Focus On: Real Estate Funds

June 1, 2006

(Published 06/01/2006) Real estate mutual funds are due for a drop.

Fundamentals were strong in real estate in recent years (of course, fundamentals were strong in tech back in the 90s). Real estate funds primarily own REITs (real estate investment trusts – essentially investment companies that own and operate buildings for rent), and to a lesser extent, real estate-related stocks like homebuilders (Hovnanian (HOV) and Lennar (LEN), and others that benefit from housing booms, like Home Depot (HD).

With property prices escalating, REITs have done spectacularly well. With new homes selling as fast as they can build ‘em (and with fat profit margins over construction costs) homebuilders have been raking in cash.

Just because an asset class takes off doesn’t mean it has to stop – Powerfund investors don’t sell just because they`re up. Two key factors kill many mutual fund golden geese: 1) declining fundamentals (over-valuation), and 2) inflows of too much money from performance-chasing investors.

Real estate mutual funds fail the Powerfund test on both counts. Today we can safely say that fundamentals are eroding, particularly in REITs, and inflows are strong.

REITs can be risky. If the economy turns south, rental revenue dries up and all available income to the REIT goes to pay interest on their massive debt (that’s how they bought the properties in the first place). However, in a strong economy with high rents and climbing real estate values (leading to windfall profits when an REIT sells a building) the business is very profitable and REITs can generally payout very high dividends to shareholders (by law they have to pay out income, much like a mutual fund).

While the stocks of homebuilders like Hovnanian have already collapsed almost 50% in price on little more than fears over future home sales (despite great earnings), REITs remain hot. While the fundamentals at REITs are strong, the prices of REITs are even stronger. This means, even taking into consideration better earnings and more valuable property, REITs are expensive.

The best indication of REIT overvaluation is the dividend yield on a low-fee REIT index fund, like one of our favorites in this category, Vanguard REIT Index (VGSIX). When you adjust out for dividends paid by REITs that are not from operating income, the yield on this fund is below 4%. A few years ago an REIT index paid about 6% in dividends or more.

So what? The S&P500 doesn’t even quite pay 2% (though ordinary stock dividends are usually taxable at a lower rate than REIT dividends, which are taxable like bond interest, or as ordinary income in most cases). REITs are bought for income, sort of like utility stocks (which are also overvalued now). Sure there is potential for growth in rental income (though there is a higher likelihood of growth in stock dividends) and more appreciation of underlying real estate assets, but there is also a chance for declines.

This risk usually means investors should get more yield in an REIT than, say, a money market fund or a government bond. That is no longer the case. Why bother? Investors can get 7% in a Vanguard junk bond fund if they want a lower-risk return. There will need to be a continuing housing and economic boom to earn more in most REITs than in a low-risk bond portfolio. Like all overblown areas, investors are paying too much for the future’s likely revenue stream.

The best thing that could happen to an REIT investor at this point is a big increase in inflation – because rents to the REITs would go up, as would their property values. Any slowdown in housing or further increases in interest rates could lead to a 15-25% decline in an REIT index.

As for fund company and investor behavior, there has been a pick-up in new real estate fund launches in the last three years. The Vanguard REIT index has about as much money in it as the Vanguard Energy fund, another over-invested area. Trouble is, REIT and real estate-related stocks don’t have the combined market cap of energy stocks so this represents a fairly large fund assets-to-underlying business size ratio.

For the record, we recently sold our last real estate fund stake in a client account due to valuations issues.

Category Rating: 5
Previous Rating: 5
Expected 12-month return: -12% (lowered from -7% in our last favorite fund report)

1. SSgA Tucker Active REIT (SSREX) 11/02 129.40% 86.52% 10.57% 34.13%
2. Mercantile Divrs Real Estate (MDVRX) 9/01 126.78% 95.89% 9.25% 27.55%
3. T Rowe Price Real Estate (TRREX) 9/01 154.56% 123.67% 10.46% 32.95%
4. Vanguard REIT Index (VGSIX) 8/02 109.86% 63.14% 9.38% 30.13%