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    An Interview With Jim Beers, Stratton Monthly Dividend REIT Shares Fund

    by Maria Crawford Scott

    FUND FACTS
    Stratton Monthly Dividend REIT Shares (STMDX) (STMDX)

    CATEGORY: Real Estate

    PERFORMANCE* (as of 9/30/02):

    COMPOUND ANNUAL RETURN (%)
      Fund Category
    1 Year 14.2 9.9
    3 Years 14.8 13.5
    5 Years 5.9 3.3

    RISK: Below Average

    TOTAL ASSETS: (as of 9/02) $133 million

    CONTACT: Stratton Mutual Funds 800/634-5726 www.strattonmgt.com

    The benefit of diversification has been the bitter lesson of the markets over the past few years.

    Although the concept sounded good in the late 1990s, it was hard for investors to turn down the exceptional returns generated by the hot sectors. Having now been burned by those sectors, individuals should be refocusing on asset allocation issues and ensuring that their portfolios are truly diversified. One asset class that should not be overlooked in this process is the REIT sector. Although REITs are still stocks and can be affected by the overall market, they have lower correlations with the broad market than many other sectors of the market.

    Several mutual funds focus on REIT investing. One fund that has done well relative to its peers is the Stratton Monthly Dividend REIT Shares. The fund has been among the top performers in its category for the last year, the last three years and the last five years (through September 30). Currently, it has about $133 million in total assets.

    In early October, Jim Beers, co-portfolio manager of the fund (along with Jim Stratton), discussed the management of the fund withMaria Crawford Scott.

    What is the investment philosophy of the fund?

      Stratton Monthly Dividend REIT Shares is an income-oriented fund—the primary objective is current income and we utilize REITs to generate that income. We pay a monthly dividend to our shareholders, and while it is not guaranteed or cast in stone, it is extremely important to us to meet that objective. Over the last few years, we’ve kept it steady at the annual rate of $1.92 [per share], and we hope to continue to do that. But it is not like a money fund where there is a set distribution amount.
    But the fund hasn’t always used REITs to generate income?
      That’s correct. Up until 1996, although we owned REITs in the portfolio, the fund was set up so that roughly 50% had to be in utilities. That would cover telecom and gas as well as electric, but we were primarily in electric utilities. At the time, the electric utility industry was going through a big change in terms of deregulation, and many companies were trying to reinvent themselves. Not only did the companies not have very much dividend growth, but in a lot of cases there were dividend cuts.

      REITs, on the other hand, were growing their dividends at a much better rate and there was a lot of interest in the sector. REITs don’t have some of the governmental oversight issues that the electrics were going through at the time. So we went to the shareholders and asked them to vote on changing the focus to REITs. And it’s worked out very well for us because dividend growth rates have been good—although certainly they’ve been better in previous years than they are currently.

    Income distributions come from income the fund receives as well as capital gains, but also from “return of capital.” What is that due to?
      Typically, some component of a REIT’s distribution is return of capital because they have very high depreciation expense. At the end of the year, REITs will reclassify their distributions to shareholders and a piece of it may be taxable as income, a piece will be gains because of sales, and a piece of it will be return of capital. It’s rather complicated on the REIT level. We gather all that information together, but it is not a straight path through to the shareholder. In other words, the fund has it’s own taxability. In some years, we may be able to pass on return of capital [which is non-taxable], and in some years we won’t be able to.
    In the REIT world, there are equity REITs and mortgage REITs. Do you primarily invest in equity REITS?
      Yes, we do. That’s a decision we made because they are the underlying owners of the property. Mortgage REITs certainly have had some great runs, but they also tend to be a little bit more volatile.
    How do you decide which REITs to invest in?
      Since our main focus is current income, when we look at the equity REIT market, with 160 or so companies, we tend to look at names that are above-average yielders in their sector. That’s not to say we’re buying the super-high yielding REITs, but it means that we’re looking for REITs that, on average, would be yielding somewhere in the 6% and up range.

      That narrows the field down somewhat, but that’s not the only screen we use. We look at the fundamentals of each sector—whether it be apartments, offices or hotels. And we look at REIT characteristics relative to their sector—their dividend coverage, historical dividend and earnings growth rates, their future expected earnings growth rate, and valuations in terms of price to earnings and funds from operations [FFO].

    The price-to-FFO measure is unique to the REIT industry?
      There is constant discussion as to what’s the best measure of REIT performance. Funds from operations (FFO) is the equivalent of earnings in non-REIT companies. The main issue FFO deals with is depreciation. Because there is property, and buildings, there is a much larger component in a REIT’s operating earnings that is comprised of depreciation. That’s an issue that a lot of other companies don’t have.

      There are guidelines on FFO that are put out by the National Association of Real Estate Investment Trusts (NAREIT), the trade organization of REITs. Given increased scrutiny and transparency in recent years, most companies are trying to adhere to the established NAREIT guidelines because they don’t want to get accused of calculating their number differently than their peer group.

    Dividend yield screens are often used as valuation measures, so although you are looking for income, you must also be looking for good valuations.
      That’s true. We are value-oriented investors.

      When you are looking for above-average dividend yield, that does tend to push you into some of the better values. But you have to be careful that you don’t get into a situation where the REIT is so high yielding that a particular event could put them into distress in terms of their dividend-paying ability.

    Do you diversify among the subsectors, and does your above-average dividend yield screen tend to skew you toward one particular subsector?
      We don’t have any set rules concerning percentage ownership in the subsectors, but we do try to diversify across the five major groups—apartments, lodging, office, and retail, which we subdivide into malls and strips.

