David Lee
T Rowe Price Real Estate Fund

Age: 45
Credentials: MBA, Stanford University; MS in engineering, University of Illinois, Urbana-Champaign
Experience: Portfolio manager, T. Rowe Price Real Estate Fund (1997-
present); research analyst, T. Rowe Price (1993-1997).
Ticker: TRREX
Inception of fund: October 1997
Style: Real estate
Assets under management: $2.3 billion
Three- and five-year performance as of Aug. 20, 2008: 5.17% and 14.06%
Expense ratio: 0.73%
Front load: None
Minimum investment: None
Alpha: 1.26 vs. S&P 500

With all the bad news surrounding residential real estate and the mortgage market, you may have missed the news that commercial real estate is doing quite well. In fact, real estate mutual funds are the second best-performing fund category following healthcare portfolios, according to Morningstar.

That is no surprise to David Lee, who has managed the $2.3 billion T. Rowe Price Real Estate Fund since its 1997 inception. "Commercial real estate isn't directly linked to residential real estate," he says. "The subprime crisis has focused on residential."

Of course, real estate funds aren't completely immune to the stock market's ailments. They're still down an average of 2.7% in 2008, but that handily beats the S&P 500's loss of 12.5%.

Last year's real estate correction had been expected for years. The category rose for seven years straight, from 2000 until mid-2007. Then, real estate investment trusts (REITs) lost an average of 17.2% for 2007, according to the industry group NAREIT. Lee's fund took full advantage of real estate's bull run. During the last five years, the fund earned an annualized 14.06%, besting 66% of real estate funds, according to Morningstar; the fund grew 12.43%, annualized. over the past 10 years, beating 77% of its real estate competitors.

The Portfolio

REITs make up the bulk of the portfolio, though Lee is quick to say that his isn't a REIT fund exclusively. "We're focused on the business and not the tax structure," he says. REITs are required to distribute 90% of their taxable income to shareholders as dividends in order to avoid paying corporate income tax. "We would prefer that management selects the tax structure to align with their business strategy," Lee says. Just 10% of the fund's assets are in real estate operating companies.

Lee sticks with the four major classes of REITs-office, multi-family, industrial and retail. This past year, healthcare REITs were added to the Dow Jones Real Estate Index, the fund's benchmark, yet Lee stayed away. "Healthcare tends to be a sale and then a lease," he says about the propensity of healthcare properties to be owned and managed by different companies. "We like our companies to operate our real estate."
Thankfully, plenty of names meet these criteria. One is Macerich, a mall operator in California and Arizona. The stock is down 16% in 2008 due to severe declines in those markets. Twenty percent of Macerich's portfolio is in Arizona alone.

Yet Lee is impressed with Macereich's plans to redevelop the Santa Monica Place Mall, a rundown structure just a few blocks from the beach. Macerich has plans to reopen the Frank Gehry-designed building as an upscale outdoor mall. Nordstrom has signed on as an anchor. "They're redeveloping with a very high-end tenant roster that is more congruent with the character of the Santa Monica area," Lee explains.
The stock has been hammered because of its declining rent rolls. The mall is now closed and Macerich isn't collecting rents. But Lee is convinced that the firm is setting the stage for impressive gains in the future. "Our investment thesis isn't based on the next quarter, but years out," he says.

He's also sticking with Kilroy Realty, which owns and operates office buildings. It's been a holding since the fund's 1997 inception. A southern California owner of office buildings, Lee likes Kilroy's geographic concentration. "They represent the type of local sharpshooter we like," he says. "They haven't tried to stretch geographically."
The firm has stayed local by focusing on West Los Angeles and San Diego and that contributed to its 11% decline in 2008. To Lee, however, the local focus is a positive: "I like that the CEO can travel to a property in one day and seal a deal with a handshake."

Smooth Operators

When it comes to real estate operating companies, the few Lee owns in the portfolio share the same traits he looks for in REITs. He likes specialized property types with a long-term income stream, such as Gaylord Entertainment, owners and operators of the Opryland Hotel in Nashville, Tenn., among others. The stock is suffering due to the economically sensitive nature of its business. It's down 20% this year.