Alpine U.S. Real Estate Equity Fund
By Harold Goodman
December 2, 2003

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Everyone needs a little real estate investment exposure in their portfolio, and mutual funds offer diversified access to this investment sector at low minimum investments. But not all real estate mutual funds are alike, and vary drastically in terms of investment strategies and portfolio holdings. The Alpine U.S. Real Estate Equity is a breed apart from many other real estate funds, which often invest in real estate investment trusts, or REITs, according to Morningstar, the Chicago-based research firm which now bestows its highest 5-star rating on this fund.

Samuel Leiber, portfolio manager, invests in a variety of peripheral real estate industries, such as hotels and home building companies. Because the fund maintains a diverse portfolio, Leiber said, in recent years it has stayed one step ahead of changing business cycles, such as the housing boom, which has been fueled by low interest rates since 2000. Leiber also notes that his unorthodox approach to real estate investing often insulates the fund from market conditions that tend to dampen the performance of other funds in the same sector, and this year give the Alpine U.S. Real Estate Investment Trust explosive upside returns which have more than doubled the Standard & Poor’s 500 Index.

In this interview Leiber discusses fundamental real estate investing strategies and explains how Alpine’s approach differs from conventional thinking on the subject.

FUNDemail: Many investment professionals say every fully diversified portfolio should include at least a small amount of real estate, but real estate mutual funds are potentially very different. What are some of the main qualities that distinguish one real estate fund from another?

Samuel Leiber: We are different from other funds because we take a broader view of real estate investing than merely focusing on REITs and income producing properties. Virtually every other real estate fund has a principal focus on income and capital appreciation is secondary, which fits a model of investing in REITS, or bonds backed by real estate companies. That is a key issue here. We focus on a broader definition of real estate, which includes companies that are focused on capital appreciation.

The fund is also designed to benefit from the early cyclical real estate plays, such as companies with short leases or no leases at all. These types of companies include hotels with nightly leases and can respond to changes in the economy faster than other types of real estate. Other types of companies where there are no leases include home builders. We think this sector has been undervalued by the stock market for about five years and has been producing about 35% per year during that time, in terms of net earnings per share. During the third quarter of this year versus third quarter of last year these companies are up about 33% and have been in the sweet spot of the economy, so we find them to be a great value as well as a great growth play.

In general, our focus is on value and finding the areas where we can buy real estate cheaper in the public market. In the lodging sector, we have found that many companies are trading at valuations which do not reflect the replacement costs of the underlying properties. Many companies are trading below the replacement costs of their assets because they have been particularly hard hit by the recession and the war in Iraq and even the SARS scare, all of which tended to limit travel and hurt their earnings. We think that as the economy improves this will be one of the first sectors to recover, which makes this an early cycle play.

FUNDemail: Why are REITs a good idea in volatile markets and what types of economic indicators, such as inflation or interest rate movements, affect this fund?

Leiber: Real estate often has stable returns because of long-term leases, so the fundamental cashflow strength is relatively transparent to most investors. That’s particularly important in a volatile market because it gives confidence that dividends will be paid, which pacifies investors who might sell otherwise their funds. There is a correlation with the bond market because one component of REITs is that historically two-thirds of their return is derived from income and one third from capital appreciation, whereas 75% of the total return in the stock market historically comes from capital appreciation and the rest from income. Real estate also performs with the economy, so they should look at gross domestic product (GDP). Demand comes from increases in employment and personal income. That, of course, comes down the pike after new companies start up and add employees.

Where we are in the economic cycle depends on how strong the economy is growing. One also has to look at real estate fundamentals in terms of supply and demand. That’s tougher for the individual to do but commercial real estate brokers can provide that information. Investors can also look at local trends in rents.

