Real Appeal (Alexandria):
A fund's success with mortar and bricks, trailer parks and drug labs
By DAVID FRANECKI
Mutual-fund investors have spent the past two years looking for shelter from double-digit annual losses. In the aftermath of September 11, the search has become more frantic.
Investors' common response has been to sprint to the sidelines and dump cash into money-market funds and bond funds.
But there's an often-overlooked fund category that has actually held up well in this tough market: real-estate funds.
As of the end of September, real-estate funds had grown 7.4% on average during the last 12 months and gained 8.3% a year during the last three years, according to Lipper. That compares with a 27.2% loss for the average U.S. diversified fund in the last year and just a 5% annual gain for the three-year period.
One of the better, but lesser-known, real-estate funds is Undiscovered Managers REIT Fund.
Table: At A Glance1
As the name would imply, the $73 million real-estate investment trust (REIT) fund is run not by a household name, but by Bay Isle Financial, a boutique asset-manager in San Francisco co-founded in 1986 by William Schaff and Gary Pollock.
The firm looks for institutional money managers with good track records and then hires them to run its various funds. (The other fund Bay Isle manages, as fund sub-adviser, is the Berger Information Technology Fund.)
Bay Isle launched Undiscovered Managers in 1998 -- after which followed two tough years in the real-estate market. Still, the duo that manages the fund -- Schaff and colleague Ralph Block -- invested conservatively, so they outgunned most of their competitors. By 2000, the pair got more aggressive, finding the values too compelling to pass up.
Due to that deft work, Undiscovered Managers REIT has amassed an impressive track record. As of October 9, the fund has gained 12.38% during the past 12 months, ranking it in the top 15% of real-estate funds, according to Lipper. During the last three years, the fund has returned 14.39% a year, ranking it in the top 5% of its peers.
Schaff, a Korean adopted as a child by a Jewish family near Pittsburgh, started his career in corporate finance at oil giant Chevron. When that firm bought Gulf, he was responsible for determining the breakup value of the company. The experience got Schaff more interested in investing, and he soon jumped to a small money-management firm in San Francisco. After about 18 months there, he felt ready to run his own shop.
Now 43, Schaff was only 28 at the time of Bay Isle's start-up. He was also the sole investment professional, while company co-founder Gary Pollock handled the business end of the operation.
The early years as his own boss were lean ones, Schaff admits: "For the first three years, I think our secretary was our highest-paid employee," he recalls with a chuckle.
The firm started out with one $10 million client, but now runs more than $1 billion in assets. And in those first days, Bay Isle was already managing diversified portfolios in the value style.
In 1993, Schaff met Ralph Block, his cohort in running Undiscovered Managers REIT and the firm's resident real-estate expert; Schaff specializes in valuing the companies.
Block, now 58, was a lawyer for 27 years before going into money management full time. Early in his law career, he dabbled in investing several times -- and got burned several times. For instance, in 1968 he bought stocks on margin and lost all of the $2,000 he and his wife had. But in 1975, he started following and investing in real-estate stocks. In the 'Seventies, very few REITs existed, but Block liked their high yields and cash-flow stability.
Now he is one of the most tenured REIT investors around: Block has written a real-estate investing newsletter for years, and has authored two books on the subject.
But being mostly "undiscovered" has worked to the fund's advantage, say its portfolio managers. Its relatively small size allows it to take positions in smaller companies, and affords it nimbleness in getting in and out of stocks -- nimbleness that isn't possible for bigger funds. Schaff and Block also say their focus on diversification has helped.
Undiscovered Managers tracks the Morgan Stanley REIT Index and rarely puts 10%, more or less, in a sector other than the REIT index. Real-estate funds in general have held up well in this tough market due to their high yields and their lack of correlation to the general market.
A small number of investors, including those in diversified mutual funds, have shifted some of their money out of other sectors and into real-estate stocks. And since REITs have such small market capitalizations compared with other stocks, a small injection of cash into the sector can go a long way, Schaff points out.
REITs have benefited, too, from the high visibility and predictability of their earnings, Block notes. The stocks were once thought of as boring or plodding because they tend to grow more slowly than so many others; "now, plodding is good," Block says.
Ralph Block (standing) and William Schaff started their Undiscovered Managers REIT fund in a tricky market, but clever plays -- in fields like health-care real estate -- have paid off.
Within the real-estate sector, Block's and Schaff's favorite picks are health-care REITs, self-storage and manufactured-home communities (a/k/a trailer parks). They like them because they are less sensitive to economic growth than other sectors.
The pair is now staying as far away from hotel stocks as possible in light of the travel decline following September 11. After the attacks, "the first day we could start selling our hotel REITs, we sold them," Block says.
In addition to an anticipated decline in occupancy, hotel stocks are extremely vulnerable now because they have high fixed costs and debt.
The fund employs a valuation model, designed by Schaff, which looks at three elements when pricing real-estate stocks:
First is a discounted cash-flow model, similar to what many fund managers use to determine the true value of a stock. Next is a real-estate valuation model, which looks at the value of the real-estate property itself, compared with the value of the actual REIT security. Third is a measure of a stock's price compared with adjusted funds from operations (AFFO) -- a measure of cash flow commonly used to measure a REIT's growth instead of earnings.
Undiscovered Managers REIT Fund holds about 30 stocks at once, a smaller number than most funds.
One of the duo's favorite stocks is Alexandria Real Estate Equities, the only REIT specializing in office space for laboratories and biotechnology companies. Alexandria is somewhat of a play on the boom in new drug development; two of its largest clients are drug giants Pfizer and Merck.
Block calls Alexandria Real Estate Equities "a virtually recession-resistant property." The company owns five million square feet of properties, mostly in key California cities, eastern Massachusetts and North Carolina -- markets where much of the health-care development takes place.
Block estimates that Alexandria will be able to grow its free cash flow at least 10% a year for the next two years. The stock isn't cheap, selling at 11 times 2002 AFFO, compared with 10 times for the average office stock. However, Schaff and Block like its growth and low risk.
Another favorite stock is Manufactured Home Communities, which operates 149 trailer parks in 23 states. Started by Sam Zell in the early 1980s, the company concentrates on high-end trailer communities with larger units and a greater variety of amenities -- for example, central driveways, patios, garages, fireplaces, even putting greens. The company boasts 93%-95% occupancy, operating cash-flow growth of 4% a year, and rent increases 1%-2% above the consumer price index.
There is limited threat to future development in most of Manufactured Home's communities, thanks to zoning laws. Its units have 10%-15% annual turnover, compared with 50%-65% in many conventional apartment communities.
There are three REITs in the trailer-park business, and Block considers Manufactured Home the most consistent of the group. Large numbers of its tenants are senior citizens -- which helps account for low turnover and low default rates.
Block expects Manufactured Home to grow its AFFO 8.5%-9% a year for the next several years, and its yield is a healthy 6.5%. That sort of double play -- AFFO growth plus yield -- has Schaff and Block bullish about real-estate stocks, going forward.
Says Block, "I have more confidence in what REITs will do than the broader market. Unless the multiples compress, we're looking at returns in the neighborhood of 12%-14%. The stocks are also slightly cheaper than they've traditionally been, when compared with the value of their underlying properties."
But as positive as fundamentals look, even Block admits that he is going to have to bow to investor sentiment -- which can be fickle. If the new investors that have propped up the sector in recent years leave, it will hurt the whole sector. After all, concludes Block: "Investor psychology is the key."
E-mail comments to editors@barrons.com2
URL for this Article:
interactive.wsj.com |
