THE MEGA BOX IS
a bright red, sprawling 19-story mall located in the Kowloon Bay section of Hong Kong. When it is finally completed some time this year, it will have 30 restaurants, an all-seasons theme park, an ice skating rink, a home-improvement outlet store and three "lifestyle" zones where dozens of retailers will cater to shoppers' individual tastes. In all, the facility will house a whopping 1.1 million square feet of space and tenants are lining up to fill it.
To an experienced real estate investor that mall may seem like a sweet prospect. It is. The building's owner, Kerry Properties, a company that manages residential, commercial and warehouse space throughout the region, has seen its stock price almost double over the last year. And it isn't the only company enjoying such a run. Across Asia, in Australia and in Europe real estate firms are posting numbers just as heady.
As the U.S. real estate market shows signs of slowing after years of robust gains, investors are searching for the next big score. Many believe they have found it overseas. That attention has boosted the profiles of a burgeoning category of mutual funds and exchange-traded funds (ETFs) that specialize in international real estate. Last year investors placed billions of dollars into the dozen or so funds in this niche and with good reason. Fidelity International Real Estate, which has a substantial stake in Kerry, returned 40% over the last year, beating the average real estate fund by six percentage points. We expect the performance in this category to continue along with the healthy inflows. "Global property securities have been getting more attention as the number of companies, their market capitalizations and their liquidity has increased," says Steve Buller, manager of the Fidelity offering.
While some of that might be a bit of performance chasing, these funds can be a powerful diversification tool. Financial planners call real estate a "noncorrelated" asset. In other words, it may perform better when other parts of your portfolio, like equities, are stumbling. Real estate investment trusts, or REITs, typically invest in office space, retail malls, mortgages or commercial property. Because of their tax designation, they are required to pass along a majority of their earnings to shareholders. That extra income on top of price appreciation is one reason why this category is favored by retirees. (But there are also tax consequences, too.)
If you already have about 15% to 20% of your portfolio in international and real estate we're talking about the combined number here shifting maybe 5% of that to one of these funds could round out your holdings in both categories.
Making that call isn't a slam dunk. After all, the U.S. market has returned an average annual 25% over the last five years, tops of the 18 fund categories Morningstar tracks. So why do investors need to go to the trouble of crossing the oceans? Some skeptics point to the housing slowdown, high gas prices, and speculators who are pushing up prices in anticipation of private-equity buyouts. All that might be a lot of noise. After all, fewer home buyers could be a boon to real estate firms specializing in apartment complexes and oil prices have come down from their record highs. "If oil comes down people will start driving to the mall again," says Tim Hartzell, chief investment officer of Kanaly Trust in Houston. He's been buying these funds for their income potential.
But there is a compelling argument for international real estate. The 12 REITs in the S&P 500 returned an average 39.2% last year, according to Deutsche Bank, but their earnings, for the most part, are due to slightly decrease this year. Meanwhile, parts of Europe and the U.K. are just starting to embrace the real estate investment trust concept. That could lead to a spat of private companies, which are typically undervalued, finally offering shares to the public. And burgeoning middle classes in India and throughout Asia have led to new apartment complexes and retail outlets. In other words, the growth may be moving overseas.
|* Fund charges a 4.5% front end load
** Fund inception date: Sept. 8, 2004
Note: Data as of Jan. 24, 2007
That has investors in a conundrum. "I like U.S. REITS but I'm reluctant to buy in at this time," says Penny Marlin, who owns her own namesake advisory firm in Delray Beach, Fla. "International is more compelling because countries outside the U.S. are just developing REIT structures. They may not be great yield instruments yet but I'm buying them for appreciation and diversification."
Marlin likes the Cohen & Steers International Realty fund. This fund, launched in 2005 by a firm well-known for its real estate expertise, has attracted over $2 billion in just under 24 months. It combines intensive financial research a strategy that, for the most part, favors cash flow and price/net asset value along with some macroeconomic factors with face-to-face company visits. We also like the fact that its managers have an average of 20 years of experience. Top holdings, which are spread out mostly in Europe, Japan and Hong Kong, include Mitsubishi Estate, Westfield Group and British Land Company. The fund returned 45% last year, which makes the 4.5% front-end load and the 1.7% expense ratio a little less painful. (Those fees should come down as the fund grows.)
Cheaper actively managed options include the Alpine International Real Estate Equity and Fidelity International Real Estate. The Alpine fund has a stellar five-year track record it has averaged an annual 30% gain during that time period and charges a cheap 1.17% expense ratio. The Fidelity fund has gone through some manager changes, but we still like it.
Buller, of Fidelity, has an army of analysts across the world that constantly study occupancy and rental rates in every major market. Once they find potential candidates they churn the numbers on dividend yields, earnings, cash flow and other valuation multiples looking for disparities both on a historical basis and according to any projections they have. Buller looks at the whole world, but he limits exposure to countries and regions to plus-or-minus 5% of his benchmark. Top holdings include Mitsubishi Estate, Mitsui Fudosan and Castellum. The fund returned 40% over the last year. And at an expense ratio of 0.91%, it features some of the cheapest fees around. "The goal of the portfolio is to own stocks with the best cash flow growth prospects at reasonable prices," says Buller.
If you want to be even more frugal you could pick up the SPDR Dow Jones Wilshire Real Estate ETF, which will only cost you $60 for every $10,000 you invest. It owns about 150 companies, mostly in Australia, the United Kingdom and Japan, which generate at least 75% of their revenues from active real estate investments. (Developers are excluded.) You will see some of the same names here like British Land and Mitsubishi Estate as you do in the actively managed funds. But this ETF is brand spanking new so it doesn't have a track record. In just six weeks it has attracted $200 million. And its trading volume about 150,000 shares a day is attractive, especially for short-term investors. "It's a very robust product," says Dodd Kittsley, head of ETF research at State Street.
Remember, though, cost should not be your only concern when delving into a somewhat tricky corner of the investment world, especially if you are in this niche for the long haul. "In this area," says Marlin, "I would rather pay for some skills and experience."