Can Real Estate Funds Keep Building on Their Rally?

Andrew Gogerty: Hi, I'm Andrew Gogerty with Morningstar, and today we're talking domestic real estate funds. The group went on a tremendous rally in 2009. From April to December, the group gained nearly 87%, more than doubling the S&P 500 Index's 42% rise.

Coming into 2010 after a short breather, the category is back on a tear, gaining almost 9% through mid-March, again doubling the S&P's comparative 4.5% gain. But the most important question is really where do we go today and what's the state of the fundamentals.

Joining me today is Jay Rosenberg, co-manager of the First American Real Estate Fund. Jay, thank you for joining me today.

Jay Rosenberg: Thanks for having me.

Gogerty: One of the things, obviously the rally was tremendous last year, especially in the middle part of the year. I wonder of you can comment on the primary drivers of that rally, especially from a total return perspective.

Rosenberg: The rally last year was really predicated on a change in the cost of capital and availability of capital. The industry was really re-capitalized. We went into the year with many of the stocks being priced for bankruptcy, essentially the present value of their cash flow until their next big debt expiration, and then zero residual value.

That was way too bearish, way to draconian. And when these companies started showing access to capital, starting with Simon Properties Group and many of the other companies issuing capital between March and the middle of the summer last year, we saw a huge rally as these companies proved to have access to the capital market, both debt and equity.

Gogerty: How about the change in terms of other fundamentals? Obviously REITs and real estate operating companies, leverage is the name of the game. But have fundamental operations changed, or was it really just that access to capital that really drove the optimism?

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Rosenberg: Change in access to capital and pricing in capital drives these leveraged hard assets like real estate companies more than anything else. It's predominately what is responsible for changes in valuation.

Fundamentals, as you might imagine in a recessionary period, have been quite weak, kind of hobbling along the bottom. Real estate fundamental changes are a lot more benign than the rest of the economy, that's why investors are attracted to real estate. They have long-term contractual lease terms that aren't subject to....The portion of their income in any one year isn't subject to changes in the economy the same way that other companies are. So the long-term contracts make those fundamentals more benign for real estate.

That being the case, it is a late cycle industry because of those lease terms that were signed in good times are actually above market in some sense. So it does take some time for the real estate companies with long-term leases to bob along the bottom.

But there are opportunities to invest in early-cycle areas of the real estate industry, such as in apartments or self-storage or lodging, that will rebound quicker.

Gogerty: Looking at your portfolio and then looking at a lot of your peers, there's a lot of commonality in the holdings. The sector is somewhat small compared to a diversified fund, obviously. But you see a lot of commonality in holdings across both you and your peers.

Rosenberg: Right.

Gogerty: What are some of the things you're doing in your portfolio to distance and separate you from your peers.

Rosenberg: Sure. We divide the portfolio into core and opportunistic. About three-quarters of the portfolio is core. About 25% of the portfolio is opportunistic. Core holdings are names that we consistently hold in the portfolio. From time to time the weights may change based on short-term technicals and fundamentals.

Opportunistic holdings are either companies that aren't structured as REITs--they own real estate and operate real estate just like a REIT, but for one reason or another they're not structured as a REIT.

There are also companies, REITs that are trading historically cheap versus where they've traded versus the peer group in the past. And we must identify a catalyst to get them back to that trading range.

Gogerty: OK.

Rosenberg: That opportunistic bucket provides a lot of that outperformance you've seen in our portfolio. And in terms of the core, it does look like we have a lot of the same holdings, but we manage them differently. We're sector-neutral; we're stock-pickers. We don't pick sectors, we pick stocks.

So we're constantly looking for relative value opportunities and taking advantage of any inefficiencies we see in the market to really arbitrage those inefficiencies and the relative value in individual stocks.

Gogerty: To expand on that topic of relative value, when we talk to some diversified large-cap managers, we've heard some say recently that the runup was really low quality. It was driven by low-quality stocks on a broad basis in '09, and that a lot of high-quality, strong-balance-sheet companies are relatively undervalued still, even after the rally.

Turning to the real estate sector, is that truly the case? Are the best balance sheets and the best selection of properties still undervalued? Or have they really kind of risen along with the rest of the sector right now?

Rosenberg: Underperforming doesn't necessarily mean they're the best value. So we went through a period of time in 2007 and 2008 where the lower-quality, the worst balance sheets in the sector really traded down because they had debt maturity, they had levered up to extraordinary levels or much higher than average levels during the mid-2000s. They had to issue equity and sell properties in order to get their leverage back down.

And for that reason, all the dilution they took, they really under-performed. There was a lot of fear about bankruptcy and other things. So coming into 2009, many of these companies were actually being priced for bankruptcy.

You can imagine, they had a long way to bounce of the bottom from being priced for bankruptcy to being back to kind of stabilized levels. And that's why we saw kind of dramatic outperformance from the lower-quality balance sheets in this space.

I will say right now we see a lot of value in the best balance sheets, not because they necessarily underperform, but because they can arbitrage their very good balance sheets and their better-than-average access to capital and pricing of capital to take advantage of what we expect to see, some distress in the marketplace.

So as assets come out of the banks and CMBS and other distressed sellers, we expect that the best balance sheets in the space will be able to mitigate their lack of organic growth by creating a layer of external growth, taking advantage of their cost of capital to arbitrage the difference in their cost of capital versus where they can pick up assets.

Gogerty: It seems like if you have the access to cash and you have the ability to wait, you could really pick off some choice stressed assets.

Rosenberg: That's the name of the game and that's why the listed space is so much more attractive right now than the private space. The listed space has extraordinary access to capital, both debt and equity, whereas other areas of real estate have virtually no access to capital. Very limited.

And that's why, more than ever before, we think that listed real estate makes a lot of sense for investors versus their other options.

Gogerty: Great. Thank you for joining us.

Rosenberg: Thank you.

Gogerty: This has been Andrew Gogerty and Jay Rosenberg from First American Real Estate Funds. Thank you for joining us.