Warning: Beware of Warnings About Real Estate

By VIVIAN MARINO at New York Times

FUND investors who amassed colossal gains in real estate over the previous few years were warned not to expect a repeat in 2005. The long-running rally could lose steam, some analysts predicted, which meant that it was time to consider selling.

But those naysayers turned out to be wrong. Many investors who stayed the course and ignored the warnings about real estate bubbles continued to profit: the sector ended yet another year among the top fund categories.

Real estate funds returned an average of 11.9 percent, according to Morningstar, after climbing 32 percent in 2004 and 37 percent in 2003. For the five years through December, the annualized gain was 18.56 percent. By contrast, including dividends, the Standard & Poor's 500-stock index returned 4.9 percent last year and 2.7 percent, annualized, over the five-year stretch.

So now the question re-emerges: Can this highflying sector continue its ascent?

"We've been surprised that real estate has stayed as strong as it has at this point," said Daniel McNeela, a senior analyst at Morningstar, who, like others, is cautious again. "The underlying fundamentals hadn't improved nearly as rapidly as the stock prices have risen."

There are some compelling reasons to sell right now. For one thing, holders who have long invested in real estate may want to cash out, at least to keep their portfolios' asset allocations in balance. And analysts continue to worry about where the economy and interest rates are headed and how those factors might affect real estate investment trusts - the bulk of most of these funds' holdings.

Many funds, including the top performers last year, owe their success to the durability of these REIT's, companies with portfolios of commercial property that pay out most of their profits as dividends. Some analysts say that REIT's themselves are becoming overvalued, along with the properties they buy and hold, and that returns this year will be less spectacular than in previous years. REIT's returned 8.3 percent, on average, in 2005, and 18.9 percent, annualized, over the last five years, as measured by the National Association of Real Estate Investment Trusts composite index.

Still, the overall case for real estate remains strong. As the economy continues to grow and to generate jobs, demand for properties like apartment buildings, retail stores and office space will only rise, said Martin Cohen, co-chairman and co-chief executive of Cohen & Steers, whose Cohen & Steers Realty Shares fund was near the top of last year's performance list, returning 14.9 percent.

The fund's main holdings include blue-chip REIT's like Boston Properties and Vornado Realty Trust, which own office buildings in strong markets like the Northeast; the Simon Property Group, which has premium shopping malls like the Mall of America near Minneapolis; and AvalonBay Communities, which builds rental apartments in pricey housing markets in California and the Northeast.

Mr. Cohen, for one, dismisses the skeptics. "I have been hearing this negative talk for the last five years," and each time there has been a decline, real estate quickly rebounded, he said.

Indeed, last year started precariously. The funds lost 6.4 percent, on average, in the first quarter amid profit-taking by institutional investors. They recovered in the second quarter, with a robust average gain of 13.2 percent, though the third-quarter return was much smaller, at 3.2 percent. The funds were up 2.6 percent, on average, in the last three months.

REAL estate funds have been resilient partly because there has not been a major spike in long-term interest rates, which can prompt a sell-off in real estate investments, Mr. McNeela said.

The funds have also benefited from the limited supply of commercial buildings being developed.

"On average, the replacement costs continue to go up," said Theodore R. Bigman, who manages Morgan Stanley real estate funds, referring to the rising cost of essentials like building materials and land. That may also help to explain the higher-than-usual number of takeovers of REIT's last year - eight completed, six pending - from companies looking for an efficient way to expand their real estate portfolios without having to build, he added.

"We feel very glad about the limited amount of cranes in the sky producing buildings in the United States," Mr. Bigman said.

One area that has had little activity is hotels. "After 9/11, the hotel industry had been in a virtual depression - new construction virtually disappeared," said G. Kenneth Heebner, manager of CGM Realty, the No. 1-performing real estate fund last year, with a 27 percent return. And the large number of hotel properties being converted into residential condominiums is shrinking the supply of hotel rooms, he said.

CGM Realty has 71 percent of its assets in REIT's. Among its top 25 holdings are several hotel REIT's, including LaSalle Hotel Properties, Sunstone Hotel Investors, Innkeepers USA Trust and Host Marriott.

Mr. Bigman, meanwhile, began loading up on hotel shares in early 2002, when many investors were dumping them after the terror attacks. His Morgan Stanley Institutional U.S. Real Estate A, No. 3 on the performance list with a return of 17.7 percent, is also invested in Host Marriott, along with Starwood Hotels and Resorts Worldwide and Hilton Hotels. (Morgan Stanley Real Estate A, for smaller investors, was up 16.76 percent and also has those holdings.) Mr. Bigman says he still likes hotel stocks because demand for hotel rooms has grown faster than supply.

The biggest holdings in Morgan Stanley Real Estate are Simon Property, AvalonBay and Boston Properties. Simon "represents a great way to get exposure to Class A regional malls," Mr. Bigman said, adding that he thinks the company is "undervalued versus both private real estate and its peers." AvalonBay, like other apartment REIT's, stands to benefit from the run-up in housing prices, as homeownership becomes less affordable, he said, and it has already profited by selling rentals to developers for condo conversions.

Mr. Bigman likes sticking with companies that he thinks are poised for growth, and he bases his investment decisions on the quality of their underlying properties rather than on financial metrics like low price-to-earnings ratios.

"Returns are directly tied to continued improvement to real estate property," he said. "Every time we buy a stock we view it as buying into a portfolio of real estate."

Mr. Heebner, on the other hand, is quicker to change sector preferences. His decision over the summer to unload shares of home builders and to acquire coal stocks, which now make up around 18 percent of CGM Realty's assets, has paid off handsomely. Console Energy and Arch Coal are among the fund's largest coal holdings, and each had a stellar performance last year. An additional 7 percent of the fund is in the brokerage firm C. B. Richard Ellis.

"We're bullish on energy prices," he said. And housing? "I believe mortgage financing has become too liberal, which has lead to rising speculations," he said. "People are buying more home than they can finance."

In other words: he thinks that there is a housing bubble.

Other fund managers would agree that some markets - particularly parts of Florida, California and Nevada, for example - have become overheated and overbuilt, but they caution investors not to confuse them with the commercial market.

"They are looking at the bubble in residential real estate, in single-family homes and condos, and translating that to a bubble in other parts of real estate," Mr. Cohen said. "They are unrelated."

Mr. Bigman concurred: "Is there a bubble in commercial real estate? We would argue that there isn't."

But he had this to say to those investors who might have been left behind in the real estate fund rally: "We're sorry you missed the best run-up that we had in years, and we strongly discourage you from expecting comparable returns. However, having a meaningful allocation still makes sense."