Searching for Safety in REITs

Michael Torres of the Fremont Real Estate Fund worries that REITs will face occupancy declines in a soft economy, but the dividends will provide a cushion

While much of the national economy and stock markets have been spiraling downward this year, the real estate sector has delivered a solid, defensive counter-punch to this gloom. With their high dividend yields and steady flow of earnings, real estate stocks have performed well in 2001 -- and this is exactly why some investors like owning REITs, they provide protection and diversity amid weak and volatile markets,

The Fremont Real Estate Fund (FREFX ), co-managed by Kenneth T. Rosen and Michael A. Torres, is up 13.6% year-to-date through December 18. By comparison, the S&P 500 index is down about 13.7%, while the Nasdaq has declined 22.3% over that period. Rosen and Torres have been managing the fund since March 2001.

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

Q: When you and Dr. Rosen took over the fund in March 2001 from the previous managers, what did you change about the fund?

A: We repositioned the portfolio to focus more on high-quality, blue-chip, large-cap REITs and away from the smaller-cap names -- as a result about 75% of the assets were turned over. We also shed some mortgage companies and health-care names.

Q: What kind of stocks do you look for? Describe your investment process.

A: We look for high-quality REIT companies, primarily in the core areas of office, industrial, apartment and major retail, which are trading at a modest discount to their underlying net asset values. We use a bottom-up method and analyze such factors as management's acquisition, development and operating records and earnings and dividend growth potential. We select our stocks from the Wilshire Real Estate Securities Index.

Q: How large is the fund? How many stocks are in it? What is the typical range?

A: We currently have about $20.2-million in net assets comprising 28 holdings. When we took over the fund we significantly reduced the number of stocks in the portfolio.

Q: Why has this been a good year for REIT stocks and REIT funds, while the rest of the market has been weak?

A: A lot of it has to do with the fundamental characteristics of REIT stocks: they provide high income (in any given year, 60%-70% of a REIT stock's total return is derived from its dividends) and they have a predictable earnings stream.

REITs are also benefiting dramatically from the decline in interest rates. Also, keep in mind that coming into 2001, many REITs were trading at significant discounts to their NAVs. Throughout the year, REITs have pretty much delivered revenue and earnings growth as they were expected to -- you haven't seen the types of negative surprises like you did with the S&P 500.

Q: What is the fund's average market-cap?

A: As of Sept. 30: $4 billion. The vast majority of our holdings are mid-cap and large-cap.

Q: What are your largest holdings?

A: As of Sept. 30: Equity Office Properties Trust (EOP ), 13.5%; Equity Residential Prop Trust (EQR ), 6.8%; AvalonBay Communities (AVB ), 6.1%; Vornado Realty Trust (VNO ), 5.3%; Boston Properties (BXP ), 5.2%; Arden Realty (ARI ), 4.9%; Post Properties (PPS ), 4.7%; Simon Property Group (SPG ), 4.2%; SL Green Realty (SLG ), 4.1%; and AMB Property (AMB ), 3.7%.

The ten largest holdings account for 58.5% of total net assets.

Our largest holdings, Equity Office Properties Trust and Equity Residential Properties Trust, were recently added to the S&P 500 index (the first REITs ever to be included) -- this should provide added visibility to the industry and attract new capital.

Q: Why such a large weighting in those top holdings? Is this simply a result of price appreciation, or is it intentional strategy?

A: A combination of both -- we like to make heavy bets on our favorite high-conviction, core holdings.

Q: Can you discuss one of the major holdings?

A: Vornado is a diversified real estate firm, but it has a large presence in Manhattan. For example, they're building the new headquarters for Bloomberg Financial in mid-town. They are enjoying rental growth in their leasing structure; expiring leases are being re-written at higher rental rates. They've recently acquired an office property owner in Washington D.C., which became a hot real estate market following the September 11 attacks.

Q: What are the largest sectors?

A: As of Sept. 30: Office, 32.0%; Apartments, 30.3%; Diversified, 13.2%; Regional Malls, 9.3%; Industrial, 6.2%; Office/Industrial, 5.6%; Consumer Services, 1.5%; Community Centers, 1.4%; Hotels, 0.9%.

