By Ilana Polyak
Hedge funds increasingly look to REITs, but should investors look at hedge funds?
Improved liquidity, higher market caps and increased fund flows are characteristics that would make any investor take notice. And certainly these developments, which have permeated the publicly traded REIT industry in recent years, coupled with historically strong returns and hefty dividends, haven’t escaped the attention of hedge funds.
Hedge funds are popping up in every corner of the investing universe. But over the last few years, a slew of new real estate-dedicated hedge funds have launched. While there are no exact figures, it is estimated that there are now about 20 such offerings, with more than $1 billion in assets. One fund, GEM Value Partners, LLC, accounts for approximately $475 million of the total. Three years ago, there were only estimated to be five or so such funds.
In addition, hedge funds that cover a broader investment strategy than just real estate stocks have also come into the sector. Clearly, a multi-year bull market in REIT shares has garnered the attention of investors and money managers alike. However, hedge funds look to capture profits through periods of rising and falling share prices—so their interest goes beyond a cyclical upswing.
Bill Hauser, portfolio manager of HVB’s Activest Lux U.S. REITs, has managed both long-only and hedged strategies during his career. According to Hauser, 10 years ago, when he was managing a real estate hedge fund, liquidity was a major concern.
"Unfortunately, those names of greatest interest as short candidates also had minimal liquidity and often the highest dividend yields. And with minimal liquidity you needed to be more concerned about the prospect of a short squeeze (whereby a stock price rises as investors who sold short seek to cover their losses by buying shares to cover their position)."
Gaining investor interest was an additional hurdle. At the time, few investors understood REITs and even fewer accepted the rationale for investment in a hedged REIT strategy. "With an increase in overall liquidity and stature of the sector, some of those issues have now diminished—but by no means disappeared," Hauser says.
To other long-time REIT observers, the increased appeal of hedged strategies is hardly surprising. It’s yet another sign that REITs have arrived. "This market has clearly been validated," says Tom Dreyer, manager of the $70 million Trilogy Real Estate Partners Fund, which launched five years ago. "There are clearly market inefficiencies that people, including ourselves, are looking to exploit."
A New Chapter
To say that REITs are the latest "hot" area for hedge funds would be stretching things a bit. After all, the entire hedge fund universe is in excess of $800 billion and REIT funds represent just a tiny fraction. Still, the new hedge funds populating the REIT universe spell a new chapter for real estate investing.
"The ability to be both long and short gives investors the opportunity to make money in good times and bad times," says Carl Tash, chief executive officer and portfolio manager of Cliffwood Partners, LLC. "Historically, we’ve had a business where you made money only by buying properties."
Unlike the more common mutual fund variety, hedge funds are generally limited partnerships of fewer than 99 shareholders. Typically they charge fees of 1 percent of assets annually, in addition to 20 percent of profits. "There’s been a natural progression in this market since the 1993 equitization of REITs," says David Helfand, president of Helix Realty Funds. Helfand, formerly chief investment officer of Equity Office Properties (NYSE: EOP), started an investment fund in July, aiming to produce gains of 1 percent to 1.5 percent a month. "This has more evolved than it has exploded. As there’s been growth in hedge funds and growth in REITs, this is the natural intersection of the two," he says.
A decade ago the equity market cap of all publicly traded REITs was $43 billion; now the market cap is $251 billion. What’s more, six REITs are included in the Standard & Poor’s 500 Index and therefore on the radar screens of large equity fund managers, ensuring a constant demand for REIT shares. In other words, there’s liquidity in a market that has historically struggled to attract buyers and sellers.
"To have a legitimate sector or asset class you need that kind of liquidity," Dreyer says.
Hedges Sprouting
The interest from the hedge fund community in REITs will only grow, say most observers. Tash believes that if REITs underperform in coming months, that will draw more hedge funds to the sector as a way to shelter client assets from some of the worst damage of declining real estate returns.