While real estate is dependant on economic growth it can also have a different cycle from other types of companies, and that can work to benefit investors because they can offset other returns at different points in the business cycle. Specifically, income producing properties typically have leases with durations of 3-7 years on average but some retail leases can be 10 or 20 years. That means those occupants are paying income during that period and changes in the marketplace are not reflective [in real estate funds] very quickly. It’s positive in cases during the later stages of the economic cycle, where equities tend to be in decline, and real estate stocks are doing quite well because they have long-term tenants who must pay their rents which were set while the economy was booming. But if the down cycle is extended over several years, that can start to have an impact when leases with an average 3-7 year duration, which are sometimes 15-33% of the leases, come up for renewal at a lower level.

Real estate tends to lag the business cycle, but that’s only the case with income-producing commercial properties, which are the stock and trade of REITs. But there are other kinds of real estate holdings. There are commercial properties owned by non-REIT properties. The key thing to understand is that there are different kinds of real estate structures.

Companies that fit in that mold would be developers creating properties or home builders or management companies, particularly hotel companies, such as Hilton or Starwood. The latter uses a traditional corporate structure which relies more on capital appreciation and less on an income component. That means it performs more in tandem with the economy and does not have the delayed performance that REITs typically have. In the cases of hotel builders and hotel management companies, since they’re capital appreciation oriented, the key issues are the economic drivers, with respect to demand for their properties. In the last few years home builders have been one of the strongest areas of demand in the entire economy. Considering the argument for growth and diversification, one has to look at real estate and understand there are many different types companies to invest in, not just REITs.

REITs are just a type structure with certain tax benefits. The whole essence of being a REIT is to pass along real estate cash flow. It is less efficient for distribution of real estate capital gains or appreciation.

FundEmail: Morningstar reports that the fund’s investment strategy deviates from what is considered a traditional course followed by the majority of real estate mutual fund portfolio managers. For example, the fund purchases structured notes and mortgage-backed securities. Would you agree with that assessment?

Leiber: We do not buy structured notes or mortgage-backed securities. They’re wrong.

FundEmail: How is it possible that the Alpine U.S. Real Estate Equity fund has more than doubled the performance of the Standard & Poor’s 500 Index since January?

Leiber: A lot more than doubled. Year to date, home building sector is up 98%. The market has lost sight of the fact that these companies’ earnings per shares are up annually 33% for the last five years. The big change with these companies is due to the fact that they have grown their market share from 7% in 1993 to 20% today. During that time, they’ve also been able to grow their revenues while the overal industry has been growing on the order of at least 8%. This is one of the few sectors of the economy that is not suffering from overcapacity, which means it’s been able to raise prices on homes.

On the other hand, commercial real estate and hotels have no pricing power at this time, but as the economy picks up we think this will turn around. If GDP continues to grow at a solid pace of 3-4% over the next four years, we think other sectors of commercial real estate, in particular the apartment, industrial and office sectors will improve. But that’s all predicated on a strong economy. Unlike other funds that focus on income, this fund can shift the mix in its portfolio between the early cyclical companies and over time transition into some businesses that will perform as the economy improves later in the business cycle. However, if we are a little early or late in moving from one sector to another sometimes that will add to the volatility of the fund.

Combine that with the fact that for much of the period the fund does not emphasize high-dividend paying stocks, which means it will be a little more volatile because it does not have the cushion afforded by a high level of income that some investors seek.

FUNDemail: Morningstar also reports that the fund has more than 40% of its assets in the financial services sector. How is this possible in a REIT?

That’s bizarre. Those are their broad categorizations. They’re very strange and very wrong. The home builders sector is a consumer durable, and we’ve had roughly 50% of the fund in home builders. We’ve had periods where we’ve been 7 or 8% in companies that invest in REITs or mortgages, but 40% is crazy. We did have a stake in a company that owned wireless towers but we bought it as a real estate play, not a telecommunications play. We’ve also owned railroads and retailers. We’ve owned forestry companies in the past because we have a much broader perspective on what is real estate; it’s not just shopping malls and apartments. They [Morningstar] have Chelsea Property Group listed as financial services company. Chelsea owns shopping malls but Morningstar uses SIC codes. It’s just moronic. If investors listened when Mornignstar rated us in March with two stars they would have missed a great run.

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