Real-estate funds only for those willing to await market recovery

The deteriorating condition of property markets worldwide has caused many investors to cut a wide swath around real estate mutual funds in the past year.

News of the Reichmanns’ financial troubles coupled with the suspension of redemptions at troubled Central Guaranty Trust Co.’s real-estate estate fund confirmed people’s fears about the decline in property values and corresponding slide in fund performance.

The simple rate of return for 10 real-estate funds in Canada for the year ended April 30 was 1.7%. On a compounded basis, the funds posted a 6.5% return for three years and 8.4% for five.

Experts now predict it could take two years for Canada’s real-estate sector to muster a strong recovery. While many financial planners agree that investor’s fears about real estate are well founded, others endorse buying these funds now because prices are near bottom.

Gordon Richards, executive vice-president of T.E. Financial Consultants Ltd. in Toronto, says ”knowledgeable people have been getting into real-estate funds for the last little while. The thinking is that the value of real estate has been down, and maybe now’s the time to get in.”

Richards downplays the market’s reaction to the suspension of redemptions at Central Guaranty.
”Many people were waiting for it to happen,” he says. ”People who understand how real-estate mutual funds work realize there’s been a significant decrease in the value of the funds, and liquidity is very difficult.

”In short, Central Guaranty hasn’t been able to dispose of properties to get the funds necessary to satisfy redemptions. That prompted the freeze.” But George Swan, senior vice-president of private client services at Bank of Montreal, believes the problems beseiging real-estate investments run deeper. ”There are deep concerns about the state of the real-estate market overall – the large oversupply of properties and the amount of time it will take for demand to catch up,” he says.

The steady drop in the rate of return for most real-estate funds is linked directly to plunging property values and rising vacancy rates, Swan adds. Peter Watson, president of Peter Watson Group, financial planners specializing in retirement strategies in Oakville, Ont., says he was once a big supporter of real-estate investing, but has since changed his tune because of the negative outlook for industrial, office and retail real estate.

”The value of industrial and commercial real estate is directly linked to the strength of the tenant,” he says. ”If there are a large number of financially prosperous tenants, the real-estate market is strong.

”But potential tenants are caught in the middle of our current economic restructuring, and that, in many cases, isn’t good for them or for the owners of the real estate they lease.”

Swan says he usually recommends clients buy individual properties or join limited partnerships that invest in rental properties.
”I don’t like (real-estate funds) because you’re buying into a pool. I’d rather know what my underlying investment is in real estate.
”With interest rates now so low, income from properties now often covers the cost of carrying the buildings whereas it wouldn’t a year ago.”

Theoretically, Richards agrees that buying individual properties might provide investors a better rate of return. But he questions how many people can afford that. Most people ”don’t have the downpayment, expertise, or time to manage it.”

Although he notes that the past two years have not been ”stellar” for real-estate fund managers, he points out that Counsel Real Estate, which posted an average annual compound rate of return at April 30 of 11.1% for five years, has outperformed treasury bills and the Toronto Stock Exchange.

He adds that no further suspensions of redemptions are expected in the real-estate funds market, but still cautions investors to study the parent company’s balance sheet and its property portfolio carefully.

”Look at the property location and the asset type to determine whether the buildings have the potential to come back in value,” he says. ”If a fund is heavily invested in Quebec, I might be more leery of that then a fund that’s heavy into Toronto.”

Watson agrees that too many investors ”look at the funds as the end result. They don’t look beneath the surface.”
Richards adds that only people with ”patient money” should invest in real-estate funds. ”Don’t expect a profit overnight,” he warns.

Nolan Wilcox, national director of marketing and sales for Roycom Securities Ltd. in Halifax, which manages two real-estate mutual funds and operates about half-a-dozen investment pools for national pension funds, believes it is an excellent time to invest in funds because properties are close to real replacement value.

He calls real estate a lagging indicator.
”Real estate always looks behind to see what’s happened,” Wilcox says. ”When it looks behind today, it sees we’ve been in a recession. Property values go down and expectations for return drop.

”But now there’s been a rationalization of values. If everyone says it’s the wrong time to buy we’ll be buying. We’re modified contrarians.”