Are REITS Ready to Rebound?
High-yielding real estate investment trusts, which invest in commercial real estate, have been battered for more than a year now. From their peak on February 7, 2007, the major REIT indexes plunged about 35%. (All results include dividends, which in the case of REITs are not insignificant.)
But this selloff follows a huge runup. From the start of 2003 through 2006, the MSCI U.S. REIT index was reminiscent of an Internet stock before the tech bubble burst. During those four years, the index soared 170% -- or an annualized 28%. That's about the same amount that home prices appreciated during the same period -- if you lived in one of the nation's hot spots, such as California, Florida or the much of the Northeast.
But now home prices are sinking in most areas of the country, and no less an authority than Fed Chairman Ben Bernanke says he doesn't expect prices to hit bottom until sometime next year.
When it comes to REITs, however, the turn may come sooner. That's the view of Mike Winer, manager of Third Avenue Real Estate Value. Winer, one of the canniest real estate investors at the helm of a mutual fund, says he's finding great values. My concern: His holdings may get even cheaper before they begin to recover.
Commercial real estate and single-family homes are very different animals, but they do share some key traits. Most important: They both rely on borrowed money. And just as the home-mortgage market has constricted, so has lending for commercial real estate.
Indeed, it would be surprising if the credit crunch didn't cripple commercial real estate. Commercial property values are tumbling, sales are drying up, and plenty of good properties are vacant.
REITs are a special kind of real-estate company that must pay out almost all their profits to shareholders annually. That's the source of their generous yields, currently more than 4% on average. REITs are a great vehicle for providing investors with income and diversification.
Just a few of years ago, I gave this simple advice about REITs and other publicly traded commercial real estate: If you're an aggressive investor, put 5% of your stock money in a well run real-estate mutual fund. If you're more conservative or are in retirement, consider upping your allocation to 10%. But that counsel is out the window nowadays.
REITs will come back in time. But I think it pays to wait just now. The prices of what were once conservative investments got bid up out of proportion to reality and are still falling.
If you want to tiptoe back into the water now, though, Third Avenue Real Estate Value (symbol TAREX) is a terrific vehicle. Winer, 52, has been at Third Avenue Management 14 years and has run the fund 9½ years. What's more, he spent his career in real estate before becoming a real estate stockpicker.
All that experience has paid off. Since inception at the start of 1999, the fund has returned an annualized 17% -- almost four percentage points per year, on average, more than the MSCI U.S. REIT index.
Just as impressive: The fund has been 25% less volatile than the index. And the fund has held up slightly better than most other real estate funds in the current selloff.
For bargain hunters like Winer, falling share prices are a good thing. "We've now swung well past reasonable valuations for real estate," he says. "Stock prices have gone well beyond even our worst case for how low we think the underlying real estate prices could go."
Winer is hardly your typical REIT manager. Only 24% of his fund is in U.S. REITs. About 10% is in foreign REITs, and the rest is in traditional corporations that specialize in real estate. Consequently, the yield on his fund tends to be below-average -- it's 2% currently. On the plus side, regular companies, unlike REITs, can retain can their profits to fuel future growth.
A bit more than half the fund's holdings are outside the U.S. "That's where we're finding bargains," says Winer, a disciple of Third Avenue founder Marty Whitman, who's known for advocating stocks that are "safe and cheap."
Winer looks for companies with good management and properties in areas where its hard for competitors to make inroads. Finally, he wants those nifty companies at attractive prices. Once he finds a stock, he keeps it five years on average. He owns just 40 stocks and isn't afraid to back up the truck when he really likes one.
Take Forest City Enterprises (FCE-A), the fund's largest holding, at 14% of assets. "It's probably the best real-estate development company in the world," says Winer. It owns and develops a wide variety of commercial property in 25 states.
Because of its strong balance sheet, Forest City was recently able to acquire 2,500 lots in San Antonio at just 25% of what a homebuilder paid for them three years ago, Winer says. Meanwhile, shares of Forest City have fallen by more than 50% since last May, to $35. "It's a screaming bargain if you have a long-term view," Winer says.
As for homebuilders, Winer isn't nibbling yet. "They may look cheap relative to their net assets, but I don't know how to get comfortable with their asset values." In other words, prices will likely continue to fall.
Steven T. Goldberg (bio) is an investment adviser and freelance writer.