Real-Estate Slowdown?
No Sign of It in Sector Funds

For the past two years, financial advisers have warned that the best days may have passed for real-estate mutual funds. And yet, they keep gaining. These funds were up an average 5.3% this year through Feb. 28, according to Morningstar Inc. Almost no category, save emerging markets and precious metals, can top the five-year results of real estate. Real-estate funds, on average, have gained nearly 24% a year over the period.

While the broader market has stumbled, factors driving the category most recently include private-equity investors' acquisitions of property companies.

To make sense of the sector, we turned to Theodore Bigman, a managing director at Morgan Stanley. Mr. Bigman has run real-estate securities investing for the Wall Street firm since 1995 and oversees mutual funds including Morgan Stanley Institutional U.S. Real Estate A, which ranks in the top 10% among peers for the past 12 months, three years and decade. His Van Kampen Real Estate Securities A is in the top 20% for each of those periods. Here are excerpts:

The Wall Street Journal: Are you a bull or bear right now?

Mr. Bigman: The sector has had phenomenal performance in the past one year, five years, 10 years, etc. Those who continue to bemoan real-estate stocks continue to focus on metrics that are not appropriate valuation metrics for REITs, such as dividend yields or earnings multiples. The average dividend yield for the REIT sector, which is at an all-time low and now is below the yield on 10-year Treasurys, has declined from 7% to around mid-3%. And the REIT sector is trading at right around an all-time-high multiple of earnings. So, they appear expensive on these metrics, but those factors have been true for several years.

The right metric to look at is how the stocks trade in relation to the value of their underlying assets, or the net asset value of the portfolios of these companies. The price of the stocks has gone up because the NAV has gone up.

In 1998, our fists were bare from banging the table and telling clients that these stocks were trading at 20% discounts to their NAV. We were pleading with clients to give us money to make them money.

Where are we today? We've told investors for a while that, over the medium to long term, they should expect real-estate stocks to outperform bonds but underperform equities. If you take consensus expected returns for equities and bonds, that's 6%-ish annually for real estate. The bottom line is you shouldn't have zero in real estate unless you think stocks will generate 15% returns and bonds 7% or 8%.

WSJ: Would you advise investors to take some money off the table?

Mr. Bigman: If you're thinking of taking money off the table, think about going from [U.S. to global real estate]. Expected returns globally will be a little better than in the U.S. ...You'll get better returns and better diversification.

WSJ: How much should investors allocate to real-estate stocks?

Mr. Bigman: This will vary depending on individual time horizon and risk/return preferences, but we can tell you that most institutional investors are in the single digits to 10% of a portfolio, and most are expanding their allocations to include exposure to the global real-estate markets.

WSJ: Private-equity firm Blackstone Group recently battled Vornado Realty Trust to acquire Equity Office Properties Trust, the nation's largest office owner. Why are office buildings in such demand as investment vehicles?

Mr. Bigman: It's Economics 101. Supply has lagged behind demand due to previous rents not justifying the costs of new construction, which has positioned the office sector in a sweet spot at the moment. We have had decent rent growth in 2006, plus room left in '07 and part of '08. With this strong rental growth, however, supply will catch up and dampen further growth. The developers are entrepreneurial.

WSJ: Is the recent burst of leveraged buyouts a sign of the sector's top?

Mr. Bigman: The high level of take-private activity says to me that pretty sophisticated market participants believe the REITs were trading at valuations comparable to direct real estate and NAV calculations are not fictitious.

WSJ: Industry executives have sold a lot of REIT shares. Isn't this worrisome?

Mr. Bigman: No. It's a little unfair to ask CEOs not to diversify their personal portfolios. Most of these companies came public between 1993 and 1996 and have 10-year options that are massively in-the-money, so I'm not surprised [by the sales].

WSJ: Morgan Stanley Real Estate and Van Kampen Real Estate Securities funds earlier this year were closed to new investors. Is that a sign you're finding fewer good investment ideas?

Mr. Bigman: We manage $25 billion in global real-estate securities, and we emphasize performance. We thought it prudent to restrict new inflows to make sure we can continue to find opportunities for existing investors. The total capitalization of the U.S. real-estate securities market is about $450 billion and $900 billion globally, so at some point we might have felt we were at the point where we couldn't generate the same performance.

WSJ: How do you compute price-to-NAV, as most companies don't publish their NAV as they do results like earnings and sales?

Mr. Bigman: We rip apart their financials, and determine what their cash flows and real-estate portfolios are worth. ...We don't consider ourselves stock investors. We are real-estate investors.

WSJ: Which areas of the real-estate market are you favoring?

Mr. Bigman: The only sector we're excited about in the U.S. is hotels. It is hard and expensive to build brand-new, major, high-end hotels in cities like New York, Los Angeles, Chicago and Boston, and the companies we favor are concentrated in these markets and trade at discounts to NAV. We feel real good about Starwood [Hotels & Resorts Worldwide Inc.], Hilton Hotels [Corp.] and Host Hotels & Resorts [Inc.], which are in our top-10 holdings.

On the margin, a number of apartment-REIT stocks are cheap relative to their NAV, though not quite as cheap as they used to be. Equity Residential is one. ...After the acquisition of Equity Office Properties, it is obvious that no company is too big to be taken over.

WSJ: So many small investors want to know, what is going on with the housing sector?

Mr. Bigman: We invest in companies that own and operate real estate, so home builders don't fit into a classic real-estate portfolio...Twenty percent of our portfolio is in property companies that own rental apartments. ...There are a few overheated markets, but most rental markets are in pretty good shape.

WSJ: Should an investor put less money in real-estate mutual funds if he or she owns a home?

Mr. Bigman: You have to live somewhere. That should be a separate decision to how you invest.

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