Doubters fear a bubble that is ready to burst.
The real estate sector entered the year with a
remarkable five-year performance run that was partly spurred by the
"dot.com" bust of the late 1990s and the resulting quest for income and
reasonable valuations.
Now, as real estate performance has sputtered thus
far in 2005, the comparisons to the high-tech boom continue to
linger-and possibly haunt-the normally quiet real estate sector. The
questions being whispered on Wall Street ask if real estate values have
gone too far out of sight after five years of serving as a "safe"
refuge for investors battered by the volatile equity market.
Namely, have the values of real estate investments
been pumped up too far by speculators and quick-money seekers? Is real
estate due for a correction, a return to the mean or, in a worst-case
scenario, a collapse?
Another danger sign reminiscent of the go-go 1990s,
some advisors say, is that many clients are calling with get-rich-quick
schemes that center around real estate holdings. These plans often
involve purchasing homes for speculation purchases and then "flipping"
them for a profit.
Real estate, some advisors say, has become the investment that everyone
and their neighbor wants to get involved in. The last time that
happened, they note, it was a foreshadowing of the stock market, led by
high-tech issues, falling off a cliff.
"It's just so similar to the tech boom of five or
six years ago," says Steven Podros, a CFP who owns and operates Wealth
Care LLC in Merritt Island, Fla., where the real estate market has been
especially hot. Podros says he's had to talk many of his clients out of
buying homes for speculation purposes, usually after pointing out to
them that the costs of ownership will outweigh any benefits they can
accrue from leasing. "You can go into any condo development these days
and find 30 units where the owners are trying to rent or sell or flip,"
he says.
Perhaps even more important to the real estate
sector is the question of whether or not the wide investor acceptance
of real estate is a permanent change in attitude, or a short-lived
trend. These are not concerns arising just from a feeling of paranoia.
Real estate investments, particularly publicly traded REITs, have
benefited from surge in popularity since 2000. Last year, the Morgan
Stanley REIT Index gained more than 31%, which marked the fifth
consecutive year in which it outperformed the S&P 500 index. The
Composite REIT Index has a five-year annualized return of 20.08% as of
March 31.
That amounts to stellar performance for a sector
that previously was a fringe component of many portfolios, when it was
included in portfolios at all. But, coming so soon after a stock market
collapse that gave birth to a three-year bear market, concerns of
overvaluation have naturally been nagging the sector.
Real estate investors have already taken note of
hedge funds starting to rotate out of the real estate sector. Even
advisors who shun tactical allocation, and stick to strategic long-term
models, are getting uncomfortable. They are, in many cases, lightening
up in real estate through portfolio rebalancing.
Some market watchers suggest that such fears may be
healthy for the market. By throwing some cold water on the heated pace
of investments, they say, it will help avoid the type of "irrational
exuberance" that gripped the market in 1998 and 1999.
That's why some in the real estate investment industry are not
disappointed by the recent slowdown of capital flows into the asset
class. About $800 million flowed into real estate funds in the first
quarter, compared with a record $3.2 billion in the first quarter of
2004.
"My sense is, that's just fine," says Michael Grupe,
senior vice president of research and investment affairs at the
National Association of Real Estate Investment Trusts (NAREIT). "I
would become more unsettled if there wasn't some variation in this data
to indicate some moderation of behavior by investors."
Indeed, few in the real estate investment industry
expect a continued run of performance of the likes seen from 2000 to
2004. Helped along by low interest rates, a low-return equity market
and a renewed investor appreciation of dividend yields, REITs hit a
high of 38.47% in total returns in 2003. Last year, which also began
with fears that the market had become overextended, the Composite REIT
Index finished with a gain of 30.4%. Also like last year, real estate
has started the year with a stumble, although the same could be said
for the rest of the investment market.
Through March 31, the Composite NAREIT Index showed
a loss of 7.50%, with all real estate categories sharing in the losses.
Retail malls, the best performing real estate category over the past
few years, was down 4.73% as of February 28. The residential sector,
where some analysts feel there is the most danger of values reaching
"bubble" proportions, has been among the worst performers. Home
financing, for example, was the single worst category as of February
28, down 10.75%.
Residential apartments, which have brought investors
good returns in recent years despite high vacancy rates and a supply
that still far exceeds demand, were down 7.64%.
It's still too early to determine if any trends are
underlying the numbers, observers say. Grupe notes that the entire
investment market has been suffering for a number of reasons, including
mixed economic indicators, the continued cost of the war in Iraq and
the huge federal budget deficit. Interest rates are starting.
