Having It Both Ways With REITs

forbes.com ^ | 06.15.07, 6:10 PM ET | Matthew Rand

[BenLurkin]

Shorting REITs requires an iron constitution. In the last 12 months REIT prices are up 17% and over the past five years the iShare Dow Jones REIT Index has nearly doubled. Jon Fosheim, manager of hedge fund Oak Hill REIT, has been shorting REITs since January 2005 (" Shorting Skyscrapers").

Despite the bullish run of REITs, Fosheim has been able to keep his limited partners happy with positive returns.

How does Fosheim do it? By pair trading, or hedging every short he enters into by simultaneously going long a stock he thinks will prosper. In all, he usually has roughly 20 longs and 20 shorts. With these pairs, he’s able to place a bet against a specific stock that he thinks is overvalued at the same time as he captures the risk that it will rise in a broader sector rally by owning a better competitor alongside the short.

Here’s an example: Home Properties (nyse: HMEPRF - news - people ). Fosheim thinks that apartment REIT Home Properties is overvalued, so he shorted it recently. The short’s done well, as HME is down 9% in June, but Fosheim thinks its current price is still too high and is propped up by speculation that the Rochester, N.Y.-based apartment manager will end up getting bought out. A short would get burned on a buyout at a premium to current prices, but Fosheim’s not worried. On the other side of the HME trade, he owns Avalon Bay (nyse: AVB - news - people ).

Fosheim won’t give out his valuations, but Green Street Advisors (the real estate analysis firm that Fosheim co-founded in 1985) said in its June report that the stock trades at a 7.7% premium to its warranted value (what Green Street thinks it should be worth), while Avalon Bay trades at a 7% discount. A Home Properties buyout would lift the apartment REIT sector, just like the Archstone-Smith (nyse: ASN - news - people ) buyout lifted it last month. Avalon Bay’s upside, Fosheim says, hedges the risk of a Home Properties buyout.

Does Fosheim cover his shorts at the same time as he sells his longs? Mostly. While Oak Hill REIT was very disciplined early on about closing out longs and shorts at the same time, Fosheim says that he now sometimes lets it go overnight if a buy-to-cover is hard to come by. That sometimes leaves him exposed to a sudden rally where he’s unhedged, but he thinks his portfolio is varied enough to withstand it.

Another intricacy of Fosheim’s strategy is that Oak Hill REIT actually consists of two funds, a short-biased fund and a market neutral fund. In each fund he puts on the same trades, one long and one short, but each fund has a different weighting to the long and the short.

The market neutral fund gives the longs and shorts equal weighting. With enough positions, this eliminates the movement of the overall market, and pegs its returns solely to good stock picking.

With shopping center REITs Kimco (nyse: KIM - news - people ) and Developers Diversified Realty (nyse: DDR - news - people ), for instance, Fosheim says that you’ve got two excellent, well-managed REITs. The difference is that Kimco trades at a 3.5% premium to Green Street’s warranted valuation, while DDR trades at a 3.6% discount. Both should respond to the same overall market movements, but there’s an unwarranted difference in valuations, says Fosheim. He’s short Kimco and long DDR. The market neutral fund should only lose money if he’s wrong about the disparate valuations.

With the short fund, Fosheim traded the same two REITs, Kimco and DDR, but he gave bigger weighting to the short. That leaves him more exposed to the possibility that the shopping center REIT market will rise, but that’s not likely says Fosheim.

All in all, two thirds of the REIT holdings of the short fund are shorts. But he also holds a big chunk of the S&P 500 (amex: SPY) in that fund. The reasoning: REITs have been too correlated with the broader market lately, so he doesn’t want his fund simply to be a bet against the whole market. If the correlation goes away, as it seemed to be beginning to do on Thurdsay June 14, when the S&P 500 rose 0.5% and REITs lost 1%, then Fosheim would sell down his SPY.

In the meantime, Fosheim is certain that REITs, which trade at a near-50% earnings premium to the S&P 500, will underperform the broader market. Holding SPY is also a bearish REIT bet, he says.

[Cedar]

At one time I had very small holdings in NFI and IMH. Fortunately, I got out of NFI with a small gain before its huge drop. With IMH, I had a small loss.

No more MREITS for me!