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This REIT Is a Bear Shelter

The real estate sector has been hot this year as many investors shun the depressed equity market. While REITs themselves typically don't deliver huge returns, they can provide a cushion in a declining market environment with their high dividend yields.

David Lee, who has run the T. Rowe Price Real Estate Fund (TRREX) since it was launched in October, 1997, generally favors large-cap companies in mainstream sectors like apartments, retail, and office properties. As of June 30, the portfolio had about $113 million in assets, comprising 38 stocks. Lee's fund carries the highest S&P overall rank of 5 STARS based on risk and return characteristics over the past three years.

T. Rowe Price Real Estate gained 10.9% for the 12-month period ended July 31, 2002, while sector funds fell an average of 20%. For the three-year period ended July 31, the portfolio edged out its peers, rising 13.7% annualized, vs. a gain of 12.4% for the average real estate fund. The Wilshire Real Estate Securities Index, which is the fund's benchmark, gained 8.9% for the one-year period, and 13% for the three-year period ended in July.

Palash Ghosh of Standard & Poor's Fund Advisor recently spoke with Lee about the fund's investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:

Q: What kind of stocks do you look for?

A: We typically like to invest in real estate companies that have strong balance sheets, strong portfolios, and are operating in vibrant markets. We have a bias toward management teams that are "value creators" -- that is, they add value by consistently growing net asset values on a per-share basis. Most of our holdings are highly liquid, large-cap names in mainstream segments of the industry.

Although we like the substantial dividend yields provided by REITs, our investment approach is more balanced. We like to focus on total return, combining distributions with capital appreciation. We have the flexibility to own stocks that are not purely real estate stocks, like homebuilders, health-care REITs, and mortgage REITs, but we tend not to invest there. On a risk-adjusted basis, we don't find them attractive investments.

Q: Why do you keep the fund so concentrated?

A: There are hundreds of REIT stocks in the U.S. to choose from, but we like to make meaningful bets on our favorite holdings. Despite the concentrated nature of the portfolio, I think we're sufficiently diversified. Our holdings themselves comprise a highly varied portfolio of assets.

Q: In the first half of 2002, real estate stocks performed very well, while most of the overall market plunged. Why did the REIT sector do so well?

A: I think investors were attracted to the dividends and high yields that REIT stocks provide, as well as their cash-flow characteristics and the contractual nature of these businesses. However, fundamentals in the real estate industry are actually weakening -- REITs are not immune to the downturn in the overall economy, but they can provide a bit of a buffer from a weak economy.

Our fund gained about 12.8% in the first half, while the S&P 500 dropped 13.2% and the NASDAQ Composite plunged nearly 25%.

Performance in the first half of the year was buoyed by superb returns from our retail holdings, particularly mall operators like Simon Property Group (SPG) and General Growth Properties (GGP), which have benefited from relatively robust consumer spending.

Q: What are the fund's largest holdings?

A: As of June 30: Equity Office Properties (EOP), Vornado Realty Trust (VNO), Simon Property Group, Equity Residential (EQR), Boston Properties (BXP), ProLogis Trust (PLD), Avalonbay Communities (AVB), Regency Centers (REG), Camden Property Trust (CPT), and Weingarten Realty Investors (WRI). These 10 stocks represented 40.3% of the portfolio's total assets.

Q: What are the fund's largest sectors?

A: As of June 30: Apartment/residential, office, shopping centers, regional mall, industrial, diversified, office and industrial, manufactured housing, lodging and leisure, and self storage.

Q: The REIT sector seems to have sold off a bit since the end of June. Has this made it more attractive to you as a buyer?

A: The sector has sold off because the economic doldrums in the country have deepened. This is clearly a troubling sign. However, as the stocks have corrected some, their valuations relative to their net asset values have indeed made them more attractive buys.

Q: Can you describe two of your recent purchases?

A: In the first half of 2002, we bought initial positions in United Dominion Realty Trust (UDR) and Essex Property Trust (ESS). Both are apartment operators.

United Dominion is a well-established nationwide apartment REIT that hired a new chief executive, Thomas Toomey, in February of last year. Toomey has an excellent track record and was formerly at Apartment Investment & Management (AIV). Before buying United Dominion, however, we wanted to see that the company could deliver some strong quarterly performances under his stewardship, which it did.

Essex Property is a company we have long admired, but we didn't purchase the stock until its price came under some pressure earlier this year as the real estate market on the West Coast weakened. Essex has a heavy presence in California and the Pacific Northwest.

Q: Tell me about ProLogis Trust. They've done very well this year -- the stock is up about 25% year to date.

A: ProLogis Trust is a REIT that operates a global network of industrial distribution facilities. They're a highly proficient developer of industrial properties, and they're also earning management fees through some of their institutional partnerships.

ProLogis is unique in that it has significant business operations overseas. They're already well-established in Europe, and they've recently launched a division in Japan. It's quite unusual for an American real estate company to have operations overseas.

Q: Your top holding, Equity Office Properties, has been sluggish this year.

A: [That's] because the office subsector as a whole has had it tough this year with declining fundamentals. But we like the company's management team and portfolio of assets. In addition, last year Equity Office acquired Spieker Properties, a deal that made it the largest merger in REIT history. But Spieker has a large exposure to the San Francisco-San Jose market, which has been under some pressure, thus hurting the performance of Equity Office's stock.

Incidentally, our exposure to Equity Office is actually an underweight position relative to our benchmark, the Wilshire Real Estate Securities Index.

Q: Do you favor one region of the U.S. over another?

A: We like real estate companies that operate in areas that provide high barriers to entry. This condition tends to exist on either coast. As a result, we have heavy exposure to companies operating in places like New York, Boston, California, and Florida.

Q: What's your outlook for the real estate sector?

A: One subject we're concerned about is the potential lack of demand in property space. While supply levels are falling, we need to see a steady increase in demand for the REIT sector to flourish -- and higher demand is predicated on a stronger U.S. economy.

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