For a seventh straight year, real estate funds outperformed in 2006. Here’s how they ranked.

By Dees Stribling

In 2006, real estate investments recorded a stellar performance, generally providing remarkably high returns for REIT investors. For the seventh year in a row, the FTSE NAREIT U.S. Real Estate Index outperformed the major U.S. market indexes, with gains of 34.4 percent in the FTSE NAREIT All REIT Index and 35.1 percent in the FTSE NAREIT Equity Index. Both figures were dramatically up from 2005, when gains totaled 8.3 percent and 12.2 percent, respectively. Around the world, real estate investment also performed exceedingly well with the FTSE EPRA/NAREIT Global Real Estate Index Series gaining 42.35 percent.

Of the 96 distinct real estate funds tracked by Lipper, 86 funds produced double-digit total returns in 2006. Those same 86 funds also outperformed the U.S. mutual fund average (for fixed income and equity funds) total return for the year.

What made 2006 such an extraordinary year? Fund managers say that a complex set of drivers in all property types fostered high returns. Additionally, capital flowed into the REIT industry as pension funds increased target allocations to real estate, and a growing number of 401(k) plans added real estate investment options.

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Simply put, U.S. and many overseas commercial real estate markets exhibited strong underlying fundamentals, a fact that didn’t go unnoticed by investors, notes Steven Brown, managing director of Neuberger Berman, Inc. “Demand for most kinds of real estate has been strong, but supply is constrained, especially as construction costs have escalated in the last 12 months from approximately 10 percent to 20 percent,” he says. “That’s a serious check on the level of construction activity worldwide.”

John G. Wenker, co-manager of First American Real Estate Securities Fund, agrees. “We were helped by a benign economic environment, especially a moderate interest rate environment—and strong underlying property fundamentals throughout the year,” he says. “Also, M&A activity was brisk in commercial real estate. Given all that, REIT funds have been able to provide better returns than other asset classes.”

Top Funds

The top five real estate mutual funds in 2006 were EII International Property Institutional (EIIPX), with a total return of 59.78 percent; Morgan Stanley Institutional International Real Estate A (MSUAX), with a total return of 56.06 percent; ProFunds Real Estate UltraSector Investors (IERBX), with a total return of 47.15 percent; Cohen & Steers International Realty A (IRFAX), with a total return of 43.88 percent; and Fidelity International Real Estate (FIREX) with a total return of 42.87 percent.

In 2006, EIIPX rode the overseas wave of rising returns in real estate. The fund’s international focus, with most of its investments in non-U.S. companies, primarily REITs or other publicly listed real estate companies in Europe and Asia, was a main factor for its top rank.

“Real estate markets around the world are quite strong, and that’s been driving returns,” says James E. Rehlaender, managing director of European Investors Inc. and portfolio manager for EIIPX. He adds that returns were actually comparable to 2005, which was also a very good year. In fact, part of the 2006 total return—approximately 13 percentage points—was attributable to the weakness of the U.S. dollar versus other currencies.

“Also, we were surprised by some European markets,” he says. “For instance, we didn’t expect the U.K. to do so well. That real estate market, especially London, has been extremely strong because there wasn’t much overbuilding. Supply is tight, and there might not be much new construction until 2009 or later.”

International Investment

As a whole, real estate mutual funds did very well in 2006, with most of those at the top of the heap reaping the rewards of overseas investment. Four of the top five real estate funds of 2006 specialized in non-U.S. investments.

Fund managers attributed overseas-generated returns to healthy real estate fundamentals in many countries, but also to the proliferation of REITs in other regions, especially in Europe.

In addition to European Investors’ EIIPX, Morgan Stanley’s MSUAX, Cohen & Steers’ IRFAX and Fidelity’s FIREX all had international investments in their current holdings. MSUAX has significant stakes in British Land Company PLC, Unibail Holding and Hammerson PLC as well as Mitsubishi Estate Co. Ltd and Sun Hung Kai & Co. Ltd. It also has a stake in the Westfield Group (ASX: WDC), which owns retail in Australia, New Zealand, the United Kingdom and the United States.

Theodore R. Bigman, the fund’s managing director, says that, as the REIT structure gains momentum around the world, investors are eager to get in on the action. “REIT-type vehicles are being created around the world, especially in Europe, and global investors are spreading the wealth there,” he says.

Cohen & Steers’ IRFAX’s top holdings include East Asian powerhouses such as Cheung Kong Ltd., Mitsubishi Estate and Mitsui Fudosan Co., Ltd., along with British Land, Land Securities Group and Westfield.

“Global real estate securities markets were up more than those in the United States for a number of reasons,” says James Corl, chief investment officer for Cohen & Steers Capital Management Inc. “For example, the United States is generally a more mature market. Also, there was a global recovery in real estate in 2006, with rents and occupancies rising and fundamentals were very robust. Add that to tremendous recapitalization and privatization trends outside the United States—billions of dollars in real estate came into play all over the world.”

Domestic Fund Favorites

Among funds that focused on domestic real estate holdings, office REITs, widely acknowledged as a strong-performing class at the beginning of 2006, continued to do well and thus be a popular component in real estate funds’ holdings. For example, Equity Office Properties Trust didn’t disappoint in its last year as a public company. Over the course of 2006, Equity Office’s total return was 58.82 percent.

