For Land’s Sake

Successful real estate investing is about being in the right place--literally--at the right time. Martin Cohen and Robert Steers got in on the ground floor of the real estate investment trust boom of the 1990s, and they have the numbers to prove it.

Their Cohen & Steers Realty Shares mutual fund gained 139% in the five years ended March 31, by far the best performance of the six real estate funds in existence for that period. What’s more, the fund’s gain was well above the 89% rise in the average general U.S. stock fund in that period.

The Cohen & Steers fund invests primarily in shares of REITs, companies that own and manage portfolios of property. REITs offer not only high dividend yields (they pass through to shareholders most of their rental income) but also the chance for capital gains if their properties rise in value over time.

Cohen, 48, and Steers, 44, met while working as stock analysts at Citibank during the 1970s, then got reacquainted at National Securities Research in the early 1980s. Their 11-year-old New York-based management company now directs $4.5 billion in total assets.

They were interviewed by Russ Wiles, a mutual funds columnist for The Times.

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Times: You created one of the first investment firms to specialize in real estate stocks. What prompted you to focus on this area?

Cohen: In 1986, we perceived this would be an area of growing interest, as a result of changing tax laws, an exceptional record for public real estate companies and dissatisfaction among many institutions in the way they had been owning real estate. So we took the plunge and started our own firm.

We didn’t know at the time that we would encounter a stock market crash, a real estate depression and a war over the next 10 years. We had assets under management and we were profitable from day one, but it took several years for this area to really blossom.

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Times: What do you look for in a REIT?

Cohen: Strong management--the key to making money in any investment. We also look for a strong balance sheet and a business plan that’s sound and achievable.

Steers: What differentiates us from our mutual fund competitors is that we have six seasoned analysts in addition to Marty and myself following real estate companies. These stocks are somewhat different because you have to visit many properties to identify the right companies. Hundreds of thousands of properties are publicly owned. It’s a labor-intensive endeavor. Experience in analyzing real estate companies gives us a leg up on our competitors.

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Times: You have often stressed the importance of being in the right REIT sectors at a given moment. Can you explain your sector strategy?

Cohen: We think sector selection is important. Just like the portfolio manager of a more generalized stock fund would emphasize certain industries, we’re keen on certain property types.

The real estate markets in this country are not homogenous. Half the task involves understanding economic trends and how they affect different property types. The other half is picking the right companies in the best-positioned groups.

Steers: Our largest weightings today are in office properties and regional malls. Though they have performed well over the past 18 months, we think they continue to have strong fundamentals and attractive valuations.

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Times: Why are office property REITs so attractive?

Steers: In most regions of the country, office properties were the most overbuilt and the last to recover [in the late 1980s and early 1990s]. Now most markets either are in equilibrium or are approaching a shortage scenario for office space that’s being reflected in strongly rising rents. Across the range of property types, the office sector has the most exciting three-year growth outlook as occupancies continue to increase.

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Times: What are some of the individual REITs you like best right now?

Cohen: Cali Realty [$30.75 on Monday, New York Stock Exchange], one of our larger holdings, exemplifies what we look for. The company has strong management, with a property focus on the office sector in the Northeast, especially in New Jersey. They’re buying properties at below-replacement costs, generating returns that are greater than their cost of capital, so their earnings are growing as a result of these acquisitions.

Cali has grown from roughly $500 million in properties to almost $2 billion over the past three years. But they’re expanding on a rational basis, in a low-risk manner.

Another company is the Rouse Co. [$28, NYSE], one of the largest owners and operators of regional malls. Last year they acquired the Howard Hughes real estate portfolio--a combination of office, industrial, retail and residential properties, all of which were purchased at a reasonable price and on reasonable terms. These properties are generating a tremendous amount of cash for the company.

A third company worth mentioning, in the apartment area, is Avalon Properties [$28.375, NYSE]--regionally focused in the Northeast, with an experienced and conservative management. In the Northeast, it’s often hard to build apartments because of the high population density. Yet there’s also a large renting population. Whether in New York, Connecticut, New Jersey or Virginia, Avalon is fulfilling the demand for housing very profitably.

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Times: Do you own much in California?

Cohen: In California, our favorite holding is Spieker Properties [$36.625, NYSE]. It’s headquartered in the Bay Area but buys properties up and down the West Coast, particularly in the office and industrial areas.

Another company for which we have high hopes is Kilroy Realty [$24, NYSE], which went public earlier this year. The Kilroy family is well respected in Southern California, and we think they have a current portfolio and pipeline of potential acquisitions that could enable the company to grow at a very high rate.

Steers: We also have a significant holding in Newhall Land & Farming [$20, NYSE] in Valencia.

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Times: How do you feel about the outlook for real estate in California in general?

