Clients wishing to smooth out the volatility in their portfolios may benefit by holding a chunk of their assets in real estate mutual funds.

Offering the benefits of diversification in hard tangible assets such as land, industrial space and office buildings, the real estate asset class as a whole has historically shown a low correlation to broad stock market averages.

“Many people have a large percentage of their assets invested in their houses, but real estate funds go well beyond residential housing,” says Mark Chow, senior fund analyst at Toronto-based Morningstar Canada. “The funds offer exposure to all kinds of real estate, much of which is not correlated to the fate of the residential housing market. And several funds offer global exposure. Real estate funds tend to be good portfolio stabilizers with their low correlation to stock markets.”

It’s important to look at the composition of a fund’s portfolio. Some invest directly in properties, while others hold portfolios of stocks and real estate investment trusts that represent securitized ownership in real estate properties. Although the sector tends not to move in concert with stocks, the funds that hold the actual bricks and sticks offer the greatest diversification opportunities against other asset classes. Included in this group are Great-West Life Canadian Real Estate Fund (sponsored by Great-West Life Assurance Co. of Winnipeg), London Life Real Estate Fund (sponsored by London Life Insurance Co. of London, Ont.) and Investors Real Property Fund (sponsored by Investors Group Inc. of Winnipeg).

The attraction of real estate is primarily the regular rental income it provides. But, longer term, there is potential for capital appreciation and, historically, the hard assets have acted as a hedge against inflation, says Paul Finkbeiner, president of GWL Realty Advisors Inc. of Toronto and manager of the Great-West Life and London Life real estate funds.

According to figures from Morningstar, the average real estate fund showed a 16.6% return for the year ended Aug. 31, higher than the 10.4% return of broad-based Canadian equity funds. For the five years ended Aug. 31, real estate funds had an average annual compound return of 11.2%, while Canadian equity funds returned 8.4%. But for the longer 10-year period, the 7.7% annual return generated by real estate funds was less than the 9.1% shown by Canadian equity funds.

The real estate industry is leveraged, and the low interest rates of the past several years have been a boon to markets. But when interest rates rise, the real estate industry often feels the pain, particularly if markets have been overbuilt and debt levels are high. To reduce risk, the Great-West Life and London Life funds won’t allow debt to rise to more than 35% of the value of their properties. Currently, the portfolio has an even more conservative 25% debt ratio.

“Our goal is to run a true real estate fund,” Finkbeiner says. “If you’re too leveraged, it can be problematic if interest rates rise. The debt can be worth more than the real estate if leverage is too high and property prices fall.”

The two funds managed by Finkbeiner have about half their property holdings in Ontario, followed by significant exposure in Alberta and British Columbia and relatively small investments in Quebec and Eastern Canada. Both funds have about half their holdings in office buildings, with the rest in multi-residential apartment buildings, and industrial and retail properties.

“Location, quality of the buildings, occupancy levels, the nature of leases and predictability of cash flow all affect pricing of properties,” says Finkbeiner. “We look for assets in major urban centres and then diversify by both the type of property and geographical location. Every building has a business plan, including an exit strategy.”

Although real estate funds that own hard assets tend to focus on Canada, those investing in real estate securities are more likely to diversify internationally because of the ease of trading in and out of their holdings.

Charles Dillingham, vice president of Morguard Financial Corp. in Toronto and manager of CIBC Canadian Real Estate Fund, is active in U.S. and Canadian real estate securities. The fund has benefited from the run-up in the value of U.S. REITs.

“Institutional investors such as pension funds are looking for real estate income to help them meet future obligations,” he says. “There have been some takeovers of REITs at a premium of 15%-20% above the market price, and that’s pushed up the market for real estate securities.”

@page_break@Dillingham has become a little more defensive in the wake of the slowdown in the U.S. housing market and the potential for economic fallout, and has upgraded from companies with low-grade industrial assets to more liquid entities with better properties. He has also increased exposure to apartments, which tend to do well when houses become unaffordable.

Last May, Toronto-based Fidelity Investments Canada Ltd. introduced a Canadian version of its Fidelity Global Real Estate Fund, taking advantage of growing investor demand for real estate exposure, as well as the burgeoning supply of global real estate securities. Steve Buller, Boston-based portfolio manager of the Fidelity fund, says there are about 400 publicly traded real estate companies around the world, including shares and REITs, with an estimated market capitalization of US$800 billion. “The universe has very much expanded during the past few years,” he says.

REITs or similar income-oriented business structures are now available in Japan, France, Hong Kong and Singapore, as well as North America. Britain and Germany are expected to allow REITs within the next year.

“The transfer of ownership of real estate properties from private ownership to publicly traded vehicles has been an underlying international trend,” Buller says.

The Fidelity fund’s investments include companies specializing in office buildings, retail (from large shopping centres to strip malls), industrial space, hotels, rental apartments, storage facilities and nursing homes. About half the assets are in North America, with the rest spread among Britain, Europe, Japan, Australia, Hong Kong and Singapore.

“Property cycles can run on different schedules, depending on the type of property and where it is located,” Buller says. “Even within a region, there can be huge differences among cities.”

He says the recent slowdown in the U.S. housing market has not affected commercial real estate, although — if the lull continues and drags down the broader economy — other types of real estate, such as offices and hotels, could be affected by loss of business.

Although real estate funds give ordinary investors exposure to a diversified portfolio of commercial buildings they wouldn’t otherwise be able to afford — without the management and maintenance headaches — they still face the same dangers as any sector fund with a mandate to focus on one industry, says Dan Hallett, fund analyst and president of Windsor, Ont.-based Dan Hallett and Associates Inc. When times are tough, there simply isn’t anywhere else to go, and real estate funds can be faced with redemptions when the prices for properties and real estate securities are at a low ebb.

“The funds that hold property directly are probably the best diversification to equity fund investors, but there can be liquidity constraints,” Hallett says. “After that, the global real estate funds are the next best diversifiers in a balanced portfolio.” IE