      It does concern us, because if a particular sector is beaten up, you may find really high yields in that sector. There may be good reasons why those yields are very attractive to us: Perhaps the companies are fundamentally sound, or the sector is going through some particular event that’s hampering their price performance.

      But you do have to be careful that you aren’t overly committed to a particular sector that might do worse than others. That’s one reason we look at REITs relative to their subsector. We try to have a mix of higher-yielding, lower-growth stories and lower-yielding, higher-growth stories to come up with a decent blend of income performance, but also capital appreciation performance.

      For instance, healthcare REITs do raise their dividends, and some of them pride themselves on raising their dividends every quarter or every year. But the increases year-over-year are not particularly high. That’s OK with us because that’s stable, steady income, so we tend to like that. But that’s not to say we wouldn’t like a REIT in a different subsector with a different kind of dividend history.

    What role does geographical diversification play?
      It’s played less of a role in the last few years. Several years ago a number of REITs put themselves out as having a national footprint, and that has lessened the concern over geographical concentration.

      We don’t try to time the sectors and we don’t try to time the market. But if we were attracted to a particular name and we already had a huge component in a particular market, that would be a qualitative factor that might dissuade us. However, there are no set rules.

    What’s an example of something you’re currently focusing on?
      Through the first part of the year, REITs did very well while the broad market suffered. But in July, there was the first big leg down in the broad market, and REITs were not unaffected by that. So right now, we’re all—REIT and non-REIT investors alike—groping with the question of when the economy is going to recover.

      One of the areas we have been focusing on, both prior to September 11 of 2001 and also after, is the lodging sector. Our belief was that, though business and leisure travel would be affected by September 11, underneath it all there’s value in the underlying properties. We maintained our lodging weighting last year and actually suffered through some dividend suspensions with the feeling that, eventually, people would continue to travel and that business travel would recover.

      Lodging REITs did very well in the beginning of the year, but as the economy has not recovered as expected, the lodging REITs have continued to ebb because their earnings numbers just aren’t there—they can’t fill the hotels.

      Despite that, we’ve added to our position in Felcor Lodging Trust (FCH). That’s a company that we’ve held in the portfolio for a long time, and though their dividend yield right now under normal circumstances would not pass our screen, this is an example of a company where we have confidence in management. Despite the fact that they have not been able to bring their dividend back to its pre-September 11 levels, we think that they are good managers of their product and good managers of their properties. Therefore, as business travel and leisure travel come back, lodging is a place to have a decent representation. And they are doing well relative to their subsector peers—all the lodging REITs have lowered their dividend, and in a lot of cases they’ve suspended or even eliminated their dividends. We’re willing to wait until there’s a recovery in that sector.

    Of your top 10 holdings, most of them are at 3% of fund assets or below. Evidently, you don’t favor concentrated holdings?
      We have tried to keep the size of the holding somewhere in the 3% range. Typically, if a company begins to outperform and becomes a bigger part of the portfolio, we would cut it back.
    What would prompt you to sell a REIT?
      On the up side, what typically happens is that as the price rises and a company runs up above its peers, its yield will drop relative to the peer group. That’s a signal to us that it’s got some good appreciation that we should take advantage of—maybe we can recycle that capital to another company that’s slightly undervalued that would pay us a slightly higher dividend. Typically, if the price rises to the point where the yield drops, it may be approaching either fair value or an overvalued situation—that makes the decision for us.

      On the down side, if a company, relative to its sector, is overextended on its dividend in terms of the coverage, or in terms of the adjusted funds from operations versus the dividend they are hoping to pay out, then they may not be earning their dividends. If we begin to sense that if a company has a major problem that may affect their earnings to the point where they might have to actually reduce their dividend, we don’t want to be around for that.

      There can also be qualitative factors—for instance, if we feel that a company has made some moves that have not added value. There’s less of it going on now, but several years ago there was some consolidation in the industry, and there were times when companies may have overpaid for an acquisition. That is the kind of qualitative issue that may cause us to sell.

      What about the industry itself? There was a time when the REIT industry was tarnished. Is that over with, or are there still problems?

      Since the mid-1990s when a number of firms came public through the IPO market, the scrutiny that the investors and analysts are giving the companies has certainly helped their credibility. That’s not to say that there won’t be corporate scandals here and there, but given what we’ve seen in non-REIT-related industries over the last 12 to 18 months, I think REITs by and large are probably in a better place than a number of other areas.

    One reason REITs are suggested as an addition to an individual investor’s portfolio is their diversification benefits—they have relative low correlations to stocks. What is the pattern that REITs have relative to the stock market?
      If you look back historically, the correlation is low, but there are periods when REITs perform in lockstep with the market.

      In an up market, REITs are going to lag the broad market and in a down market the theory would be that REITs would not go down as much.

      But REITs have attracted investors recently for other reasons as well.

      If you look back at 2001, there were 10 or 11 interest rate cuts. The rates on money markets and CDs—instruments that investors typically utilize to generate income—have fallen significantly, and so the above-average-yielding REITs garnered some attention in both the retail and institutional marketplaces. I also think that the Nasdaq bubble in 2000 brought people back to tangible-type investments. Getting a dividend every quarter from an investment is important to the investor now—especially after the horror stories that investors endured by overcommitting to technology in the late 1990s. Certainly in 1998 and 1999, when REIT fundamentals were good and dividends were healthy, nobody wanted to talk about REITs. After all, you could get 20% appreciation in the first day in a Nasdaq issue or an Internet issue. Hopefully, people have learned from that, and are looking at asset allocation and correlations as a reason to allocate some portion of their portfolio to the REIT stocks.

→ Maria Crawford Scott