Three of Our Favorite Managers Talk Real Estate

After averaging returns of more than 20% per annum for the five-year period from 2002 through 2006, major real estate investment trust (REIT) indexes tumbled around 15% in 2007 and are down around 3% for 2008. So, are commercial and multifamily residential real estate in the same trouble that single-family housing is in?

In order to get the lay of the commercial and multifamily landscape, mutual fund analyst Andrew Gogerty directed a panel discussion at this year's Morningstar Investment Conference with three of our favorite real estate fund managers, David Lee of  T. Rowe Price Real Estate Fund (TRREX), Michael Winer of  Third Avenue Value Real Estate Fund (TAREX), and Kenneth Statz of  J.P. Morgan US Real Estate Fund .

The Credit Crisis and Its Effects
Although all the managers pointed to evidence that transactions were slowing and prices were falling in the private markets, they agreed that most of the underlying businesses themselves were not impaired or grossly overvalued. Statz pointed out that the stocks seemed to be under pressure lately, since they are part of financials indexes, which many investors are shorting. This phenomenon doesn't reflect problems with the businesses, however.

Second, the ability to borrow money, which real estate businesses need to grow, is somewhat restricted in the current credit environment, but the panel concluded that Wall Street would find ways to put money to work. The inability to borrow also means that buyers must finance property purchases with much more equity than they needed as little as one year ago. In the private market, the bid-ask spreads are greater now than they've been in the past, which means that fewer transactions are taking place as buyers are bidding less for properties while sellers aren't lowering their asking prices. When deals do take place, it seems that the sellers are blinking before the buyers do, as evidenced by slightly rising cap rates (rent less basic expenses as a percentage of the purchase or sales price of property). In other words, buyers are demanding a greater stream of rental income as a percentage of what they pay for the property, which means that prices are declining a bit.

Finally, the lack of easy borrowing has slowed the buyouts or taking-privates of publicly traded REITs, which had helped elevate the entire sector's prices. The recent saga of  Post Properties , which last week announced the withdrawal of all bidders from its recent sales process, is indicative of the current state of the debt markets.

Finding Opportunity
The good news is that, despite tighter credit putting takeouts on the back burner, none of the managers was at a loss for how to put money to work. Statz likes multifamily properties, which he thinks will benefit from the housing meltdown producing a greater pool of renters. He also thinks talented management teams can add the most value in mall or retail REITs, and has mall operator  Simon Property Group (SPG) at the top of his portfolio.

David Lee of T. Rowe Price takes a steady, mainstream approach to the sector, favoring blue chip REITs in most major property types (multifamily, industrial, office, and retail), but he has shown a willingness to explore different parts of REITs' capital structures on occasion by owning some convertible bonds with put options, when he can find them at attractive prices.

Michael Winer of Third Avenue has the most value-oriented approach, emphasizing a REIT's balance sheet as much as its cash flows. For example, Winer will buy land companies that don't sport impressive current cash flows or dividends if he thinks that a talented management team concentrating on future resource conversion (selling or developing the land) can create shareholder value. Winer likes land companies such as  St. Joe Corp (JOE), which owns more than 700,000 acres of land in the Florida panhandle, and real estate companies in Asia such as Hang Lung Properties.

Our Take
Clearly, the days of 20%-plus annual returns are over in real estate. However, we think most mutual fund investors who run their portfolios along asset allocation principles should continue to maintain a 5%-10% exposure to real estate given its solid returns over time and its low correlation to stocks and bonds.

And although real estate won't necessarily rise in lock-step with inflation, we think it has inflation-combating characteristics over the long term. As long as there isn't dramatic overbuilding, landlords can mostly raise rents to cover higher expenses, and land itself tends to appreciate with inflation. Finally, although the tight debt markets are constraining growth, they are also likely inhibiting overbuilding--and overbuilding is what invariably leads to the most severe downturns in the real estate cycle.

More opportunistic investors who don't adhere strictly to asset allocation models won't find the bargains that existed in the early part of this decade. Moreover, we're not sure multifamily is quite as rosy as Statz argues because, despite a greater pool of renters emerging from the housing meltdown, the overbuilding in single-family homes and condominiums is serving to create competition for apartments. Still, we think the recent market decline presents a couple of opportunities.

First,  Duke Realty , which has built a solid business developing office and industrial parks in the Midwest, is trading below Morningstar analyst Jeremy Glaser's Consider Buying price. Although the firm doesn't sport an economic moat, it has produced returns on gross real estate assets above 9% over the past five years. Also, despite Duke's stumble in the first quarter of 2008, with occupancy falling from 95% to 93% due to some speculative building and the bankruptcy of the Bombay Company, the firm has solid tenants such as  Amazon.com (AMZN) and  Monsanto  that are seeking additional space. Duke's full-service development capabilities make it an attractive real estate outfit for growing firms. Finally, Duke is financially sound with a fixed charge coverage ratio above 2 times and dividend coverage at 70% of funds available for distribution.

Second,  Mack-Cali (CLI) has an attractive suburban New York City office footprint. Its occupancy is in the low-90% range, but its rent growth has been slowing a bit lately (same-store rental revenues grew only 1% year over year in the first quarter of 2008) as it feels the effects of a slowing economy. Still, the firm's balance sheet is in good shape, with debt at 40% of gross assets and its fixed charge coverage ratio at more than 3 times. Dividend coverage is less impressive, as the firm paid out around $1 million more than its adjusted funds from operations in the first quarter, but we think the firm can easily borrow small amounts until business improves.

Click to see Morningstar conference coverage.