A Real Estate Fund for Now and Later

I'm cautious about funds that specialize in real estate investment trusts (REITs) -- high-yielding tax-advantaged companies that by law must distribute almost all their income every year. The average REIT fund is up about 13% this year and rose 17% last year. That followed 30%-plus gains in both 2003 and 2004.

Trees don't grow to the sky. REIT valuations are stretched, so I think investors who don't need the income should tread carefully. "REITs aren't grossly overpriced, but they're trading at levels that don't appeal to us," says Mike Winer, manager of Third Avenue Real Estate Value (symbol TAREX). "Most REITs are trading at premiums to their net asset values." Net asset values are computed by estimating the worth of the underlying real estate properties a REIT owns.

If you haven't guessed already, Third Avenue Real Estate Value is no average real estate fund. Winer has only 30% of the fund's assets in REITs. The rest is in real estate operating and management companies -- ordinary corporations that specialize in real estate. He also makes special investments, such as retailer Kmart, which he bought because of the underlying value of its real estate. It was later acquired by Sears.

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Third Avenue Value, for that matter, is no ordinary fund company. It's a deep-value shop that lives by founder Marty Whitman's "safe and cheap" mantra. Whitman's funds, including this one, buy securities when they are truly beaten down, then hold on patiently, until they reach fair value. For instance, Winer bought homebuilders in 2000 when they were trading at 60% to 70% of book value and sold them "about three years early. You can never buy and sell at exactly the right time."

Indeed, for the most part, Winer buys things he can sit with a long time. On average, he holds stocks nearly eight years.

What's so compelling about his fund, in addition to its diversification, is its low risk. It's far less volatile than most real estate funds. For instance, while the average real estate fund lost 8% from mid March through mid May, Third Avenue dropped only 5%. Count on the fund to hold its own in bull markets, but do exceptionally well in bear markets.

This year, Winer's fund is up just 8% -- five percentage points behind the typical real estate fund. But since inception in late 1998, the Third Avenue realty fund has returned an annualized 19% -- more than two percentage points better per year than the average real estate fund.

When Winer, 50, closed the fund about a year ago, he had 30% of assets in cash and a flood of new money. Today he's down to 6% cash -- and says he's still finding plenty of bargains.

But they aren't in REITs. Instead, Winer is finding buys overseas, largely in Asia, where he had 8% of the fund at the end of June. He's bought a fistful of Hong Kong companies that own properties in mainland China. Yes, he concedes, there's political risk in China. But the companies he owns are trading at a 30% to 40% discount to their underlying value "based on our conservative estimates." Another 12% of the fund is in Europe. "Most of the opportunities today are outside the U.S."

Given its wide-ranging charter, the fund isn't too large, with assets of $3 billion. Expenses are reasonable at 1.14% annually. Don't look for income here, though; the fund pays out about 2% annually. That's because the stocks you'll find in the fund are more like growth companies than income investments. Rather, this fund is a great diversifier. Putting 5% or even 10% of your stock money here is a good idea. Commercial real estate, incidentally, has little correlation with the residential real estate market. So don't stay away just because you think housing prices are due for a fall.

Prefer to buy a stock or two? St. Joe Company (JOE) is a longtime Winer favorite. Trading near $85 a year ago, it fetches just $45 today. St. Joe sold off in sympathy with the falling shares of homebuilders, which Winer says makes little sense. "Homebuilders are its customers," he says. St. Joe owns 830,000 acres in northern Florida and is developing the land. It trades significantly below Winer's estimate of its net asset value.

Canadian Brookfield Asset Management (BAM) is a strange mini-conglomerate. It owns 50% of Brookfield Properties, which, in turn, owns "some of the highest quality office properties in North America," including premier office buildings in New York and Washington, D.C. The parent company also puts together institutional investment partnerships and is involved in hydro power generation.