The REIT rally of the last four years is likely drawing to a close, Tash says. Historically REITs have returned 10 percent to 12 percent a year, yet over the last four-and-a-half years, they’ve produced average gains of 18.7 percent per annum. Tash adds that the ensuing reversion to the mean could signal several years of negative returns. Rising interest rates could also hurt profits, resulting in lower earnings and lower multiples, after years of expanding earnings and multiples, he says.
"If you’re looking at rising interest rates, multiples contracting, REITs trading at or below the returns of the last four or five years, then it’s not a bad time to be in a long-short strategy for the next couple of years," Tash says.
"If you’re looking at rising interest rates, multiples contracting, REITs trading at or below the returns of the last four or five years, then it’s not a bad time to be in a long-short strategy for the next couple of years."
—Carl Tash
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Putting up the Hedges
It’s hard to lump all the hedge funds together. After all, the risks they are willing to take and the returns they are seeking to achieve vary considerably. Nonetheless, there are some commonalities.
Most of the funds use long and short strategies, and adjust their long/short bias depending on market dynamics. In recent years, a rising market has enabled some managers to deliver outsized returns by maintaining a long bias and employing leverage. At the same time, some funds have underperformed after taking on excess short exposure and as a result, at least one fund has recently closed operations. Some funds seek to employ a dollar-neutral or risk-neutral style, in which case they are avoiding making calls on market direction.
In Hauser’s view, the real test comes through performance across varying parts of the investment cycle. He refers to Warren Buffet’s adage that "it’s only when the tide goes out that you learn who’s been swimming naked."
Still others use arbitrage tactics. Almost all of the funds also invest in non-REITs, such as homebuilders, hotels and manufactured housing, in order to fill out the investments. Some funds go even further by buying retail or health care names that are linked to REITs in those sectors.
Some managers look for a market disconnect, such as overvalued or troubled names that they think will decrease in value before establishing a short position—they are looking to actually profit from their short sales. Hauser notes that other managers focus on short sales as part of their risk mitigation strategy (rather than as a stand-alone profit center). In these cases the manager focuses on relative values. As long as the short positions increase in value less than the corresponding longs, the trade makes money.
At mid-year, short interest remained highest in those property types most leveraged to a cyclical recovery (apartments, industrial, lodging) and lowest in more defensive sectors (including retail). Short interest in REITs has climbed to equal that of the overall market—2.2 percent of float.
Hauser observes that while the overall equities market has recently experienced a period of historic low volatility, volatility for the REIT sector has actually increased. Therefore, he says shorting REITs has become more appealing for experienced investors. REITs have historically been praised for their low volatility. Paradoxically, volatility is a key ingredient for certain financial instruments to develop. As a result, derivatives such as futures and options are still of limited use in REIT investing.
Capital Structure Arbitrage
Another widely used strategy is balance sheet arbitrage. A manager can short common shares, the ones that have lowest priority for repayment among all shareholders in the event of bankruptcy. At the same time the manager can buy the preferred stocks or bonds that have higher standing on the balance sheet. There are times when common shares are overvalued, yet the bonds and preferred are more attractively valued.
With the large number of newly launched closed-end funds investing in preferred stocks in early 2004, hedge fund managers figured there was built-in demand for preferred stocks of all stripes and the strategy paid off.
Mike Elrad, senior managing Partner of GEM Value Partners, notes that, "There are likely to be more capital structure arbitrage opportunities if interest rates increase. Fixed income and equity investors will become increasingly dislocated in their investment objectives."
Tash of Cliffwood describes another tactic. At times a manager can short grocery stocks or retailers while buying up shares of supermarket-anchored REITs where the stores are major tenants. "A common strategy in 2002 might have been to short Safeway while going long on Pan Pacific Retail Properties (NYSE: PNP)," he says. "That hedged our REIT exposure because the grocery stores were doing horribly but the retail REITs were up."
Of course there are challenges to running a real estate hedge fund. The biggest is what to do with REITs’ hefty dividends while shorting a stock. When an investor shorts a stock, he or she borrows shares at one price and sells the borrowed shares hoping the price will fall by the time the stock must be purchased in order to return the shares. But while holding the shares, if a dividend is announced, it must be covered by the short seller.
