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Real estate funds underperformed in 2007, but some professionals say it won’t last

By Dees Stribling

Without a doubt, real estate funds moved through some stormy times in 2007. But no storm lasts forever. Even at the beginning of 2008, talk of silver linings emerged, made plausible by property fundamentals and more attractive values.

“We’re still in the middle of a global crisis of confidence, but when the dust settles, there will be a recovery for real estate,” says James E. Rehlaender, managing director of European Investors Inc. and portfolio manager for EII International Property Institutional (EIIPX).

In some ways, Rehlaender notes, a bounceback is likely in 2008, if only because much of the decline in 2007 in fund values stemmed from what he characterizes as panic selling. “The lower valuesultimately don’t make sense, because fundamentals didn’t crater,” he says. “The markets’ underlying strengths have been obscured for now, but the fundamentals are still too strong for that to last.”

However, worldwide financial stability might take some time to achieve, says Jay Rosenburg, co-manager of First American Real Estate Securities. “There’s still a lot of uncertainty,” he says. “REITs aren’t going to start their recovery until there’s more stability in the broader financial markets, which could be well into 2008.”

		Real Estate Funds Closed-End Funds Global Funds

Recession is a specter that haunts the U.S. economy, but it’s also spurring macroeconomic stimulation, up to and including the three-quarter point rate cut by the Federal Reserve in mid-January. “We expect the Fed to cut interest rates until we’re either not in a recession, or have avoided one,” says Steven Brown, managing director of Neuberger Berman. “We could see a late spring recovery in REITs, as REIT yields become favorable compared to Treasuries.”

		Closed-End Funds: Balanced by Modest Supply Growth The wider financial crisis buffeted closed-end real estate funds every bit as much in 2007 as other real estate funds, but they may regain some ground in 2008 as investors come to the conclusion that fundamentals didn’t suffer that much.

Brown posits that 2008 will probably see modest economic growth and a reduced volume of real estate transactions. “There’s still risk from credit crunch fallout, and a more difficult borrowing environment will persist well into this year,” he says, adding that it will be quite a few years before conditions are remotely like 2005 or 2006—years marked by outstanding real estate fundamentals and a low-interest rate environment. “Going forward, there will be weaker demand for real estate than in recent years, but also more modest supply growth.”

Rosenburg notes that when growth returns, it will be different. “To the extent that we have total positive returns, they’re going to depend on cash-flow growth and dividend yields, not the asset appreciation that we’ve seen over the last number of years,” he says.

The U Turn

How did stability and modest growth become the new goals of real estate fund managers? In mid-2007, commercial real estate made a U-turn, and the credit crunch precipitated by the U.S. subprime meltdown may have put the squeeze on real estate funds as well. Overall, it wasn’t a good year for real estate funds, though there were a handful of relatively strong performers among the main run of the industry.

Of the 108 distinct real estate funds that Lipper tracked in 2007, not many showed positive returns, while the average decline was 14.17 percent. At the low end of the spectrum, some funds declined nearly 30 percent. This downward movement also represented a complete reversal from the previous year, when several funds scored double-digit positive returns.

The uncharacteristic thing about these abrupt downturns is that they happened despite fairly strong real estate fundamentals, note industry observers. For example, commercial real estate defaults in the United States, though expected to rise somewhat in 2008, are still at historic lows—approximately 0.33 percent, according to RBS Greenwich Capital.

“It was quite a year,” says John G. Wenker, co-manager of First American Real Estate Securities Fund. “The deeper question is what caused seven years of outperformance that ended last year. Over that period, asset appreciation, which was driven by the declining cost of capital, trumped cash-flow growth.”

In mid-February 2007, Wenker recalls, real estate funds were up roughly 13 percent for the year—an unsustainable pace, as it turned out. “That was right around the time of the Equity Office sale, and it was a high-water mark for REIT valuations,” he says. It was downhill from there.

Brown says that last year played out two separate stories. “Previously, values were supported by aggressive lending, and that aggressive lending ended with the credit crunch. Values can’t be supported at that level any more.”

The Top Funds

Though the general direction of real estate funds in 2007 wasn’t up, a handful of funds did move that way. In first place among the funds that Lipper tracks was CGM Realty (CGMRX). Its increase for 2007, 34.42 percent, was reminiscent of the highs a number of funds achieved in 2006.

