Walter Frank: "In providing our allocation advice and our fund choices we are always mindful of the needs of diversification. Because of that we are continuously on the lookout for an alternative investment or two to add to the portfolios, provided we believe the alternative can contribute to performance as well.
A standard alternative investment is real estate, but of course, considering that real estate in the form of subprime loans was the villain in the case of this recession, it was not the center of our attention for some time. Even so, we do keep an eye on the sector. Lately real estate funds, such as T. Rowe Price Real Estate Fund, have been performing. We decided to find out what is behind the performance and David Lee, Portfolio Manager of the T. Rowe Price Real Estate Fund, provided us with an interview.
We were surprised by Lee's uncomplicated answer to our question of what was driving interest in the sector now. Boiling down his answer to its bare essentials, Lee's reply was that the stocks were cheap. Investors were bargain hunting. Like all other investors, said Lee, investors in real estate are forward looking and as the stocks were hammered, "people got to the point where they were saying the stocks are reflecting all of the negative news already."
Have they reflected all the bad news, Lee asked rhetorically, we'll just have to see. Lee expects that we will still see prices fall as more transactions take place to establish a price level. As he pointed out, transactions have not been plentiful. Even so, in lee's opinion, the market said collectively, "the stocks have been punished enough and let's start thinking about the recovery," and "the (real estate) market proceeded to perform well along with the "green shoots" recovery that is occurring throughout the broad market."
Backing up the market's judgment that real estate company's stocks are cheap, Lee pointed out "that when we do our valuation work many companies are trading at levels that are very attractive in historical terms."
One further theme is that "people understood that deleveraging had to take place" (debt became equity and diluted the position of the original owners). Despite the dilution, multiples expanded, said Lee, greater than the dilutive effect. (The deals turned out to be positive). This, of course, helped to provide a more positive view of investing in real estate.
Lee believes that among professional, i.e. institutional real estate investors, there was a great deal of money moved to the sidelines as the sector nose-dived. Then, as the sector turned around, there has been a scramble to put that money to work. Large cash holdings hurt (short-term) performance. The result is the spurt in performance that we are experiencing.
We explored other reasons for the interest in the sector, other than the "green shoots" explanation, but Lee was not keen on any of them. An obvious one is yields. Yields have been the traditional source of interest in real estate funds, where REITs dominate the holdings. Lee acknowledged that yields have played a part, but he noted that attractive yields can be found throughout the fixed income markets and elsewhere.
Besides, as he put it, there is a "cautionary tale" here concerning REIT yields. For this year 2009, "the IRS gave REITs a hall pass." "The IRS," Lee explained, "is allowing the REITs to reduce their cash distribution to 10% of their distributable net income, and pay the other 90% in stock if they want to." Some REITs have reduced their cash distributions and some have also paid out in stock as well for their distribution. "By and large," said Lee, "the industry as a whole has reduced its distribution, but because the stocks have fallen so much, the yields are still relatively high."
We also brought up inflation as another reason for the real estate rally, but again Lee downplayed its importance.
We asked Lee about his portfolio. He replied that he is overweight retail, in particular the large regional malls. Yes, they are troubled, but as he said they are hard to replace. (We thought, good luck on finding financing to build a new mall in this environment). As he said, the consumer has to come back some if this economy is to grow at all. Another group in the portfolio is the "bread and butter" retail centers, the smaller strip malls.
The bottom line for Lee, aside from the general market recovery, is that we are going to see very little new commercial real-estate construction for some period of time, no matter what the shape of the recovery. For real estate, the important issue will be whether it is a jobless recovery, as the two previous recoveries were - or not. The more jobs, the better for real estate (think empty office space and think consumer incomes). In any case, he looks forward to a sustained recovery in real estate values after the destruction of the last eighteen months."
-- JUNE 2009