Real estate funds have been top performers of late, with the sector up an average of 10.5% for the year, compared with the 0.17% drop in U.S. diversified equity funds, a broad measure of diversified domestic equity funds, according to Lipper.
To get more insight into reasons to invest in real estate funds -- other than their recent performance -- and to understand where real estate stocks are headed, we spoke with one veteran, Michael Schatt, who has been the portfolio manager of the (PHRAX)Phoenix-Duff & Phelps Real Estate Fund since 1997.
1. Let's start with the basics. Why put a real estate fund in your portfolio? What role does it play?
Two basic roles: Provide current income through dividends, and diversification. There's a very low correlation between REITs [real estate investment trusts] and the broader equity market, as well as the fixed-asset -- bond -- market.
2. Speaking of lack of correlation, REITs have been doing well compared to the S&P 500
over the past year or two. Some people say that REITs are hitting a high-water mark here, and it might not be a good time to invest in them. What's your outlook for the rest of the year?
Portfolio Manager, Phoenix-Duff & Phelps Real Estate Fund
|Managed since: 1997
|Assets: $42.5 million
|One-Year Return: 23.24%/Beats 56% of Peers
|Five-Year Return: 9.62%/Beats 74% of Peers
|Expense Ratio: 1.30%
|Maximum Sales Charge: 5.75% Front
|Top Holdings: Vornado Realty Trust, CBL & Associates Properties, Boston Properties
Returns as of 4/18/02.
Top holdings as of 03/31/02.
Well, go back to the first question, which implied, "Why do you invest in REITs?"
The dividend yield is still attractive, safe, secure. And visible. The current sector average is, I think, 6.33%. That's just not available in any other place in the market right now. That compares favorably, certainly, with dividends that are available in the equity market, and very favorably with dividends that are available in the bond market right now. So that's certainly one point.
In an era -- which I don't want to overemphasize, this sort of Enronization of corporate America -- but in an era where there's some question about the visibility of earnings across the board, REIT earnings are very visible. Not just because they've been very prudent in their accounting and disclosure, but also because the heart and soul, the underpinning of the industry is based on assets, tangible assets that you can go out and touch and value. And this is further supported by leases that are out to, for the most part, credit tenants [financially stable tenants], credit individuals. So a significant portion -- I'll make a guess for illustrative purposes -- 90% of the year's income for many of these REITs is already known on day one of the year.
There aren't too many other investment opportunities in which you can find that same circumstance where you know what the income for that company is going to be the day they open the door for the year.
3. Then what's the downside to owning REITs?
The downside, as in any other investment, is overvaluation. That is a result of too much chasing too few investment opportunities. So it's possible you can overpay for them. I don't see that being the case right now. If we were just to look at one yardstick again -- going back to perhaps the most important, and that is dividend yield, that 6.33% average for the sector -- I don't see a lot of circumstances in which an investor today would be overpaying.
4. That revenue you talk about is visible, unless tenants declare bankruptcy and get out of their leases. How much of a risk is that this year from Kmart (KM)
and other tenants?
Not any more than it has been in any other year. In the areas where you may see bankruptcy -- and it seems to be written about most in terms of retail, either shopping malls or strip shopping centers, but it certainly could have some occurrence in the office market or the industrial market as well -- the number turns out to be quite small. Less than 1% [of tenants], for the most part.
The risk to be managed is to examine the portfolios more closely and make sure that there is not a large exposure to any one tenant. This is a commonly followed piece of information that's revealed by each one of the REITs.
5. Your top holdings include Vornado Realty Trust (VNO)
, CBL & Associates Properties (CBL)
, Boston Properties (BXP)
, Chelsea Property Group (CPG)
and General Growth Properties (GGP)
. What do you like about them?
The common theme amongst our holdings would be a very competent and very experienced management team. And a management team that looks at its business as being one of value creation.
[That means] buying properties, building properties and adding to the value through property management, through positioning their properties in the marketplace, through working with tenants, bringing in credit tenants, structuring their leases correctly, operating their buildings correctly. And who view the value creation process as -- well, just that, as a process, if you will. The assets are in their portfolio for a time. They're not there in perpetuity. And as they're able to create value, they dispose of the asset, capture the value that they've created, and reinvest that differential in the next value creation opportunity.
