1. ING Real Estate W IREWX

2. Fidelity Real Estate Investment FRESX

3. Managers Real Estate Sec Fund MRESX

4. Virtus Real Estate A PHRAX

5. GMO Real Estate III GMORX

The phrase “real estate” for most of us conjures up images of the residential housing market. However in the world of mutual funds investing, the overwhelming preponderance of investments funds make in the real estate sector are commercial in nature – office buildings, industrial parks, shopping complexes, hotel and entertainment facilities and the like. Many funds choose to invest primarily in Real Estate Investment Trusts (REITS), a type of security that qualifies for a particular type of tax treatment by adhering to certain conditions, such as paying out at least 90% of taxable income in the form of dividends and investing at least 75% of their assets into qualifying real estate investments. Both REITS and REOCs (Real Estate Operating Companies) are pooled vehicles that offer indirect investment interests in diversified commercial real estate properties and derive cash flows from rents, mortgage interest or other income associated with those properties.

In terms of risk and return characteristics, real estate funds tend to behave somewhat like equities (which is to say higher potential returns and higher volatility); however, traditionally they have also exhibited low levels of correlation with common stocks, such that REITS, REOCs and the funds that invest in them are quite often classified by portfolio managers as “alternative” investments rather than equities. Real estate securities also tend to possess higher annual dividend payouts than other assets (partly due to the tax treatment issues briefly described above), and this can be attractive to certain investment profiles. Finally, real estate generally speaking is one of the most “local” businesses out there – as opposed to the common stock of large cap companies whose income tends to be derived from multiple global locations (in multiple currencies), the cash flows realized from real estate investments are based almost entirely on local factors. This can be useful for investors who want to pinpoint exposure to a defined geographical territory.

Roger and Carla Littleton

Roger and Carla Littleton have been married for six years and are in their mid-30s with no children. They live in a major East Coast urban area and have successful professional careers. Like many of their peers they caught a bit of the real estate bug during the second half of the 2000′s and tried a bit of speculative investing in various properties – though luckily they managed to limit their losses when the market fell apart in 2008. They did learn a thing or two from their travails, such as how to calculate income streams from rent and other payments, how to factor closing and other costs into a multi-year cash flow model and other tricks of the trade. Recently they have been noticing that after getting pretty badly pounded during the market crash, real estate securities have been doing rather well as of late. They are cognizant of the diversification benefits real estate funds can provide, and they enjoy mulling over the business plans and value propositions of different commercial properties – is this a good climate for Atlantic City entertainment complexes? How about those suburban office parks in the technology belt around our own city? Roger and Carla set up a Jem5 profile for real estate funds to see what might make sense for their portfolio.

Comments: The real estate sector, of course, has had quite a volatile ride in the past few years and this is clearly visible from the very high standard deviation numbers – these actually look more like emerging markets equities than the S&P 500, for example. Nonetheless the top funds in this sector still can boast low double digit or high single digit average annual returns over a ten year period, and they have been particularly strong in the past year.

The overall Jemscores are in the 50s primarily due to the higher risk element. Roger and Carla have a healthy risk appetite, but still prefer to not take any more risk than is necessary to achieve certain objectives. They might ordinarily be wary of investing in assets with such a high standard deviation, but they do believe that with economic growth returning to the US there will be a new spurt of demand for commercial real estate space that could benefit these funds. In any case they are not likely to allocate more than 5% of their total portfolio dollars to this asset class.

The other thing they like (not shown above but accessible via the Jemstep ranking functionality) is that all of these funds exhibit low correlation to the S&P 500, with R-squared values below 0.50 in all cases. Just as a reminder, correlation is measured in a range of -1.0 to 1.0, with the endpoints indicating perfect negative and positive correlation respectively.

Roger and Carla decide that ING Real Estate has the characteristics they are looking for (in terms of risk/return, correlation and relatively attractive fees) and prepare to add this fund to their portfolio.

*Note: Jem 5 is a regular feature on the Jemstep blog which represents our top mutual fund ratings for unique investor profiles. For more information, read our first post in the series.

TAGS: Jem 5, reits