Name: Patrick Donnelly, CFA Title: Associate Portfolio Manager Born: 1968 Experience: Donnelly worked for AEW Capital Management as a real estate analyst and for investment bank and brokerage services firm Tucker Anthony, where he focused on REITs. He then became a principal at State Street Global Advisors (SSgA) and served as assistant portfolio manager and analyst for SSgA’s real estate investment division, the Tuckerman Group. Donnelly joined the Lee Munder Capital Group in 2002 and has helped devise and implement the firm’s REIT strategy. He earned his B.A. from the University of Massachusetts-Amherst and an M.B.A from Bentley College. A chartered financial analyst, Donnelly belongs to the CFA Institute and the Boston Security Analysts Society.

Successful REIT portfolio managers Patrick Donnelly and Arthur Hurley make a good team. They refined their REIT strategy while working together at State Street Global Advisors, and then in December 2002 they took their combined expertise to the Lee Munder Capital Group, an investment boutique in Boston serving high net worth and institutional clients with $2.6 billion under management. Portfolio recently sat down with this dynamic duo and learned why they feel REIT investors who focus too much on NAV and FFO multiples are looking through the wrong end of the telescope.

Portfolio: How well has your fund performed against its benchmark, the Dow Jones Wilshire REIT Index?
Hurley: Our strategy has consistently outperformed the benchmark going back to 1998. Since inception at Lee Munder Capital (Jan. 2, 2003 through Sept. 30, 2005), we’ve produced a cumulative total return of 110.5 percent for our investors versus the Wilshire REIT Index’s 101.7 percent total return over that same time period.

Portfolio: If you’re outperforming the index, you must be concentrating your portfolio in some way.
Donnelly: We typically own 20 to 30 names out of an investable universe of about 200 publicly traded REITs. We’re relatively concentrated versus most of our peers, and we tend to focus our exposure to what we believe are the most advantaged names. We think that’s the most prudent way to invest if you’re attempting to generate superior returns. Otherwise, if your exposure is spread out over too many names within this small universe, you’re really running a closet index fund. Our clients are not paying us to generate index-type returns. We’re paid to add value.

At the same time, we believe that we have enough names to give us more than adequate diversification. This is shown by our risk management tool that measures our portfolio risk using ex-ante tracking error, geographic exposure, property-type exposure, market cap and dividend yield.

Portfolio: What is your outlook for REITs for the rest of 2006?
Donnelly: We do not expect the same exceptional returns we’ve seen in the past few years, but fundamentals should continue to improve and you should see earnings growth in the high single digits from the group. We’ve had very strong multiple expansions over the past few years which we don’t expect to continue. Multiples will remain flat or even contract a little bit. If you add on the dividend yield of, right now, 4.5 percent, you should see total returns in the high single digits going forward.

Portfolio: What are the most frequently asked questions your clients pose regarding REITs?
Hurley: The most common question is whether there is a real estate bubble. Many investors are looking at the signs of a slowdown in the residential market and wondering whether that translates into the commercial market. There’s obviously a big difference, and we see reasons why commercial should continue to hold up—stable cash flows, underlying asset values and attractive yields.

Portfolio: Your approach to REIT investing emphasizes unique business models, barriers to entry, and turnaround situations. Talk a little about each and why it’s important to your strategy.
Donnelly: With regard to business models, we look for REITs that have a specialized skill set in their product or their market that provides them with pricing power or other ability to produce superior returns on invested capital over time. We believe historical return on invested capital (ROIC) is one of the best indicators of management’s ability to add value. We don’t select commodity traders, i.e., REITs that are just buying and selling assets. We look for the value-add and find it a lot of the time in the development or redevelopment process.

An example would be Corporate Office Properties Trust (NYSE: OFC), a D.C.-centric REIT that builds out office facilities for governmental agencies, defense-related agencies and defense industry users. Corporate Office leverages its extensive relationships in this area to fulfill the space needs and the specialized requirements of these users which may include security aspects such as blast-proof sheathing and special load-bearing construction.

