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  • September 17, 2012

    David Lee David Lee, portfolio manager of the T. Rowe Price Real Estate Fund and the T. Rowe Price Global Real Estate Fund.

    In the current financial environment, yield and income are scarce commodities, with long-term government bond yields plunging to multi-decade lows. Globally, investors in search of yield have naturally gravitated to high-dividend-paying equities, including the attractive income provided by real estate investment trusts, or REITs. Following a period of weakness during the economic recession and global financial crisis of 2008, the commercial real estate sector has performed well. Investors remain interested in monitoring commercial real estate fundamentals and whether the asset class will continue to be a good investment in the coming years. The following Q&A reflects the views of David Lee, portfolio manager of the T. Rowe Price Real Estate and Global Real Estate Funds.

    Real estate stocks have done relatively well lately. Is it time for investors to consider allocating part of their portfolios to this asset class?

    Diversification is essential, and commercial real estate investments have shown lower correlations to broader equities and fixed income over time. Investors with an allocation to commercial real estate have benefited from this diversification element and improved the long-term risk and return profile for their portfolios. The merits of including an investment in commercial real estate (e.g., REITs) come from both income—the ability for REITs to pay higher dividends due to the steady cash flows derived from long-term leases—and appreciation, which is driven by growing net asset values through portfolio improvements and rent increases over time.

    In light of the diversification benefits, we believe an allocation to commercial real estate is appropriate in a broadly diversified portfolio. Investors looking for income or appreciation can find value in many REITs in the current environment.

    What types of properties are doing best?

    On the demand side, the best-located properties are still recovering faster than inferior properties, both in terms of fundamentals and investor appetite. The recovery in prime assets and prime markets has been better than that of third-tier markets. Listed real estate portfolios have recovered ahead of private markets—a situation accentuated by public companies having superior access to capital via equity, debt, and preferred securities.

    One subsector where we are seeing a pickup in supply is apartments, as fundamentals have held up well due to increasing renewals and occupancy levels. Demand seems to be keeping pace with any new construction. Homeownership levels continue to trend lower, implying a greater propensity to rent for new households. Today, despite historically low mortgage rates, home financing remains scarce. Gone are the days when homeownership was viewed as a surefire way to build equity.

    What other areas look good to you now?

    On a broad level, we have been seeking flexibility in a mix of holdings with the potential to participate in a broadening economic recovery, yet they are positioned to prosper in uncertain times. We have been focusing on companies with offensive business models and defensive balance sheets. New supply is not an issue for dominant regional malls, which continue to enjoy strong demand—particularly in upscale markets. Local strip shopping centers also are doing well as occupancy gains were achieved within the "small shop" category that reflected an expanding economic recovery beyond national tenants. As we await further strength in this recovery, we are also enjoying above-average dividend yields from these shopping center holdings.

    What is your longer-term view of real estate, looking out to the end of this year and into 2013?

    At the close of the second quarter of 2012, real estate fundamentals were still improving, although the pace has become more measured. Job growth, while not robust, is resulting in positive absorption against a lack of new supply. Leasing activity remains good. Small business leasing continues to improve with a stabilization of bad debt. The debt and preferred markets are open at very low rates, although what can be easily refinanced has generally been done as management teams work to stagger future maturities and limit additional borrowings.

    Some REITs are selectively engaging in development by reviving stalled construction projects where there are favorable incremental returns. Many companies remain focused on disposing their weaker assets and redeploying the proceeds into stronger assets. A general lack of new supply, combined with modest demand and low rates, is a favorable environment for owning real estate. If demand recovery persists and yield alternatives remain scarce, we believe that REITs are well positioned to benefit from favorable supply/demand dynamics.

    Are you optimistic about the potential for global growth?

    We are hopeful about eventually seeing viable resolutions to the global financial crises overhanging the markets, leading to revitalized economic activity, which would serve as the primary driver for real estate. Despite lingering uncertainties, global markets managed to generate positive returns during the first half of the year, with real estate stocks in particular bouncing back sharply from a weak second half in 2011. Several Asian markets were especially strong, even as investors digested the prospects of slowing economic growth in China.

    Can China engineer a soft economic landing?

    It's still unclear. The government is engaged in a delicate balancing act, attempting to tamp down overheated residential real estate appreciation while simultaneously trying not to cool down other areas of the economy. An important leadership change will take place this year, which has generated much speculation about the remaining actions of the outgoing leaders and potential directives from the new ones coming in. In Hong Kong, a newly elected official focused much of his rhetoric on residential pricing issues. China's home-purchasing restrictions are also dampening commodity demand and pricing worldwide, which is having an impact on several exporting countries.

    What about Europe?

    Recent elections signified widespread discontent with painful austerity measures and unresolved debt problems. European real estate, particularly away from weaker southern European markets, seemed to reflect a search for "safe havens" with the potential to retain their value in the midst of a weakening currency and changing government leadership. There is no shortage of macro factors influencing varied asset classes nor has there been a shortage of shifts in expectations about the possible outcomes as the year progresses. Global leadership changes may amplify these uncertainties, at least in the short run, but they also offer the possibility for hope and optimism for new resolutions.

    Due to its concentration in the real estate industry, the fund's share price could be more volatile than that of a fund with a broader investment mandate. Trends perceived to be unfavorable to real estate, such as changes in the tax laws or rising interest rates, could cause a decline in share prices. Any foreign holdings would be subject to risks inherent in non-U.S. securities, including currency fluctuations.

    Diversification cannot assure a profit or protect against loss in a declining market.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.