The Delaware REIT Fund has not lost its appetite for retail real estate. Despite the deluge of dismal headlines slamming the retail sector, the $107 million mutual fund has been an active buyer and seller of retail REIT stocks over the past year. Currently, 26 percent of the fund is weighted in retail holdings — 11 percent in shopping centers and 15 percent in regional malls.
“The retail sector is rife with uncertainty right now,” says Damon J. Andres, vice president and portfolio manager for Philadelphia-based Delaware Investments. “Because of that there have been some violent swings in terms of relative performance that give us opportunity to get in and out of these stocks.”
Talk of a recession and slowing consumer spending has not prompted mutual fund managers to pull back from retail. But funds are altering investment strategies to hedge against mounting risks in the retail sector. For example, the Delaware REIT Fund is targeting retail REITs that have less development exposure and high concentrations of properties in “defensive” locations such as in-fill sites surrounded by dense populations and good demographics.
One example of that strategy is the fund's stake in Baltimore-based Federal Investment Realty Trust. The REIT focuses predominantly on urban markets. For instance, about 30 percent of Federal's 18.2-million-square-foot portfolio is located in the Washington, D.C., metro area. Federal does have some development lease-up occurring, but Andres likes the firm's locations and surrounding demographics. “The downside is that you have to buy a relatively expensive stock, but at times you get what you pay for — especially in times of crisis,” he adds. As of mid-April, Federal was trading at $77.90.
Making “safe” bets
Mutual fund managers are approaching retail buys more cautiously in light of the current market turmoil. Regional malls remain a favorite with many fund managers because of their healthy fundamentals — stable occupancies and rent growth.
When leases expire in regional malls, particularly in class-A regional malls, they are renewed at levels that are 15 percent to 20 percent above the last lease signed, notes Rick Romano, a principal at Newark, N.J.-based Prudential Real Estate Investors and a portfolio manager for the Dryden Global Real Estate Fund. “So you've got pretty good internal growth, and you don't have a lot of supply of regional malls being added in the U.S.,” Romano says.
A flight to quality retail properties is another common strategy. Fund managers favor class-A shopping centers that have a better chance of preserving occupancies and rents during the economic downturn. That strategy has made Indianapolis-based Simon Property Group a top pick for many funds.
The expectation is that even if there is a dip in the economy, Simon's properties will still be very attractive to the average retail tenant. “Therefore, they will be able to sustain occupancy levels and continue to roll leases up to market rent levels in their properties,” says Joe Betlej, a vice president and portfolio manager at St. Paul, Minn.-based Advantus Capital Management. One of the funds that Advantus advises on is the Ivy Real Estate Securities Fund.
Fund managers expect vacancies to be more pronounced in class-B and class-C retail centers as retailers scale back on new store expansions. That said, some of those lower-quality properties can represent an attractive investment opportunity if the price is right. “Some of the [class-B] malls are trading very cheaply. So we do like [them] for that valuation perspective,” Romano says. CBL & Associates Properties Inc., for example, in mid-April was trading at $23.35, a 30 percent discount to net asset value with a reported dividend yield of 9 percent.
Steering clear of risk
Power centers are viewed as risky buys right now in part because of the abundant construction in that sector over the past five years. Power centers are also taking a hit as major big-box retailers ranging from Target to Bed Bath & Beyond and Circuit City announce plans to scale back on new store openings. “We feel that sector is most at risk, and we are underweight when you look at companies in our portfolio that own power centers,” Romano says. In fact, Dryden Global does not own any company where power centers are the core business.
Grocery-anchored centers have a reputation for being recession-proof. (However, how people buy food does change with budget grocers tending to perform better.) But that doesn't mean that grocery-anchored centers are a sure thing for fund managers. “Although we don't worry about the grocery anchor, we worry about the in-line space, which is typically local businesses,” Romano says.
