After a great run, real estate investments have suffered over the past year, with the average real estate mutual fund down 18%, according to Morningstar. David Lee has managed the $2.5 billion T. Rowe Price Real Estate Fund (TRREX) since it opened in October 1997, so he has seen tough times before. In the two years after the fund started, shares of real estate investment trusts (REITs) lost almost 20%, even as the Standard & Poor's 500-stock index raced ahead 50%. "Even my family was calling up saying they were going to disown me," Lee jokes.
But starting in 2000, real estate shares went on an incredible seven-year run, ignoring the Internet crash and more than doubling, on average. Lee's fund has gained almost 13% a year over the past 10 years, beating the S&P 500 by more than 8 percentage points annually and performing better than three-quarters of all real estate funds. Boston-based BusinessWeek correspondent Aaron Pressman spoke with Lee at Morningstar's (MORN) annual conference in Chicago on June 27.
Real estate was the best place to be for a while, but that run seems to have ended. What's hurting real estate investment trusts?
After those seven years, a correction wasn't surprising. I won't say it was expected, but it wasn't unexpected. So far this year, we're just about flat, while the overall market is down 8% or more, so we're outperforming again. I suppose you could call it a Pyrrhic victory.
It's as simple as the economy. You've five months of job losses now, and this group correlates closely with job creation. Office buildings require job creation, obviously, and shopping malls need the retailers to grow. So the demand side is down temporarily. We're not at panic button-type levels. Long term, we're very bullish on the U.S. economy. That's been a very good bet.
We're very optimistic about supply. There hasn't been a lot of new commercial real estate construction this year. Commercial construction starts have fallen off a cliff. So that bodes well for an eventual recovery, although I can't predict exactly when it will start.
Has the credit crunch hurt the sector much? Aren't real estate companies frequently in need of fresh loans?
The real question is whether these real estate companies will be able to refinance their debts, and the answer is they've been able to so far. The public companies are prudently capitalized. Look at Simon Property Group (SPG). They just did a debt offering, and it was oversubscribed. They got a very good rate.
Potentially, more difficult times may be ahead for more leveraged companies—some of the private companies. I think banks are going to demand more equity before making those loans.
In general, public REITs aren't heavily leveraged, certainly compared with their private counterparts. The public markets have done a good job of policing that. Anybody who tried got put in the penalty box; it was so expensive for them to raise equity that it didn't make sense. A lot of the companies in our fund have balance sheets to take advantage of potential weakness in the market if there are forced sales.
The consumer is also having a tough time, and I keep reading about retail chains closing stores. Won't that hurt the retail-oriented REITs?
We really like the mall companies. There's good scarcity value in regional malls and not a lot of construction going on in the mall business. Short of going bankrupt, we're not convinced that all these retailers can close their way to profitability. They're going to continue to pay rents to have stores in the highly profitable malls.
I thought mall operators charged each store a percentage of sales for rent, so don't the operators suffer if consumer spending drops?
Regional mall companies have moved away from percentage [of sales] rents to contractual rents. They can handle these short-term lulls because of the contractual rents.
The Federal Reserve seems to be signaling that an interest rate hike is on the horizon. Do REITs get hit if the Fed starts hiking rates?
If the Fed is raising rates because of inflationary fears, real estate has historically been used as an inflation hedge. So that could be good for REITs. If the rate hike is because the economy is strong, REITs all own physical assets with physical demand, so that's also good.
Among the various subsectors of REITs, which are you looking at for the best values?
We've never been in mortgage REITs. We do own residential apartment communities, some of which are starting to benefit from the housing situation: It's harder to purchase homes, so there's a greater propensity to rent. Industrial REITs, with warehouses, are pretty economically sensitive right now.
Your fund doesn't own any of the so-called specialty REITs, such as trusts that own nursing homes or computer data centers. Why is that?
We're heavily concentrated in what I'd call the major food groups. We haven't been in health-care REITs, and right now would be the wrong time to do that. We don't own any of the technology center REITs, either. We're not into the specialized REITs that are tied to a particular use and a particular industry. I'd much rather go with prime locations. Some of the specialized trusts could be good stocks, but it's just not the way we invest in real estate. I focus on location, location, location.
Does the fund look outside the U.S. much?
A lot of companies are doing that for us. We're seeing international expansion by AMB (AMB), ProLogis (PLD), Kimco Realty (KIM) and Simon, for example. That's how we're getting international exposure. And this might be the best asset class for international expansion.