As the commercial real estate market pulled out of a slump--lasting from 1987 to 1990--the mutual-fund industry responded with a boomlet in funds that invest in property. These funds charged ahead, with average gains of 23% a year from 1990 through 1993, then paused to catch their breath. For investors who want current income and diversification, this could be the time to hop on board before they resume their ascent.
Future returns may not be so dramatic, but analysts say the upswing has at least five more years to go. One reason: New construction has fallen off in recent years, so a lot of late-'80s oversupply has been sopped up. "Although the economy is slowing, it's still growing, and that means increased demand for commercial real estate assets," says Lehman Brothers analyst Michael Giliberto.
Investing in commercial property is far easier now that real estate mutual funds have, since 1990, soared in number from 5 to 22 and in asset size from $80 million to $1.5 billion. Previously, the most accessible route was to buy real estate investment trusts (REITs), bundles of properties sold as stocks. But REITs tend to focus on one sector, such as shopping malls, and can be hard to evaluate. Funds invest in many types of REITs, diversified across property types and geographical regions. They can also reach into related fields, such as construction or building-materials companies.
Because property funds react to supply and demand in the real estate cycle, usually longer than the equity cycle, their performance varies from stocks, and thus they help diversify a portfolio. They are also less interest-rate-sensitive than bonds or utilities. "When the Fed first started raising rates and utilities got smashed, REITs did well," says Robert Steers, co-manager of Cohen & Steers Realty. Or at least better. For the first half of '94, realty funds lost 2.2% vs. a 9.5% deficit for utilities. And since they're less rate-sensitive, property funds may serve as an inflation hedge. Higher rates can enhance hard asset values and drive up rents--and investor income. They raise construction costs, making property more valuable. And real estate funds are less volatile than other hedges such as gold funds.
TAX BREAK. Like bonds and utilities, funds pay regular income, currently about 4%. But as the economy grows, fund dividends are poised for growth of 8% a year, as managers raise rents, says Giliberto. Bond income can't increase, and regulatory restraints should hamper the payout from utilities.
Another plus is the tax treatment that property-fund dividends receive. A portion--usually one-quarter--is considered return of capital, so it's not taxed. Instead, it goes to reduce the basis in your fund shares. When you cash out, you pay capital gains on the difference. Thus, if you bought a share of Fidelity Real Estate Investment Fund for $20 and received $4 in dividends, $1 would go toward reducing your basis to $19 for the following year. You would be taxed currently on only $3.
Real estate funds are lagging for the moment. After a feverish three years, they stumbled in 1994 but still pulled ahead of stocks and bonds, returning 3.17%, vs. 1.29% for the Standard & Poor's 500-stock index and -2.92% for the Lehman Brothers bond index. Why the lull? Too many REITs came to market in 1993. One big REIT, Manufactured Home Communities, didn't meet its earnings estimates last year, and yield-seekers who bought real estate funds ran back to bonds as rates rose.
But analysts say this situation can't last. Short of a recession, the fundamentals are too strong, and an increase in pension-plan investments in real estate funds should help drive up prices, says Barry Greenfield, manager of Fidelity Real Estate. He thinks REITs will rise again in 6 to 12 months. So now may be a good chance to buy: "The fundamentals are the same, but the prices are down," says Morningstar analyst A. Jason Windawi.
When choosing a fund, you might start with a veteran, because many new funds are less than a year old. Fidelity Real Estate, started in 1986, is one of the most conservative. With an average annual return of 12% over five years, it seeks safety over performance by sticking with "blue chip" REITs, says Greenfield. He may sacrifice gain but doesn't get hurt as badly when the market dips. He owns mostly apartment and retail REITs.
Slightly more aggressive is Cohen & Steers. With a three-year annual return of 14%, it has outperformed the stock market--with one-third the volatility--by seeking top-tier REITs with demonstrated ability to raise dividends, says co-manager Steers. He looks for regions with strong economies and for properties enjoying the best supply-and-demand balance. He favors apartments and malls, many of which are selling at deep discounts to their real estate value.
Two newcomers, CGM Realty and RPF Real Estate Securities, are run by managers with respected non-REIT track records. They are both fans of hotels and storage facilities, which have been in great demand lately. CGM is down 1.43% since it started last May. Manager Ken Heebner avoids bigger REITs and bets on smaller, less-followed companies selling at lower multiples and higher yields. RPF manager Andrew Davis, whose fund was down 1.76% over the past 12 months, spreads his assets into insurance companies with large real estate portfolios.
Dangers lurk. The small, high-dividend REITs that CGM likes may not be able to boost dividends further, says rival Steers. And the non-REIT stocks that RPF favors can backfire. Sam Lieber's Evergreen U.S. Real Estate Equity Fund lost 12% in '94 because of a 26% weighting in construction shares, which fell as interest rates rose.
Moreover, since there are only 200 public REITs, trouble for one biggie can hurt the whole market. And real estate is cyclical--so it will dip again. But many pros believe that won't be for quite a while. In the meantime, real estate funds can add diversity to your portfolio and current income with potential for growth. And they will never wake you up at 3 a.m. to complain that the pipes have burst.