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Real Estate: Back in favor

With better corporate governance and increased liquidity, open-end real estate funds have buffed up their once-tarnished image among investors.

When commercial property values collapsed in the early 1990s, open-end real estate funds felt the full force of the downturn. Investors rushed to pull out of these vehicles, only to discover that portfolio managers weren't willing to unload properties at fire-sale prices to accommodate redemptions.

"In the early '90s these funds got a black eye," says Stephen Hansen, who runs ING Clarion Partners' Lion Properties Fund in New York, "and for the next six or seven years, they suffered net withdrawals."

No longer. The equity base of these investment vehicles increased from about $23 billion in early 2000 to $31.3 billion at the end of June, says Hansen. Launched in 2000, his Lion Properties reported $1.4 billion in assets as of mid-July; investors have committed an additional $600 million, which the fund will accept as it can accommodate new capital.

The major players, along with ING, include funds sponsored by J.P. Morgan Chase & Co., Prudential Real Estate Investors, RREEF America, which is part of Deutsche Bank Group's DB Real Estate, and UBS. For many funds there's a nine-month backlog of investors who want to sign up.

What accounts for the change? Credit an increase in real estate allocations among institutional investors, part of a wider search for alternative assets and income-generating investments; improved corporate governance among fund managers; a move to independent, third-party appraisals of fund assets; and performance-based, instead of asset-based, fees.

Most significantly, open-end funds now offer greater liquidity to investors. Funds have begun to use leverage, albeit at relatively low levels, averaging 17 percent for the core-style funds, which focus on the most stabilized, income-producing assets, and 31 percent for the value-added funds, which employ a slightly higher risk-reward investment strategy. In addition, many of the funds have established credit facilities and have capital commitments from their parent companies that better prepare them to accommodate investors who want to withdraw.

These days there's enough pent-up investor demand -- an estimated $3 billion­plus of equity is waiting to be invested in these vehicles -- that several new funds have arrived on the scene. Teachers Insurance and Annuity Association­College Retirement Equities Fund of New York launched a core open-end fund at the beginning of August; initially seeded with three properties valued at $100 million from TIAA-CREF's general account, the fund has a commitment of $200 million to $300 million from its parent and will be marketed to its traditional college and university defined-contribution-plan clientele as well as the broader institutional universe. According to David Morrison, managing director of TIAA-CREF Asset Management and portfolio manager of the new fund, the target is to have $1 billion in gross assets, including about 30 percent leverage, in three years.

Another core-style open-end fund was launched in July by Hartford, Connecticut­based Cornerstone Real Estate Advisers, an affiliate of the MassMutual Financial Group. Initially capitalized with $545 million in properties from MassMutual's general account, the fund anticipates bringing in new investors beginning in October and raising another $200 million in equity through next July.

Increasingly, pension funds big and small are investing in open-end funds. ChevronTexaco Corp.'s domestic defined benefit plan currently keeps 8 percent of assets in real estate, including open-end funds. Says Don Paiva, the investment strategist who oversees real estate for the company's pension fund, "We need geographic as well as sector diversification in our real estate space, and an open-end fund gives us that."

Paiva says that he's clear-eyed about the limitations of these investment vehicles. "You would be naive to think that open-end funds offer total liquidity, " he notes. "They don't."