Relative to the Wilshire REIT index, we are overweighted in office and apartments; we're at the market-weight in industrials; a bit underweighted in regional malls, and significantly underweight in shopping centers. We have no exposure whatsoever to such sub-sectors as manufactured housing and factory outlets.

Q: Is your tiny exposure to the hotel industry a result of the September 11 attacks?

A: While the terrorist attacks have had a devastating impact on hotels, we've been underweight there all year -- we felt that the country was in a recessionary environment since the spring. As a consequence, we either disposed of or avoided stocks with the most earnings volatility such as hotels. At the same time we have increased our allocation to the apartment and industrial sectors.

Our only hotel stock, Host Marriott (HMT ), was hurt badly following the events of September 11 -- the price has recovered a bit since then, but we sold our stake in the company.

Q: What are your sell criteria?

A: We primarily sell a stock when its price reaches a premium to its underlying real estate value -- we determine what that premium is through our internal proprietary research. When we purchase a stock initially, we have a discrete price target for it.

Q: Can you cite a stock you recently disposed of and why?

A: We disposed of a company called Brookfield Properties (BPO ), which owned assets that flanked the World Trade Center. Unfortunately, we felt it would take some time to regain confidence in the location and get the tenants re-situated. The sentiment turned very negative on the stock and we decided to move out of it.

Q: What is the fund's turnover ratio?

A: For the 12 months ended Sept. 30, it was 144%, but that reflects the large amount of repositioning we undertook when we took over this fund. On a normalized basis, the annual turnover would be about 30%.

Q: Is most of the commercial real estate property in this country owned by private real estate firms or by the type of publicly-traded companies that you own?

A: The U.S. commercial real estate business in the early stages of a major transformation. Private real estate empires are being replaced by financially strong, well-managed, public firms. However, the majority of real estate property is still in the hands of private companies.

There are about 110 public REIT stocks in our universe. We have not seen a great deal of merger-consolidation activity in this sector. If a REIT is performing well, it really has no need to merge with other entities. I also don't think we will see many REIT IPOs in the near future -- for one thing, to become recognized on the IPO landscape, you'd have to come out with a $1 billion company and it would take a long time to amass that much in assets in the private markets.

Q: Specifically, what kind of impact did the September 11 attacks have on the REIT industry?

A: It has had the most devastating effects on hotel stocks. Some have seen their occupancy rates decline from the high-60% to mid-70% range to as low as 30% in wake of the attacks.

The September 11 attacks destroyed over 11 million square feet of office space in downtown Manhattan. Office companies with portfolios located in midtown Manhattan and the outlying areas of New York City subsequently saw their valuations increase in anticipation of a tighter market.

One of the reasons our fund has continued to perform well, in spite of the devastating terrorist attacks, was our overweight position in office companies located in midtown Manhattan and the surrounding areas of New York City, as a tight office space market emerged in Manhattan in the wake of the attacks. Such stocks included SL Green Realty, Mack-Cali Realty (CLI ), Reckson Associates Realty (RA ) and Vornado.

Q: What is your outlook for the sector going into 2002?

A: In the short-term, we think REITs will outperform the broader markets, which will continue to suffer from a slowing economy. However, as we enter 2002, we are keeping a cautious stance on the REIT sector. Quite simply, as the economy slows down, demand for real estate properties will also moderate. Earnings guidance for REITs has been tempered -- but at least they haven't gone to negative.

One major concern we have is that as the economy softens, REITs will face occupancy declines that could threaten the safety of the dividend for some companies. But nearly all the companies in our portfolio could likely withstand a significant drop in occupancy without endangering the dividend as a result of steadily declining payout ratios over the past few years.

Of course, the dividends will provide a cushion; we're looking at an average equity yield of about 6.5% for next year. However, given that some of our stocks have appreciated as much as 40% this year, they will have to `grow into' their valuations. That will require some time.

The low interest rate environment will continue to be a benevolent force on REITs. If these REITs can deliver `reasonable' growth next year, say 4%-6%, on top of the 6.5% equity yield, we could see double-digit returns for some of these stocks.

From S&P FundAdvisor

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