In terms of the high barrier to entry types, we look for REITs that produce fantastic internal metrics because they’re in markets where there’s less land inventory to build upon. We typically see that mostly in the downtown markets—Boston, New York, San Francisco, D.C. and southern California. In these markets, you tend to have superior rental rate growth because the supply of space is constrained.

Boston Properties, Inc. (NYSE: BXP) is one of the best examples. They have Class A properties in central business districts in New York, Washington, D.C., Boston and San Francisco. These markets have enjoyed superior rental rate growth for a number of years relative to non-constrained and weaker markets like Dallas, Atlanta and Chicago. Notably, in Chicago, the suburbs especially, rents are now about where they were 20 years ago.

In regards to turnarounds, we look for companies that have made missteps by expanding outside their core competency—geographically, by product type or business line. We invest where we can identify a catalyst that will return the company to what we perceive to be fair value in a reasonable amount of time.

Name: Arthur Hurley, CFA Title: Portfolio Manager Born: 1970 Experience: Hurley holds a B.A. from the University of Massachusetts- Dartmouth. Hurley managed portfolios, performed credit analysis and traded corporate bonds for the active fixed income group at State Street Global Advisors (SSgA) before becoming lead portfolio manager for SSgA’s real estate investment arm, the Tuckerman Group. He moved to Lee Munder Capital Group in 2002 as portfolio manager for the firm’s REIT strategy. Hurley chairs the firm’s Outside Research committee and serves on its Trade Oversight committee. He is a member of the CFA Institute and the Boston Security Analysts Society.

Hurley: A recent example would be Nationwide Health Properties (NYSE: NHP), a health care REIT that had overleveraged its balance sheet under a prior management team at a time when its operators were running into some problems. A new management team came in and really fixed up the balance sheet, while at the same time its operators were improving their coverage ratios or working through bankruptcy. These improvements moved NHP’s multiple back in line with its peers.

Portfolio: Some money managers choose not to buy REITs when they’re at a premium to net asset value (NAV). What role does NAV play in your analysis?
Hurley: We look at NAV, but it is not always core to our analysis. You need to look at REITs as more than a passive collection of assets, and analyze management’s ability to add value. This value-add can create a franchise value that can be difficult to measure in an NAV calculation.

I think a good example of the recognition of franchise value is what recently transpired with one of our largest holdings, CenterPoint Properties Trust (NYSE: CNT). A joint venture formed by CalPERS and LaSalle, two very savvy institutional real estate investors, agreed to buy the company at a substantial premium to Street-estimated NAV.

Portfolio: There are others who won’t invest in REITs because they feel funds from operations (FFO) multiples have gotten too high.
Hurley: We look at earnings multiples, but it’s much more important not to lose sight of the future fundamentals of an individual name and management’s ability to consistently create real shareholder value. We’re willing to pay a higher multiple if we feel the company has the skill sets that enable it to produce superior returns on its cost of capital versus its peers. We don’t shy away from that.

Portfolio: You advise investors to hold REITs long term and to avoid trying to market-time the sector. Why are REITs such a good long-term investment, and why is market-timing the wrong strategy?
Hurley: We feel it is a risky proposition to attempt to market-time any sector, generally speaking. While most investors claim to have a long-term investment horizon, studies have shown investors often attempt to profit from shorter-term moves and, more often than not, these investors underperform the market. Attempting to market-time the REIT sector could result in similar underperformance. Indeed, over the past five years we have heard many market prognosticators expound as to why the REIT market would falter over the coming year and why it would behoove investors to pick a different entry point. Those investors that followed the so-called expert advice missed exposure to one of the best performing sectors over this time period.

Instead of market timing, we suggest utilizing REITs for portfolio diversification and portfolio optimization. By maintaining a long-term investment time horizon, investors can take comfort in the diversification benefits, unique return profile of the group, and the improving fundamentals of the real estate market.

Editor’s Note: DISCLOSURE—Lee Munder Capital Group owns shares in the specific REITs mentioned in this interview in its REIT strategy portfolio.

Christopher M. Wright (www.sinewaveinvestor.com) is a regular contributor to Portfolio.