They're not, for the most part, in the business of asset accumulation. ... There's always a certain percentage of their portfolio that's being sold or turned over. Whether it be 5% each year, or 10% or 15%. Much of it determined by the marketplace.
6. What's going on remarkably well or badly among different property sectors?
Well, the regional malls have done extremely well here. Part of it is because they had been undervalued up until recently. The undervaluation, I think, a lot of that had to do with fear. For the last 18, 24 months, there was a sense that regional malls were going to be threatened by e-commerce. And then as we went into the end of last year, the beginning of this year, there was certainly a great deal of discussion about how would the consumer react in this recession. Would there continue to be retail sales? What type of support would they have? How would those changes in those spending patterns affect the regional mall?
And coming out of the fourth quarter -- the Christmas shopping season -- the regional malls turned out to have held up quite well. While shopping may have not have been as robust in terms of the level of growth as in the past, the sales numbers showed that they were quite healthy.
7. Is the danger of the consumer spending slowdown in this recession passed?
I don't know that it's passed completely, but it appears as if it has passed to the point where it has a dramatic impact on the decisions that retailers are making.
We're seeing a continuation of leasing -- new leasing -- by retailers. A continued expansion in terms of the number of stores by retailers, driven by reasonably healthy results -- perhaps with the exception of department stores -- coming out of the last couple of quarters, based on the spending of the consumer.
8. What property sector are you least optimistic about?
There are two, for the present. Apartments would be one. I must admit that's one that's almost counterintuitive. I would have assumed coming into a slowdown in the economy that apartments would have done rather well, and that the impact of the slowdown in the economy would have been to slow down single-family home buying. And that is the competitor, if you will, for apartments.
But it turns out, as has been pointed out regularly, that indeed this slowdown did not have an effect. That single-family home buying was very robust, much of it owing to low interest rates, low mortgage rates. So that apartments, in terms of their occupancies, were pinched on two ends: They had the continued move-out from people who were buying a new home, and maybe at record pace. And at the same time, they had a sort of doubling-up or returning-home phenomenon by those people who were squeezed by the job cutbacks brought about by the slowdown in the economy.
And then maybe a third factor in there was that while the demand for apartments was contracting, the supply of apartments, unlike most other real estate products, continued to move along at a reasonably healthy rate.
It takes a slowdown in development of new product, and then a general economic turnaround that results in job growth, before we see a dramatic change in the current position of the apartment market. It's not a snap-back for apartments.
[Two,] lodging is very much dependent on the transient business traveler's return. And again, that is going to be dependent upon general economic recovery -- providing a stimulus to businesses to essentially send their people out attending meetings again. And until that happens, I don't think we're going to see a big turnaround in lodging.
Apparently, the vacation traveler has come back, and the small-group-meeting user has come back, but we're still waiting for this business transient traveler to come back. But I think that has already been priced into the lodging stocks. They've had a very healthy run from their low point, post-Sept. 11, and I think it's all anticipatory at this time. So it doesn't look like a good value within the REIT sector.
9. What's the impact of Alan Greenspan's indication Wednesday that the Fed
is not going to be raising rates anytime soon?
It says to me a couple of things. One, the REITs remain healthy. They've had very modest leverage, and so we're not going to be challenged by any move up in rates. They've all been able to take advantage of relatively attractive low interest rates.
To the extent that low interest rates serve as a further stimulus for development, that's not good news. Although there are other factors involved. The low interest rates make it easier for new developments to pencil out.
One of the advantages in the past for REITs has been cheap cost of capital. But with low interest rates, that cheap cost of capital is available to private real estate companies as well.
And to the extent that this might be an opportune time for REITs to go out and acquire additional properties -- to put new properties in their value creation pipeline -- I think they're already experiencing some fairly fierce competition from the private marketplace, part of which is driven by the fact that we're in a low interest rate environment. They have access to capital they can afford to pursue assets with a lower yield than can the public real estate companies.
10. Last question. Relative to your work here, what's your nightmare news? What's the worst thing you could read about in the paper tomorrow?
Record new construction starts.