With REITs hotter than ever, advisors are looking overseas for newer, riper real estate securities.
International real estate in the past few years has
taken on a very different meaning from beachfront property in Honduras,
or a Spanish colonial palace in Nicaragua where you can sit by the pool
sipping Flor de Cana rum and smoking a double maduro cigar.
Rather than looking covetously at attractive plots of land in places like Panama ("Is that the new Costa Rica?") or Bulgaria ("Is that the new Croatia?"), advisors are instead looking at international real estate as the hot asset class-a holiday away from the scorching climes of the U.S. stock market.
Though the U.S. is still the largest real estate market, only a small part of that is securitized, and more than half of listed real estate is overseas, according to various indices. Pensions and endowments in particular have been irrigating foreign land with new money. And now foreign governments are helping smaller investors open the spigots: Nearly 21 countries have passed or considered laws allowing the formation of real estate investment trusts, or REITs, tax-free portfolios that pay 90% of income out as dividends and allow investors a transparent and liquid way to tap into a variety of holdings-hotels, malls, office parks, skyscrapers, etc.
Moreover, the market is set to get much larger after two of the largest European economies, Great Britain and Germany, adopt REIT laws of their own in 2007 (the U.K.'s REIT legislation went into effect on January 1, and Germany is expected to follow suit early in the year). The addition of these huge financial engines in Europe could bring hundreds of billions more in REIT assets to market. (The nine British property companies converting to REIT status and joining the S&P/Citigroup Global REIT Index in February had a total market value of more than $71 billion at December 27.) The arrival of the REIT structure means investors can avoid the troubles of direct ownership but still get a taste of booming markets such as China and India, where the growth is not likely to cool for a while.
Diahann Lassus, a financial advisor and president of Lassus Wherley, a wealth management firm with offices in New Providence, N.J., and Naples, Fla., likes what she sees. She has a 3% to7% allocation to REITS after increasing the international component of her holdings to more than half in the latter part of 2006.
"As more countries adopt the REIT structure, the money flows are going to follow," she says. "A lot of the market was undervalued because before there was no easy way to get money into those markets. As we are able to do that with the REIT structures, it will allow money to move around the world much more easily."
Louis Stanasolovich of Legend Financial Advisors Inc. in Pittsburgh has moved 5% to 10% of client portfolios into international REITS. Many advisors have had their heads turned by the eye-opening 30%-plus returns the international sector has turned in, though he concedes that trend may not last. "We don't expect to see the same returns we did over the last three years," Stanasolovich says. "But we expect 10% to 15% returns over the next three to four years."
According to the $905 billion FTSE EPRA/NAREIT Global Real Estate Index of 338 publicly listed securities-an index created by the National Association of Real Estate Investment Trusts (NAREIT), along with the FTSE and the European Public Real Estate Association-global REITs saw a total return of 42.35% in 2006. That includes a 36.26% return for North America, 36.49% for Asia and a whopping 66.99% for Europe.
The recent interest in the asset class also has been inspired by unfavorable macroeconomic issues at home. U.S. investors have become worried about rising domestic inflation, the falling value of the dollar (which they want to hedge with foreign holdings) and the likelihood that the economy will slow. Stateside real estate investments themselves have seen such explosive growth in the past seven years (and outperformed the market again in 2006) that there is some worry that REITs might be played out here. Moreover, advisors fear that the rising net asset values of U.S. real estate securities are cutting into the high yields that make domestic REITs so attractive. By contrast, portfolio managers say that NAV is trading at a discount overseas.
"The stats are pretty overwhelming when you look at what's available in real estate securities in the U.S. versus the world," says Ryan M. Fleming, a planner in Washington, D.C., with Armstrong, Fleming & Moore Inc. Fleming allocates about 15% to real estate and within that, about 5% to 7% to international. "What really convinced us was dividends. We had underallocated in bonds for three or four years, and in order to get clients more yield we've had them invested in [domestic] real estate. The portfolios have done well as a result, but the yields disappeared as asset values have grown."
