REITS Hit Hard
After 7 Good Years

Mutual funds specializing in real estate are getting clobbered, hit by a one-two punch of woes in the property markets and the tumult in the debt markets.

Although real-estate stocks staged a late rally yesterday, their recent troubles were highlighted this week by a 31% one-day drop in the stock of KKR Financial Holdings LLC Wednesday, a real-estate investment trust, after the company reported financing problems.

The result is that after seven years of spectacular gains, funds investing in real-estate investment trusts are posting huge losses -- some with losses topping 15% over just the past month. That is particularly bad news for investors who poured nearly $18 billion into these funds in the past year and a half.

Meeting Redemptions

As some investors sell, fund managers are forced to sell holdings to meet those redemptions.

The average real-estate fund investing primarily in the U.S. has lost 17.2% over the past three months and is down 16.5% so far this year, according to Morningstar Inc. In contrast, the average diversified U.S. stock fund is up 0.7% so far this year and down 5.9% over the past three months.

The pain is somewhat less for global real-estate funds, a strategy that has been growing in popularity. The average global real estate fund -- which will invest both in and outside the U.S. -- has shed 15.2% over the past three months and is down 10.3% since the start of 2007.

The timing is bad for many investors. REITs have surged in popularity thanks to the strong performance they posted during the bear market for stocks earlier this decade and on the back of the subsequent real-estate boom. Even with this year's rough performance, the average real-estate fund was up 18% a year over the three years through the end of July.

Investors chasing those gains poured a record $11.2 billion into real- estate mutual funds last year and an additional $6.9 billion during the first six months of this year, according to Financial Research Corp.

As this year got under way, there were concerns about the residential real-estate market, but portfolio managers were optimistic that other corners of the industry -- such as commercial space -- would remain strong. In addition, REITs got a big boost from the private-equity boom, where investors were willing to pay high prices to take REITs private, which in turn helped drive up the value of REITs.

Now, however, the credit crunch has driven up the cost of financing commercial real-estate purchases and in turn crimped the profit outlook. Also, the end of what had been a private-equity boom has removed a prop from under REIT share prices.

Morningstar analyst John Coumarianos says that after years of big gains, REITs were vulnerable to big declines. "Almost across the board they had become very overvalued," he says.

To the Exits

Investors heading out the doors are complicating matters. According to AMG Data Services, more than $400 million has been withdrawn from real-estate funds in just the past two weeks, which have roughly $36 billion in total assets. "That's been a definite factor in the decline," says Alex Peters, manager of Franklin Real Estate Securities Fund.

Munder's Pain

The hardest-hit among actively managed real-estate funds has been the $70 million Munder Real Estate Equity Investment fund, which is down 25% so far this year, much of that in just the past few weeks. One top holding, RAIT Financial Trust, which is a so-called mortgage REIT specializing in financing for commercial real-estate, has collapsed 80% since the start of this year.

The fund also had a small stake in KKR Financial, according to its most recent shareholder report. A spokeswoman for Munder said the fund's manager wasn't available for comment.

The Franklin fund, too, has taken it on the chin. Mr. Peters says that earlier this year he had began to worry about the prospects for some of the commercial real-estate stocks that had previously weathered last year's concerns about residential real estate. "They seemed priced for perfection," he says.

Meanwhile, he felt that home-building stocks, which had already been beaten down, were starting to look attractive and shifted the portfolio. Unfortunately, in the latest downdraft, home builders fared even worse. The Franklin fund is down 23.4% so far this year.

The only relative haven has been non-U.S. REITs, particularly companies operating in Asia, fund managers say. "The U.S. has been the epicenter of the problems," says Keith Pauley, chief investment officer of LaSalle Investment Management.

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