With the average REIT paying a yield nearing 6 percent, that’s hardly a negligible sum. In fact, one analyst at a large investment bank who studies hedge funds for high net worth clients believes that covering the dividend is one of the biggest obstacles to attracting more hedge fund players to REITs and could prevent REITs from becoming full members in the hedge fund club.
Portfolio managers deal with this obstacle in different ways. Some unwind their short positions before the dividend is declared only to short the stock again once the dividend date passes. Others go long dividend-paying REITs that match the ones they short. The dividends they receive on their long positions pay the dividend for the shorts. Of course there are transaction and market impact costs to each trade that must be considered.
"Over the last few years with REITs doing so well, it made no sense to just sit and pay the dividend," Dreyer says. As a result, he wove in and out of short positions as dividend dates neared and passed. Now he’s more likely to cover the dividend on his short positions because he thinks the market, as a whole is likely to fall.
Elrad of GEM notes that, "It is easier for us to build our short exposure (relative to long) because many investors are reluctant to short a security with a high dividend. Our perspective is to look at both long and short investments from a total return perspective, not just a fixed-income component."
"It would be difficult for all but the top echelon of managers to overcome the huge fee structures of hedge funds."
—Robert Steers
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As Easy As ETF
Another challenge for hedge fund managers looking to REITs is how to use exchange-traded funds (ETFs). The emergence of ETFs—index funds that trade on an exchange in real time—has improved liquidity for REITs in general because they’ve brought more investors into the market. There are now three such offerings, containing varying levels of liquidity—all of which invest in a basket of real estate securities. As Portfolio went to press, Vanguard Group announced plans to introduce a REIT ETF.
An ETF allows an investor to gain exposure to an entire market in one fell swoop and also the ability to short that same market. And unlike individual stocks, ETFs are not subject to the uptick rule, meaning they don’t need to wait for a stock to move higher before shorting it.
Dreyer of Trilogy for example, shorted the Cohen & Steers Realty Major Fund during the recent market volatility in April, when REITs experienced their worst one-month decline in almost 30 years. The index fell by 16 percent in April alone, but Trilogy remained flat.
Despite the ease of use in ETFs, managers of the REIT hedge funds complain that they are often locked out of executing such trades because they can rarely borrow the shares.
"It’s the macro hedge funds that have the sway with the trading desks," Tash says. "We don’t have that kind of sway. We’re too small, and we can’t borrow the shares."
However, Elrad comments that, "ETFs barely existed five years ago. It is easy to underestimate the significance that ETFs will have to publicly traded sector funds such as REITs."
The Other Side
Yet not every real estate expert is ready to jump on the hedge fund bandwagon, despite the attractive fees that hedge funds generate.
Cohen & Steers Capital Management, veteran real estate investors, has opted to steer clear of hedge funds for now. Their reason is multifold, explains Robert Steers, co-chief executive officer. Steers and his partner, Martin Cohen, believe that the public real estate market isn’t big enough for the frenetic investing that hedge funds engage in. Though liquidity has clearly improved from the nascent days of the early 1990s, it’s hardly that of other markets. The market cap of the entire REIT universe is less than that of the stock of Microsoft alone.
And the names that a savvy real estate money manager would identify as attractive short positions—often those with looming financial problems—are still thinly traded. It could take days or weeks to build meaningful positions in such small issues.
"It would be difficult for all but the top echelon of managers to overcome the huge fee structures of hedge funds," Steers says.
Finally, Steers worries that managing a hedge fund while simultaneously running an open end mutual fund (in fact, the Cohen & Steer’s Realty Shares is the largest REIT mutual fund at $1.7 billion) are incompatible. The small universe of real estate stocks could mean that the mutual and hedge fund might take contrary positions in the same stock and the managers could be seen as having a conflict of interest.
Barry Vinocur, editor of Realty Stock Review and REIT Wrap, echoes similar concerns. He also questions the issues of conflicts and capacity. After all, only seven REITs boast average daily dollar volume of more than $20 million—and those seven account for 25 percent of the volume of the entire universe.