Thus international investments are looking like ripe, low-hanging fruit in the same way their U.S. counterparts did in the 1990s, offering the yields of bonds but also the long-term appreciation potential of stocks, and with little correlation to U.S. equities. According to a study by Ibbotson Associates Inc. done for NAREIT, the correlation of U.S. large-cap stocks to Asian real estate from 1990 to 2005 was 0.31; to European real estate it was a paltry 0.06. Advocates of the asset class say there is not only low correlation with U.S. stocks and bonds, but low correlation from country to country.
"REITs and publicly traded equities have delivered outstanding returns over the last few years," says Michael Grupe, NAREIT's executive vice president, research and investor outreach. "But sometimes overlooked is REITs' impressive long-term performance." Over the past 30 years, NAREIT says, the average annual returns for the FTSE NAREIT All REITs Index was 13.40%, while the S&P 500's was 12.47% and the Nasdaq Composite's was 11.28%."
The shifting tide has prompted a handful of mutual fund companies to step up with new international real estate product offerings. In 2006 alone, these firms included The Kensington Funds, Goldman Sachs, Northern Funds, Dimensional Fund Advisors, ING Funds and DWS Scudder. They join other recent entrants Cohen & Steers, Fidelity Investments and European Investors. In December 2006, State Street Global Advisors launched its StreetTracks Dow Jones Wilshire International Real Estate exchange-traded fund (RWX), the first ETF comprising only real estate securities outside of the U.S., based on the Dow Jones Wilshire exUS Real Estate Securities Index.
The returns of such portfolios this year have been in the nosebleed area: According to Morningstar Inc., Cohen & Steers International Realty A fund (IRFAX) was up 43.88% at December 29, while the S&P 500 was up 15.79% for the year; the Fidelity International Real Estate fund (FIREX) was up 42.87%; and European Investors' E.I.I. International Property Institutional fund (EIIPX) was up 59.78%. The Alpine International Real Estate fund (EGLRX), a veteran among these portfolios, having geared up in 1989, reached 38.74% in 2006.
The Morgan Stanley Institutional International Real Estate A fund (MSUAX) reached 55.56% for 2006. But the company closed the fund to new investors in January, partly because of outperformance and new inflows, which pushed it to $1.2 billion in assets.
Judging the long-term performance of this sector has been difficult, because most of the mutual funds dedicated to this asset class have opened recently and don't yet have the three-year track records many advisors feel comfortable with. This means confidence in the manager's methodology, discipline and ability to seek value is key. The funds also are too pricey for some: Kensington's expense ratio is 1.85% for its class A share, and it has a front load of 5.75%; Fidelity's expense ratio is 1.12%, Cohen & Steers' is 1.7% and Alpine's 1.18%. Because many people get into REITs for the yield, those expenses could meaningfully cut into income, says Morningstar analyst John Coumarianos.
Others, however, say that it's worth it to get the extra alpha from experienced managers in a rangy new field such as this one. "I'm much more concerned about the disciplined valuation of individual securities than other factors," says Michael Kresh, a planner with M.B. Kresh Financial Services Inc. in Islandia, N.Y., who uses Kensington's fund. "If there is positive alpha, I'm not that concerned about expense. If I was, I'd go to an international index and buy a bucket at a low cost."
There also are the more conventional international pitfalls, such as market risks, currency risks and geopolitical risks.
But other fundamentals might make it all worth it. Despite the cooling of the U.S. housing market, many think that even the U.S. commercial real estate market has not hit its peak yet. The reason? It's a landlord's market. The exploding demand for real estate has not been followed by a frightening building boom, portfolio managers say, because commodity costs have kept construction in check. And overseas, they say, the REIT structure has created a more disciplined allocation of capital that has allowed the market to avoid the overbuilding problems such as the U.S. has suffered in the past. With greater demand and static supply in markets such as Hong Kong keeping vacancy low, the hope is that both rents and prices will continue to rise.
