After five years of scorching returns, REITs scare me. But Jason Wolf, an analyst on my favorite real estate fund, Third Avenue Real Estate Value, thinks a return to modest returns is more likely than a selloff. By Steven Goldberg, Contributing Columnist February 6, 2007 How long can real estate investment trusts continue to soar? Some people, including me, have been arguing that the party is due to end soon -- and not in a pretty way. After all, REITs -- high-yielding companies that own commercial real estate -- have returned an annualized 25% the past five years. Those returns are practically in the same league with those of tech stocks before they fell off a cliff starting in 2000. By contrast, Standard & Poor's 500-stock index has delivered only an annualized 8% over the past five years. What's more, "cap rates," the annual rents that commercial real estate buildings produce divided by the buildings' market prices, have fallen to around 6%. Those are never-never-land levels. That's not much more than you can get on a high-grade corporate bond -- with a lot less risk. But after talking with Jason Wolf, an analyst on Third Avenue Real Estate Value (symbol TAREX), my longtime favorite real estate fund, I'm not as convinced that the end is near -- nor that REITs will crash when the REIT bull market ends. Wolf isn't a REIT bull. But he sees reasons not to be overly pessimistic about REITs. When you buy a building, he notes, you expect its value to increase over time. That's always been a reasonable bet. On the other hand, if you buy a new bond and hold it to maturity, you can't get any appreciation. What's more, Wolf points out, interest rates are still low. A REIT with solid credit can still borrow money for less than what it can earn from its rents. Finally, the commercial real estate market has evolved dramatically in recent years, Wolf says. REITs and other commercial real estate investments have grown in popularity, not just among individuals looking for plump yields, but among all manner of institutional investors, including pension funds and large corporations. "The interplay between the capital markets and real estate has lowered the cost of capital for REITs and all commercial real estate," he says. Wolf's bottom line: Over the next five years, he expects much more modest returns for REITs, but he doesn't expect losses. The Third Avenue fund's appeal I'm still worried. Which is part of the reason I like Wolf's fund so much. Piloted by Mike Winer, the fund has only 25% of assets in REITs. REITs are specially organized corporations. They escape income taxes by passing on almost all their profits to shareholders each year. As a result, REITs generally produce generous yields -- although their distributions aren't eligible for the low 15% income-tax rate on qualified dividends. But those big payouts also put REITs in the position of having to scramble to find money to grow their businesses, Wolf says. Too often they end up selling more stock to the public, which can dilute the value of stock you already own. "We've always had a preference for real estate operating companies," Wolf says. These are ordinary companies that specialize in real estate. "We like companies to have the ability to retain their cash flow and use it to grow. They can plow cash back into their businesses." Third Avenue Real Estate Value is part of Marty Whitman's small group of value funds. All the funds practice Whitman's philosophy of investing in stocks that are "safe and cheap" -- that is, they look for financially solid companies that trade at big discounts to their estimate of intrinsic value. They tend to hold companies for many years. Wolf prefers to invest with real estate developers rather than companies that merely own large amounts of commercial real estate and lease it out. "We try to buy the best management teams and companies that we can, and we prefer diversified companies," he says. "If we choose managements well, they'll make the best decisions on how to deploy their assets." Wolf and Winer put the fund together one company at a time -- with no regard for whether they're investing more in one commercial real estate sector or another. Lately, however, their value approach has led them to invest more overseas -- 35% of the fund's assets are invested in foreign companies. When they find a stock they like, Winer and Wolf aren't afraid to back up the truck. The fund has more than 8% of assets each in four of its 48 stocks, including 13% in Forest City Enterprises (FCE.A). Put another way, about 40% of the fund is in these four stocks. This is an unusual real estate fund in other ways. Because it owns so few REITs, it yields a relatively paltry 2.4%. Returns have lagged the average REIT fund and the REIT indexes a bit in this sizzling market. The fund returned an annualized 23% over the past five years to February 5, two percentage points behind the NAREIT index. Third Avenue ranks behind 80% of REIT funds, according to Morningstar. I'm not concerned. I'll take a 23% return anytime. The fund is far from a pure REIT fund, and it's likely to hold up better than REIT funds in a poor REIT market. Indeed, my biggest problem with this unique fund is its tendency to hold a lot of cash. Currently, the fund has 10% in cash -- a status Wolf calls "fully invested." The 1.11% expense ratio is okay, but it's a lot to pay for cash. My only other concern is asset growth. The fund now has $3.2 billion invested, and the average market value of its holdings is less than $5 billion. Other Third Avenue funds hold many of Real Estate's stocks. Real Estate trades infrequently, but getting out in a hurry would be close to impossible from some of the large positions. Although Wolf and Winer today are finding their best bargains overseas, there are a still a few U.S. stocks they say they'd buy today. Forest City is one, says Wolf. It specializes in complicated deals. Many of them involve development of parcels of land in big cities, such as New York, Los Angeles, Boston and Denver. The company has a superb track record, Wolf says, along with heavy insider ownership. St. Joe Company (JOE) is great story. The largest owner of private land in Florida, with some 700,000 acres, the company is slowly developing that land. During the residential real estate bubble, the stock got bid up to $80, but now it's back in the $50s. That, says Wolf, is buy territory. Steven T. Goldberg is an investment adviser and freelance writer.