"We are leading the parade, but it is a parade," he
says. "I think the market pretty much across the board has entered the
year with a heightened awareness and concern about the risks that are
out there."
Nancy Holland, portfolio manager
of the ABN Amro Real Estate Fund, says she is looking for REITs to turn
in a total return of 5% to 8% this year. Like Grupe, she attributes the
slow start partly to lingering questions about the economy and the slow
pace of the economic expansion.
"The economic news has been so inconsistent," she
says. "We get strong employment one month and then the next month
retail sales are weakening."
Holland feels the talk of a bubble and the
comparisons to the high-tech boom are unfounded. Fundamentally
speaking, she says, the real estate sector is a far healthier place
than the dot.com sector was in the 1990's. She notes that, aside from
the office and apartment markets, demand is catching up to supply for
all real estate markets.
Economic expansion, she says, will continue to make
the fundamentals better. "What may seem negative in the short term is
really positive as the economic expansion fills the vacant space and
gives the landlords pricing power," she says.
In regards to her fund's portfolio, Holland says she
is overweight in the industrial and retail REIT sectors. "Retail
remains positive and the companies have a lot of built in earnings
growth from lease renewals and replacements," she says.
Industrial properties will be among the first
beneficiaries of the economic expansion, she says, benefiting from more
inventory and the movement of more goods. "Industrials have had a great
run but we think there is still room in pricing there," she says.
Holland is underweight on the net lease and
healthcare categories, primarily because they are so dependent on new
acquisitions to maintain earnings growth. She's sitting on the fence
when it comes to office space, and slightly underweight in residential
apartments. Both categories, she notes, have been dealing with excess
supply in recent years, particularly apartments. While she feels
increased interest rates will be a boon to apartment properties, she
doesn't see an immediate improvement in these categories. "We don't
expect to see an uptick until 2006, based on the growth rate of the
expansion and the typical lag between employment growth and decreasing
vacancy."
The exceptions, she says, are niche companies that
focus on particular regions or markets. The fund, for example, has
invested in office properties focusing on the Washington, D.C., and New
York City markets.
For the advisors who are watching what the managers
are doing, the real estate market has in many cases forced some
adjustments in strategy. But most seem to feel that real estate
holdings are a valuable portfolio diversifier, as well as a source of
income, that deserves a permanent place in most portfolios.
At the Abacus Planning Group in Columbia, S.C., it's
been a matter of aggressive rebalancing to get previous year's real
estate gains into other areas of the portfolio, says financial analyst
George Flowers. The typical client portfolio has about 3% to 5% devoted
to REITs, he adds. "We're seeing a lot of similarities to 1999, so we
have been aggressively scaling," he says. "But we always feel there's a
place for REITs and we're not going to get rid of them. They're a
natural inflation hedge that produces income."
RegentAtlantic Capital LLC in Chatham, N.J., also
uses a strategic asset allocation approach and has been using REIT
investments for 20 years, says Edward Stuart, a vice president and
wealth manager at the firm. But the firm did decide to address what it
perceived to be "generous" values in the REIT market compared to
historical norms through the utilization of offshore REIT investments.
The firm this year decided to devote a little less
than half of its REIT allocations to foreign holdings, which it sees as
a diversifier since foreign REITs are not correlated to domestic REITs,
Stuart says. The firm also views the move as a hedge against the dollar.
The move wasn't easy, Stuart adds, since there are
few fund vehicles available for foreign REIT investments. The firm
decided to go with the Morgan
Stanley European Real Estate Fund after it was indicated the fund might
expand its holdings to regions outside Europe, he says. Dimensional
Fund Advisor funds is also working on an international REIT fund, he
adds.
"There's not a lot of international REIT mutual funds out there at the moment," Stuart says.
The availability of REITs in employee-sponsored
401(k) plans, another indicator of acceptance of real estate by
investors, is growing-but slowly. In the late 1990's, about 5% of all
plans offered a real estate fund, according to NAREIT. That has since
grown to 12%, according to the association.
One notable addition to the list within the past
year was IBM, which sponsors one of the nation's largest employee
401(k) plans, according to Grupe of NAREIT. There are also proposals in
Congress to add a REIT fund option to the Federal Thrift Savings Plan,
the retirement savings program for civil service, postal and military
personnel.
Another reason Grupe feels that REITs are in
portfolios to stay, unlike the dot.coms of the 1990s, is that the
sector's earnings and performance are not a matter of speculation. "We
are talking about hard assets," he says. "They are not disappearing.
They are going to be there, occupied by tenants, with rents paid. I
think that's a world of difference from what you've had in the
technology sector."