Those concerns are prompting fund managers to be more selective in their grocery-anchored center acquisitions. Romano likes strong markets such as Seattle and Houston that are exhibiting positive job and economic growth. Florida, on the other hand, is a tough sell for many buyers due to the state's housing crisis. “We want to be more focused on those areas where we feel the in-line spaces of local businesses are sustainable and can actually be driving income growth right now,” Romano says.
Lifestyle centers are another tough sell. “We are concerned about lifestyle centers, largely because of the tenants that spur growth — namely the ladies' ready-to-wear tenants — are not hitting their sales targets,” Betlej says. The problem is that many upscale tenants entered lifestyle centers on favorable lease terms. The question is how likely are those tenants to renew when their leases come due, and how likely are they to roll up to true market rents, he adds.
Development and capital constraints
In addition to analyzing the underlying assets, fund managers are wary of buying into REITs that are heavily focused on development or don't have good access to low-cost capital. Development margins are starting to compress. So companies that were relying on development as a main engine for growth are now scaling back on construction, which translates to lower returns.
Developers Diversified Realty, for example, has a relatively aggressive development pipeline and high expectations. “The ability for them to execute on that pipeline will be very challenging in the current climate,” Andres says.
Dryden Global is one fund that is shifting away from companies with a large development arm. Instead, the fund is focusing more on companies such as Simon that derive value from the operation of existing properties. “While Simon does have a development pipeline, a lot of it is international, where we are seeing better growth,” Romano says. Simon is also continuing to add value through options such as retenanting and expansion of existing centers, he adds.
The U.S. is home to more than 80 real-estate-oriented mutual funds. Although not all of those funds maintain retail holdings, those that do are clearly keeping a close watch on mounting challenges facing the retail sector.
“What's most worrisome to us is what's going on in the jobs market,” Romano says. The U.S. economy reported a net loss of 232,000 jobs during the first quarter. “Historically, what we have found is that consumers are pretty good spenders as long as they have a job or feel good about their job. That has started to change,” he adds.
Yet despite the economic turmoil, fund managers still like the underlying fundamentals of retail real estate. Asking rents are forecast to rise 2.6 percent this year to about $20 per square foot, while the overall vacancy rate is expected to rise 50 basis points to 10.2 percent, according to Encino, Calif.-based Marcus & Millichap Real Estate Investments. (For more on leasing trends, see story on page 170.)
Developers have begun to slow the pace of retail construction with starts tapering off. However, an estimated 125 million square feet of new retail will be completed in 2008. That's down from 145 million square feet of space that was delivered last year, but still quite a bit above other recent years, according to Marcus & Millichap.
In fact, retail actually compares favorably to some other real estate investments such as the troubled residential market. “Apartments are in a more precarious position right now because they have a significant correlation to job growth and they have very short-term leases,” Andres says. The long-term leases prevalent in shopping centers are expected to help owners preserve cash flow — and yields — even during a slower economy.
Flow of funds
Fund managers are treading carefully in the wake of a tough year. Real estate mutual funds took a hit from plummeting REIT prices in 2007. Capital that fled the sector resulted in a negative capital flow into real estate mutual funds over the past year. The total net flow of funds for REIT mutual funds in 2007 was negative $7.6 million compared to $5 million in the black during 2006, according to AMG Data Services in Arcata, Calif.
That negative flow of funds is not a big surprise considering the performance of real estate mutual funds last year. The 80 open real estate mutual funds that Lipper tracks reported an average loss of 15.55 percent in 2007. At year end, those funds accounted for about $790 billion in net asset value.
However, fund managers are hoping the tide has turned. A positive net flow of funds returned to REIT mutual funds in January 2008 with $431,000 moving into the sector during the first quarter, according to AMG.
One reason for the positive shift is REIT dividend yields are comparing favorably to other investments right now. REIT dividend yields averaged 5.5 percent in the first quarter. By comparison, cash deposits are generating returns of 2 percent.
“That is starting to give investors some comfort that they don't have to worry as much about volatility in REITs,” Romano says.