"Real estate fundamentals are made up of supply and demand," says David J. Oakes, the portfolio manager at real estate specialist Cohen & Steers which has opened offices in Hong Kong and London in the past 18 months and recently completed its purchase of Brussels asset manager Houlihan Rovers S.A. "With job growth, population growth and the growth of retail sales, demand matters, but we believe supply is the most important factor affecting real estate returns over time. And more markets outside the U.S. have the supply characteristics of New York City rather than Dallas."
There are also places like Japan, which strategists say is just starting to shake off its 15 years of hibernation, and China, whose growth is impossible to ignore. "All the building going on in China is mind-numbing," says Kresh. However, he also says that real estate companies in that country are difficult to value, and investors must get their exposure through REITs in Hong Kong and Singapore. "We're interested in more developed areas in Asia, and in companies that are as similar in structure to American REITs as possible so there is decent transparency and it's not hard to compare it to the underlying stock price in its trading," he says.
Oakes agrees. "With the transparency of the REIT structure, you lower the likelihood that three companies are building on three corners of the same block like you did before."
Fidelity's fund held 75 stocks at the end of September, according to former portfolio manager Matthew Lentz. (Steven Buller, the fund's original manager, resumed management on January 5.) The top two holdings are Japan's Mitsubishi Estate Co. Ltd., an owner of Tokyo office buildings, and Australia's Westfield Group, an owner of 121 shopping centers in four countries, including the U.S.
The Fidelity fund also has had a 234% annual holdings turnover, which might make it less tax efficient. And it is concentrated, says Lentz, with the top ten holdings representing 42% of the assets. As far as the turnover, Lentz says it is the result of the fund's increase in size, as it started at $200 million and had gone up to about $860 million in December. "I think part of the turnover is that there has been a ton of new securities created and new IPOs, and the fund flow has been significant, and that has pushed the turnover. That is going to come down pretty dramatically."
Kensington, a real estate-only shop that opened in 1993, launched its open-ended international fund in May to cater to financial advisors and has already built up more than $100 million in net assets. It only holds about 63 names, and its top two are also Westfield Group and Mitsubishi Estate.
"The focus of the fund is primarily in more developed countries," says portfolio manager Paul Gray. "We're not going to look at emerging markets companies. We're focusing on the biggest companies with the best management teams in the U.K., Western Europe, Australia and Japan. The way we approach China and India is that we really look to companies that have a track record there, primarily in Hong Kong and Singapore and to a lesser extent in Japan."
Cohen & Steers' top holding is also Mitsubishi Estate. "They own a portfolio of some of the best and best-located important office buildings in central Tokyo," says Oakes. "After 15 years of land value and the rental decline, we're seeing rents increase. And this is the Park Avenue of Tokyo."
Another popular holding in these portfolios is British Land Co. PLC, a large U.K. property firm that converted to REIT status and came under new management with the change in the U.K. law on January 1. The company says it expects its first full-year dividends to increase 94%.
Hot Money, Cold Feet
This universe of picks is generally smaller, and there are some worries that a lot of hot money flowing into the space could raise valuations and move markets. Arthur Oduma, senior equity analyst at Morningstar says that with Germany and U.K. adopting REIT structures, the expectation of conversion may have driven up share prices, what he calls a "conversion premium."
"We do worry about capital flows into the space," says Kensington's Gray. The California Public Employees Retirement System, "which is the biggest pension fund in the U.S., said they were going to invest half of their real estate overseas, with a significant amount going into securities. But it's generally a pretty liquid market, especially the bigger companies. If it gets overheated there are some risks, but we don't think they're there now."
The conflict between the short-term desire for yield and the long-term desire for growth leads international real estate advocates to caution that these should mainly be considered longer-term holdings and not a place to chase returns and quick yield. "The markets have a potential to be more volatile than the U.S. market," says Gray. "So I would view it as a three- to five-year holding and would not consider it a fixed-income alternative. It shouldn't take the place of bonds because of yield, because it is an equity investment."