"Unless the real estate securities market grows proportionate to the number of new funds being offered, it will be difficult for these funds to grow," Vinocur says.
By way of example, he points to the excessive number of long-only mutual funds lingering with limited assets under management and questions whether that group is overdue for consolidation. "Right now, there is a lot more heat than light coming from the area of hedged real estate strategies." Will we wind up with a group of small, insignificant niche players, he adds, or will the market be taken seriously enough to draw meaningful interest?
Vinocur adds that recent performance from the group may be deceptive since many of the firms maintained a very long bias and not all employed hedging techniques. And some have already broadened their investment universe well beyond REITs or REOCs—an important consideration for investors.
Last May, Vinocur took on the issue of hedge funds coming into the REIT industry with his special report, Welcome to REITLand, Now Leave! It should be noted that Vinocur drew a major distinction between real estate dedicated funds and larger, more dominant generalist funds that recently entered the space. In any case, he expressed concern that the REIT industry as we know it may be endangered, in the sense that two of the three long-held virtues of low volatility, stable (if not growing) dividends and low correlation to the overall market are coming under fire. Even with improving fundamentals, dividend growth remains a concern—and with the entrance of all-powerful hedge investors, volatility has increased to previously unforeseen levels.
"Over the longer-term, how will increased volatility impact investor’s perception of the sector? The answer could be very different for institutional investors versus high net worth or traditional retail—after all, each of these groups has come to invest in REITs with slightly different priorities," Vinocur says.
Other Causes for Concern
Unlike mutual funds, hedge funds do not trade on U.S. exchanges and are not required to register with the SEC. As a result, they are not regulated and investors are not afforded protection under the 1940 Investment Company Act. However, on July 14th, the SEC voted to publish for comment landmark rules including required registration of hedge fund advisers under the 1940 Act.
Since the 1998 failure of Long Term Capital Management (LTCM), discussion has elevated regarding need for regulation of hedge funds. LTCM’s strategy involved exceptionally high levels of leverage and exposed frailties in the overall financial system that required intervention by the Federal Reserve. Since then, some controls have been established to avoid the excessive leverage applied by LTCM.
With increased capital flows, there have been increases in the number of fraud cases. In recent years, more than 40 fraud cases have been initiated. Some regulators have said in each of these instances they are only able to take a reactive rather than proactive role—they are arriving at the scene of accident after the damage has been done. As a result, the SEC has faced pressure to initiate regulation of the hedge fund industry. Many industry participants welcome regulation. An estimated 40 percent to 50 percent of U.S. funds have voluntarily registered with the SEC, according to the commission’s staff.
Meanwhile, others have suggested that regulatory involvement defies the primary role of these funds. Under current law, hedge funds are intended to operate with complete flexibility and provide balance and liquidity to often under-followed corners of the market. Many professionals, even those outside of the industry, suggest that the financial market itself should be the ultimate regulator.
A recent scandal emanated from Canary Capital Partners’ ability to time trades with several of the largest mutual fund complexes. The scandal resulted in sweeping changes for the mutual fund industry. While investment minimums and SEC requirements have previously limited entry to sophisticated investors, a new breed of fund of funds have attempted to "democratize" the industry—effectively enabling less knowledgeable investors entry into hedged strategies with minimum investments as low as $25,000. Those proposing regulation add that increasing investment by institutional investors has indirectly placed common investors at-risk through 401(k)s and other retirement plans.
The shroud of secrecy under which funds operate has also drawn fire. Some managers have responded with greatly increased transparency for their investors. Nonetheless, issues persist. For example, the Clinton Group came under fire last year when an employee disputed subjective mark-to-market valuation measures that the firm applied to often-illiquid investments.
In the end, it is up to each investor to determine if the characteristics of hedge funds are in line with their particular investment goals. Like other investment alternatives, there are pros and cons to investing in these funds. Whether investors opt to choose a hedge fund, it appears that hedge fund managers will increasingly choose REITs as a way to bolster their performance.
Hedging Their Bets