Cohen: We have liked California for the last two years, as California has recovered and the property markets there have responded extremely quickly. If anything, it gives us a little pause that they have rebounded so quickly. There’s a lot of capital flowing into California.

Steers: Most pure California real estate plays are the highest valued companies for their respective property types. Investors have been bullish on California, northern and southern, for more than a year. That’s reflected in prices.

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Times: Many investors still are wary of the boom-bust nature of real estate. Do you think lenders and developers could fuel another commercial property boom that would result in massive oversupply, depressing property prices for years afterward?

Steers: We think past mistakes tend to be repeated, but one difference this time is that there’s so much more institutional real estate ownership [through REITs]. During the last real estate downturn in the late ‘80s and early ‘90s, REITs had a combined capitalization of around $5 billion. Today it’s in excess of $100 billion.

We believe this will instill more discipline on the market. When real estate companies want to [issue REIT stock] through secondary and initial public offerings, they have to explain how they will use the proceeds. In places where this doesn’t excite analysts, those companies will get priced out of the market, and capital will stop flowing to whatever regions the companies focus on.

Now more than ever, real estate valuations are closely tied to the capital markets and the cost of capital. You’ll see money flowing for acquisitions and development only as long as the proceeds provide a return that’s substantially in excess of the cost of capital. If interest rates increase so that it costs companies 8% or 9% to raise money, yet they can put it to work for only 7% or 8% returns, they won’t be able to raise capital anymore.

It’s not that we trust that the banks, insurance companies and pension funds have learned their lessons. Rather, the capital markets are likely to act in a more rational manner and force the REITs to do likewise. Real estate cycles won’t go away, but they won’t be as volatile.

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Times: Many investment advisors are pitching real estate, and REIT mutual funds specifically, as a good diversification move for investors who own mainstream stock and bond funds. And in last summer’s stock market pullback, REITs in fact held up extremely well. But in this spring’s market decline, REITs declined with the broad market, though not as steeply.

Do REIT funds really offer that much protection against a stock market decline?

Steers: If you look at REITs in comparison with the Standard & Poor’s 500 index or the Lehman Bros. corporate and government bond index, the beta [a measure of volatility] and correlation numbers strongly suggest that REITs do act as a good diversifier.

REITs also have provided returns that are competitive with stocks. In fact, over the past 20 years, returns from REITs have exceeded those of the S&P; 500.

Cohen: Probably 80% of our shareholders own our fund through financial advisors, who use it for their real estate allocation. These advisors believe real estate exposure does provide portfolio diversification.

The beta of our fund is around 0.09, an extremely low number. [Beta measures an investment’s volatility relative to the stock market overall, with 1.0 being the market’s volatility.] The statistical evidence [supporting diversification] is overwhelming.

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Times: Your fund’s assets total about $2.6 billion, making it by far the largest REIT fund. Is size beginning to become a handicap in investing in this industry?

Steers: If performance is any indication, the answer is no. We use the NAREIT equity REIT index, the Wilshire real estate securities index and the Morgan Stanley real estate securities index as our benchmarks. In 1996 we beat these benchmarks, after fees, by several hundred basis points [several percentage points], and we beat most comparable mutual funds.

Also, as we mentioned, our investment style involves sector rotation. If you look at our portfolio weightings over the years, you’ll see there have been substantial changes. Our apartment weighting in 1996 was cut almost in half while our office weighting doubled.

As long as you see that we’re able to alter our property weightings, it means we’re facing no constraints in managing the portfolio.

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Times: Any additional comments?

Cohen: I would emphasize that you have to think about where we are in the real estate cycle today. Although there’s equilibrium in some markets, we’re generally in a very positive environment. Going forward, the supply for space will not be as great as the demand, assuming the economy keeps growing.

Real estate emerged from what might have been its deepest depression ever in the early ‘90s and today is quite healthy. I think that ensures a good outlook for several years.

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Cohen & Steers Realty Shares

Strategy: Seeks income and capital appreciation through investing mainly in real estate investment trust shares.

VITAL STATISTICS

YTD total return: +0.4%

1996 total return: +38.5%

1996 total ret., avg. real estate fund: +30.9%

5-year total ret., through March 31: +139.5%

5-year total ret., through March 31, average real estate fund: +86.1%

5-year total ret., through March 31, average general stock fund: +88.9%

Five biggest holdings as of March 31: 1. Spieker Properties 2. Vornado Realty Trust 3. Public Storage 4. Rouse 5. Highwoods Properties

Max. sales charge: none

Assets: $2.6 billion

Min. investment: $10,000

Phone: (800) 437-9912

Morningstar risk-adjusted performance rating, 1-5: HHHHH

Sources: Lipper Analytical Services, Morningstar