The fund’s top 10 holdings by percentage at the end of 2007 included two REITs—international industrial REIT ProLogis (NYSE: PLD) and Digital Realty Trust (NYSE: DLR), a REIT that specializes in corporate datacenters and other technology-related real estate.

Besides those two real estate companies, CGMRX was driven by such diverse worldwide entities as Brazilian iron ore producer Companhia Vale do Rio Doce, Potash Corporation of Saskatchewan, Inc. and Southern Copper Corp., which owns mines in Mexico and Peru. Fertilizer and crop nutrient producers are represented in CGMRX’s portfolio as well.

Global Funds Keep Growing Investors’ continue to seek diversification through global funds in their investment portfolio, and the 2007 global returns reflect that escalating hunger. It should come as no surprise that the number of global real estate mutual funds has increased in the last year from 93 funds in 2006 to 199 funds in 2007. Additionally, the funds increased to more than $60 billion AUM, up from $39 billion AUM in 2006. The funds originated from 26 countries, seven more than last year’s funds: Australia, Austria, Belgium, Canada, Finland, France, Germany, Great Britain, Guernsey, Hong Kong, Ireland, Italy, Japan, Luxembourg, Malaysia, Malta, the Netherlands, New Zealand, Norway, Portugal, Singapore, South Africa, Spain, Switzerland, Taiwan and the United States.

The only other Lipper-tracked funds to increase more than 10 percent in 2007 were Cohen & Steers’ three Asia Pacific funds, which registered growth of 11.81 percent (APFCX), 12.52 percent (APFAX) and 12.87 percent (APFIX). Also breaking into the black last year were Alpine Equities International (EGLRX), at 2.84 percent, and two ING International real estate funds—IIRIX and IIRAX, which eked out 0.9 percent and 0.61 percent gains, respectively.

The Course of International Real Estate

With the top funds all internationally focused, the best place for real estate funds in 2007 wasn’t the United States. Unlike 2006, however, when virtually all funds were doing well, in some cases international holdings probably made the difference last year between an increase and a decline—especially if the holdings happened to be in Asia.

The Cohen & Steers’ funds, which focus on Asia, came out on top among those funds with mostly real estate holdings, as compared with the CGM Realty fund.

However, not every part of the world did as well. For example, Europe may have caught some of the same subprime contagion that afflicted U.S. real estate markets. “The first half of the year was business as usual, but then investors headed for the doors,” Rehlaender says. “It was a worldwide phenomenon, but Europe was hit especially hard, with billions in outflows from funds. In some ways, it was a panic reaction, since fundamentals aren’t that bad.”

Domestic Property Bright Spots

There were a few bright spots among domestic property types. “Not all property types performed badly,” says Neuberger Berman’s Brown. Health care REITs did reasonably well, he noted, as did industrial REITs. “The sell-offs we saw in commercial real estate affected them, but not quite as much as other categories.”

The relatively small universe of specialty REITs outperformed every other classification in the FTSE NAREIT total return index, which attained 14.56 percent growth in 2007. The key to growth seemed to be linked to commodities, as opposed to pure real estate plays, such as timber and datacenters.

Another positive performing REIT sector was health care. According to NAREIT, the six REITs that composed that sector posted a 2.13 percent increase in 2007.

Industrial real estate, while not breaking any records, survived the year. NAREIT put U.S. industrial property REITs’ gains at 0.38 percent.

Other property types saw down years to varying degrees. Office properties as a class were down 18.69 percent, while REITs that own more-or-less equal shares of office and industrial suffered a 33.09 downturn. Retail REITs saw a 15.77 percent decline and vmultifamily REITs lost 22.21 percent.

Outlook for 2008

However, despite the 2007 returns, investors should take note of the consistent long-term performance of real estate, which includes delivering performance, stability and portfolio diversification. “For long-term risk-adjusted performance and diversification, nothing in the stock market even comes close to what REITs offer,” says Brad Case, NAREIT’s vice president of research and industry information.

In the face of continued REIT and overall stock market declines early in 2008, optimism isn’t dead. “If there’s a recovery in the second half of 2008 in the broader stock market, REITs will be carried up, too,” Brown says. “The cycle will start to turn again.”