If your clients are looking for some relief from woefully weak financial markets, mutual funds and segregated funds that invest in the bricks and mortar of hard real estate may be the answer. These funds have proven their value as true portfolio diversifiers.

There are only a handful of funds investing directly in real estate properties, as opposed to real estate securities or real estate investment trusts. They include segregated funds GWL Real Estate Fund, sponsored by Great-West Life Assurance Co. of Winnipeg, and London Life Real Estate Fund, sponsored by London Life Insurance Co. of London, Ont., as well as Investors Real Property Fund, a mutual fund sponsored by Investors Group Inc. of Winnipeg.

These three funds, sponsored by related companies, showed positive returns for the year ended Nov. 30, 2008, a period that saw the S&P/TSX composite index slide by 30%. The GWL fund gained 6.9%, the London Life fund gained 6.6% and Investors Real Property gained 4.3%.

“Property funds provide valuable portfolio diversification benefits,” says fund analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “REITs and publicly traded real estate stocks are affected by stock market volatility, but property funds tend to show much steadier performance and solid long-term returns.”

Typically, bricks-and-mortar real estate offers an annual cash yield based on rents and leases, as well as capital gains potential as buildings appreciate in value. Real estate funds, then, offer a diversified portfolio of properties for those clients who don’t want the headaches of being a landlord or property manager themselves. The fund manager is responsible for finding tenants, renovating buildings, understanding zoning regulations, performing maintenance and doing landscaping, and paying taxes.

The daily liquidity provided by these funds is another attractive component of holding real estate through segregated and mutual funds. But money flows must be carefully managed, as properties cannot simply be quickly flipped to meet an unexpected wave of redemptions. These funds are, therefore, managed extremely conservatively with low levels of mortgage debt and a generous cushion of ready cash to meet redemptions.

“Property funds are holding an illiquid asset in a liquid structure,” Hallett says. “It works fine as long as the fund flows are working in the manager’s favour. If not, the funds risk a repeat of the early ’90s, when some real estate funds suffered a flood of redemptions and had to freeze redemptions to avoid being forced to sell properties at fire-sale prices.”

The Investors and GWL funds were established in the early 1980s and have successfully weathered a couple of real estate downturns — “A good indicator,” says Hallett, “of their long-term viability.”

The London Life fund was introduced in 1998 and is managed by GWL Realty Advisors Inc. of Toronto, the same firm that manages the GWL fund. The London Life and GWL funds share ownership of many of the same properties. The GWL fund is about twice as large as the London Life fund, with 172 properties and assets under management of $3.9 billion for the former, vs 170 properties and $1.9 billion in AUM for the latter.

“We invest in quality properties and rarely bring in other institutional partners,” says Dave Rose, vice president and portfolio manager with GWL. “During the past few years we have been big enough to buy major properties on our own, which gives us better control.”

Diversification is an important benefit of real property funds for individuals who couldn’t otherwise afford expensive investment properties. The GWL and London Life portfolios are invested about 50% in office space, 15% in industrial properties, 15% in multi-family residential and 10% in retail. About 95% of the properties are located in major Canadian cities: Toronto, Vancouver, Edmonton, Calgary, Montreal, Halifax and Ottawa.

“We are extremely conscious of liquidity,” says Rose. “You do not get the same liquidity on properties in Guelph [Ont.] or Fredericton.”

In the retail sector, however, it can be a challenge to find good properties with stable tenants, and Rose casts a wider net in the retail segment, including cities such as Victoria and Kelowna, B.C., or Belleville, Ont., if the right location and the right tenants can be found.

“It’s important to have diversification of tenancy,” he says. “The factors affecting retail properties are a lot different than those affecting multi-family buildings providing homes to thousands of tenants.”

@page_break@The GWL and London Life funds’ office properties cater to a wide range of tenants, including government and bank workers, accountants and engineers. Tenants of industrial holdings are similarly diverse, but there is a stronger focus on warehousing than on manufacturing.

“We focus on ‘clean’ industrial tenants,” Rose says, “and avoid industries such as automobiles and metal stamping, in which there can be environmental issues.”

Investors Real Property has a similarly diversified asset mix, but because of strong inflows in recent years, the fund has almost half its AUM — or $2 billion of $4.1 billion — in cash. Net sales of the fund for 2008 have totalled a strong $640 million, and fund manager and vice president Murray Mitchell has spent about $500 million of that on property deals that will close by yearend.

The geographical mix for Investors Real Property is 40% in Toronto, 22% in Vancouver, 9% in Montreal, 9% in Calgary, 8% in Ottawa and 5% in Edmonton. There are also a few holdings in Winnipeg, Saskatoon, Regina, Halifax and Victoria.

“We view each individual property as a business,” Mitchell says. “Our focus is on well-constructed, income-producing real estate with strong tenants. We put a strong focus on tenant retention, and are willing to make prudent investments in improvements to facilitate tenants’ businesses and hang on to them for the long term. Real estate is not just about location, location, location; it’s also about high-quality tenants.”

The real property funds are not property flippers; when they buy a property, it tends to be for keeps. The funds are also highly conservative when it comes to debt. The GWL and London Life funds, for example, have mortgage debt equivalent to 15% of the value of real estate assets. Investors Real Property has mortgages worth a scant $150 million of the $2.1-billion portfolio. Such low levels of debt provide a cushion against rising interest rates and give the funds the flexibility of additional financing if necessary.

“We have very few mortgages relative to the size of the portfolio,” Rose says, “and the low 15% leverage gives us a tool we can use if we see opportunities. If there’s an asset we really want to buy, we could get additional financing if needed.”

He prefers to keep mortgage debt to less than 25% of AUM, and says it’s never been more than 30%.

Although the real estate funds have held up well through the economic downturn of 2008, they could be negatively affected in 2009 if the economy continues to contract, resulting in increased vacancies and lower rents.

“We’ve locked up a lot of long-term leases, but we are not bulletproof and there is risk out there,” Rose says. “Retail could be a sensitive area, although tenants such as food stores and Shoppers Drug Mart will probably be fine. Electronics and other discretionary items may be harder hit.”

Although an economic downturn may pinch rents, it may also provide some attractive buying opportunities if other highly leveraged property investors get squeezed and are unable to refinance in tight credit conditions, forcing them to sell.

“Over the next year,” Rose says, “we expect there may be some attractive buying opportunities as some competitors fail to get the financing they need.”

The funds have their properties appraised once a year by an independent appraiser. GWL changes its appraiser every three years for “a fresh pair of eyes” and staggers its appraisal schedule so one-quarter of the properties are appraised every quarter, and properties are revalued gradually as market conditions change. IE