Other office REITs popular among high-earning real estate funds included Boston Properties, Inc. (NYSE: BXP), which provided a 50.92 percent total return for the year, and diversified REIT Vornado Realty Trust (NYSE: VNO), clocking a 45.56 percent total return for the year.

“As we entered 2006, a number of office REITs were trading at discounts to their net asset values, and as the year progressed, prices rose,” Neuberger Berman’s Brown says, whose real estate fund (NBRFX) rated a 37.83 percent return in 2006.

Though perhaps less glamorous than office properties, industrial properties also provided good returns for real estate funds last year. ProLogis (NYSE: PLD) was the sector’s star performer for real estate funds, with a 38.96 percent total return in 2006. “The industrial sector has had positive fundaments in last few years, especially rental gains,” says Jay Rosenburg, co-manager of First American Real Estate Securities.

Retail was a strong performing sector once again, both domestically and internationally. In the United States, Simon Property Group (NYSE: SPG) was a popular choice among top funds. The REIT tallied a 32.18 percent increase in total return in 2006. Among non-U.S. based retail owners, Westfield Group was a popular favorite.

Looking ahead, Brown believes that investment in retail landlords will remain popular. “Interest rates are peaking and gas prices moderated, so the consumer will be in good shape in the near- to mid-term,” he says. “Retail will continue to benefit from those conditions.”

Last year was also a good one for apartments as an investment class. “Apartments did well because housing prices had gone up too far, making renting more attractive for a lot of people. This drove up apartment occupancies and rents,” Brown says. “Fundamentals for the apartment business have improved because interest rates aren’t as low as a few years ago.”

Funds are especially fond of Archstone-Smith (NYSE: ASN) and AvalonBay Communities, Inc. (NYSE: AVB), and with good reason. AvalonBay, which owns about 47,000 apartment units, turned in a 45.71 percent total return in 2006, while Archstone, which owns 82,000 units, recorded a total return of 38.96 percent.

“We’re constantly fine-tuning our portfolio based on what we see in supply and demand patterns among apartment markets,” Rosenburg says. “Lately, we’re starting to see same-store performance for Sunbelt markets approaching the coastal markets.”

Real estate funds didn’t neglect the hot hospitality market, either. The hospitality business accelerated like gangbusters all year with record occupancies and revenues per available room (RevPAR) nationwide. Host Hotels & Resorts (NYSE: HST) was the star performer in that segment, with a 29.55 percent total return through 2006.

2007 Outlook

For 2007, fund managers expect strong returns once again. Some, like William Seale, chief investment officer of ProFund Advisors, LLC, says returns probably won’t be as good as 2006, but it will still be a strong year. “We might see 12 percent returns overall,” he says. “However, circumstances will be different. The Federal Reserve Board will certainly increase interest rates because inflation numbers will be outside its comfort zone. Investors may not do as well in 2007 as in 2006, but they should do well. The markets will be more cautious, but real estate will still be a good investment.”

According to European Investors’ Rehlaender, there probably will be bumps in the road in 2007, but he points that 2006 had its bumps as well, including a period of major stock sell-offs in the spring. “However, those bumps ultimately didn’t interfere with a very good year,” he says.

Also, Rehlaender says the continued growth of the REIT structure worldwide, especially in places such as the U.K. and Italy, will continue to be a factor in introducing investors to real estate. “The growth of the REIT structure will also help drive global capital into real estate, because investors can now own real estate more effectively through the stock market,” he says.

Brown points to continued merger and acquisition activity as a driver of stock value, as it was in 2006. He declines to predict that there will be as many mammoth deals in 2007 as last year (such as the purchase of Trizec Properties or the acquisition of Equity Office). Nevertheless, he says there’s M&A momentum.

“In 2007, there will be continuing M&A in the REIT sector because of the large amounts of money raised by private equity funds and opportunity funds in 2006,” Brown says. “A lot of that money hasn’t been put to work yet. That’s only one factor in driving returns, of course, but it should be an important one.” All together, he expects to see 10 percent-plus total return from a diversified REIT portfolio.

First American Real Estate Securities’ Rosenburg sees strong investor interest and solid returns ahead in health care. “We’ve increased our exposure to this sector because we see great fundamentals,” he says. “It’s also one of the few sectors left in real estate that hasn’t seen a vast amount of consolidation yet, so there’s a lot of potential for growth through M&A."

“There will be continued strong fundamentals in every property type,” IRFAX’s Corl says. “So there will be above-average cash-flow growth for real estate stocks. This year may not be a repeat of 2006; however, it will be a solid year. ”

Yet, First American Real Estate Securities’ Wenker thinks some caution is appropriate. “Valuations appear to be at an all-time high, and cap rates appear to have bottomed,” he says. “It’s hard to anticipate more cap rate compression, and domestic capital flows might moderate.”

Yet, he points out that companies can shine in other ways and do very well. “Companies that have external growth programs, asset management programs or other clear ways to raise NOI will continue to grow,” he says. “Overall, there won’t be quite the growth of the last two years, but there still will be a lot of winning stocks.”

Bigman is also a little more cautious in his predictions for 2007, but hardly pessimistic. “Over the medium and long-term, investors should look for high single-digit returns again,” he says, adding that he is also keen on the continued prospects of growth overseas. “Listed property companies outside the U.S. probably will outperform U.S. REITs,” he says.

Overall, Wenker predicts positive news in the REIT world. “2007 will be a good year, since REITs will continue to be competitive with the broader equities markets.”