John Wenker and Jay Rosenberg manage the First American Real Estate Securities Fund for Minneapolis-based FAF Advisors, Inc. They’ve been playing a hot hand, ranking in The Wall Street Journal’s third-quarter roundup of the top 10 performers among real estate funds. First American is first among domestic real estate funds, and a top-50 10-year best performer among all 3,000 funds the newspaper tracks.

Wenker, the fund’s lead manager for the past seven years, was joined by Rosenberg as a co-lead manager in May 2006. The fund now has about $1 billion in assets, up from about $60 million when Wenker’s team took the reins. They invest in publicly traded, income-producing real estate companies, primarily in equity real estate investment trusts (REITs). For the past five years, they’ve had the wind at their back with a strong economy, good job growth, and increasing occupancy rates. Is the music almost over?


{Q} If I invested new money now, would I be investing in a real estate fund at the very top of a market cycle?

{A} I don’t believe that we’re at the top of a market cycle in commercial real estate. Currently, we have the best fundamental environment that we’ve had in the last four or five years. There are increasing occupancy levels and the ability to increase rental rates in most of the major markets in the United States.


{Q} REITs as a group have been on a tear. How much farther can they go?

{A} Currently, REIT pricing and private real estate market pricing is fairly rich on a historical basis. The drivers of the sector have been strong capital flows, merger and acquisition activity, the low-to-moderate interest rate environment, and steady economic growth with decent job creation.


{Q} What is a ‘capitalization rate’?

{A} The ‘cap’ rate is the discount rate used to determine the current value or prospective cash return on an investment property. Cap rate also refers to net operating income yield, or yield on the cost of investment properties. The cap rate is determined by dividing the property’s net operating income by its purchase price. Blended cap rates across property types are about 6 to 6.5 percent.


{Q} Do lower rates suggest a valuation problem?

{A} You could look at it two ways. Yes, people are paying more for properties and getting a lower yield, but how does that yield relate to the yield on investments available to them elsewhere? Second, the yield on real estate is not a constant. There is the potential for a property to grow net operating income over time, by either increasing occupancy or rental rates or both. You can look at a 6 percent cap for a property today with the expectation that it will go to an 8 percent yield.


{Q} So, yields are down now?

{A} Yes. Historically if you look at a 10-year average, REITs have provided a dividend yield 1.15 percent higher than the 10-year Treasury. Today, with the 10-year at about 4.7 percent and the average REIT dividend yield at 3.8 percent, we have a negative spread of 0.9 percent.


{Q} What are the signs that the commercial real estate market could be peaking?

{A} We spend a lot of time performing quantitative  and qualitative analysis on individual companies. Another large piece of our investment process is looking at the economic environment and understanding how it will impact our little REIT sector. We believe the sector will be competitive with other investments until there is a more dramatic change in the economy or the interest rates.


{Q} What makes you think that?

{A} There are two strong underlying supports for the sector. First, there is a tremendous amount of pension fund and institutional capital looking for ways to access the sector. Second, merger and acquisition activity will heat up further if pricing gets cheaper. In addition, we believe that with a 3.5 to 4 percent dividend yield plus 2007 earnings growth of 6 to 8 percent, total returns in the sector will be competitive with other asset classes.