayed volatility that bricks and mortar buildings didn't. After all, privately held buildings don't get priced on a market every day as stocks do, and old fashioned real estate investors didn't like to see the value of their holdings fluctuate every day. Stock investors, for their part, avoided REITs for being real estate with supposedly inferior management teams unable to exploit growth opportunities.

Nevertheless, REITs have taken off in recent years, as investors recognized their healthy yields (REITs by law distribute 90% of their income as dividends) and decent growth opportunities. Additionally, many investors have warmed up to REITs because they view real estate investments as a hedge against inflation and because they value their diversification potential. (Real estate securities' performance has a low correlation to that of stocks and bonds.) Moreover, higher commodity prices and more discipline among developers have conspired to put a damper on overbuilding, which has traditionally been the plague of the real estate industry. Finally, investors have realized that commercial real estate represents a $4 trillion market, even if a fraction of it is in public, liquid securities; it's hard to be overexposed to such a big market even if you own your home. Owing to these many factors, the specialty- real estate fund category has gained nearly 22% annually over the past five years through mid-September 2006, beating all competitors except precious metals and emerging markets.

Are REITs Overpriced? The Bulls Say: Not Until There's More Development
So with REITs finally finding favor among investors, is it possible that they are in bubble mode? The bulls say no, arguing that higher commodity prices and labor costs make it expensive to put up new buildings, keeping supply down. For now with a solid economy, REITs, which pass through rents from tenants to shareholders after upkeep expenses, are able to benefit shareholders nicely by raising rents. Higher rents may eventually justify new construction--but bulls like Marty Cohen of Cohen and Steers in a recent Barron's interview say that hasn't happened yet, and only a spate of new building without adequate demand for space will crush the market. Moreover, the low interest rates that encouraged so many people to buy homes have driven up prices so high in some instances that prospective homeowners are choosing to rent instead. The bulls say that high home prices have made it a landlord's market. Finally, it's a boom time for hotels, with robust business and leisure travel and the memories of overbuilding in the 1990s still fresh enough in developers' minds to keep supply tight.

The Bears Say: Too Much Growth is Priced into REITs
The bears, by contrast, don't think that rents justify prices paid in recent acquisitions. In real estate, investors speak of a "cap rate," which is basically expected net rent/price, and some private investors have recently purchased REITs at a 4% cap rate. To put this in perspective, a stock whose earnings are 4% of its price has a price/earnings ratio of 25, and generally has significant expectations of growth. After all, an investor can safely earn well more than 4% on a 10-year U.S. Treasury note. Real estate bears are skeptical that the anticipated growth in rents will materialize.

Additionally, REITs have begun issuing convertible bonds, which managers have an incentive to do when they think their stocks are expensive. If their judgment about the stock is correct, the option is effectively worthless, although the market presumes that is has some value. The presumed value of the option means that the market gives the business the opportunity to borrow money at a lower rate with a convertible than with a straight bond without a valuable option attached to it.

One more strike against REITs: No REIT, save the embattled mall developer Mills (MLS) (which is under an SEC investigation), is trading at a sufficient discount to Morningstar equity analysts' fair value estimates to place it on the 5-star stock list.

Tread Carefully and Keep a Long-Term View
So what's a real estate investor to do? Continued high double-digit returns are unlikely, so if you've decided that the sector should be part of your long-term asset-allocation plan, you'll want keep your expectations in check. If you don't have REIT exposure, consider making multiple purchases instead of taking a full position all at once, and consider staying at the lower end of your allocation range for the time being. If 5% to 10% exposure is what you're aiming for, stay closer to 5%. Those who already have exposure to the sector should rebalance, shaving REIT exposure and adding to other holdings.

New and experienced real estate investors should also consider the role that real estate does--and does not--play in a portfolio. True, real estate has had a very low correlation with stocks and bonds historically. But real estate's value as a hedge against inflation may well be overrated. Ownership in a business that can pass on higher costs to customers is what beats inflation over extended periods of time. This includes REITs, but that means they're not likely to fight inflation any more or less effectively than other businesses. Some REITs with unique, high-end properties can raise rents more easily than others, just as in other sectors some businesses have more pricing power than their competitors. To view the entire category as a kind of magic bullet against inflation, however, is a mistake. Finally, REITs have experienced drops recently when interest rates have gone up. Be prepared to see REITs lose some of their "low correlation" attributes and start trading more like bonds or certain equities such as utilities in the near future.

Top Picks
Here are some funds that provide solid access to commercial real estate.

Investors who work with a commission-based advisor should look at  JP Morgan U.S. Real Estate (SUSIX). This fund employs a double-barreled research approach, first assessing macroeconomic conditions to assess real estate's subsectors and then applying fundamental analysis to choose the best securities. It typically holds a concentrated portfolio, preferring to manage risk with its valuation techniques instead of with diversification. This makes mistakes more costly but success more pronounced when the managers get subsector and stock picks right. Lately the fund has benefited from an outsized allocation to high-end apartment REITs. We think the experienced management team and deep research resources will allow this fund to maintain its strong record.

A great no-load option is  T. Rowe Price Real Estate (TRREX). Manager David Lee has run this fund from its inception in late 1997. Lee employs a straightforward approach, analyzing REITs from both a cash-flow and net-asset-value perspective and controlling risk through subsector and geographic diversification. He also takes management skill into consideration, because real estate operators must be skilled asset allocators. Lee's simple approach has landed the fund in the top quintile of its peers for the trailing five years through March 2006. The fund also sports one of the highest yields in the category, even though Lee's value approach could potentially lead him to lower-paying REOCs at some point. In any case, long-term investors should be rewarded by his emphasis on total return.

Finally,  Third Avenue Real Estate Value (TAREX) is distinguished from our other Analyst Picks in that it prefers real estate operating companies to real estate investment trusts. REOCs are not required to pay a dividend and can plow their profits back into their businesses and invest for future growth. Manager Michael Winer controls volatility by choosing businesses trading at a discount to underlying asset values rather than through subsector diversification. Dividend-seekers will be disappointed here, but the fund's total-return focus makes it appealing nonetheless.


John Coumarianos has a position in the following securities mentioned above: TAREX. Find out about Morningstar’s editorial policies.