Following a generally poor year in 2007, North American property returns have been on a roller coaster ride thus far in 2008—with positive returns during the first quarter more than wiped out by losses during the second quarter, only to turn around again during the most recent period. The continued financial crisis here and abroad, coupled with a bailout plan that as of quarter end had yet to be worked out or approved by Congress, continues to wreak havoc on the markets. When all was said and done, the Fund's MSCI US REIT Index benchmark had tallied a 1.8% gain for the year-to-date through September 30, 2008, thanks to a strong 5.4% return in the third quarter. This compares to a -8.4% return for the S&P 500 Index during the third quarter and a -19.3% return for the year-to-date. 

During the third quarter, Healthcare joined the Self Storage and Apartment sectors as one of the top performing areas of real estate for the year. Healthcare benefited from its perceived defensive characteristics, despite what we consider largely uninspiring valuations. Amid a period of economic turmoil, it helped that the sector has typically been more dependent upon demographic trends (aging of the population, baby boomers retiring, longer life spans) than economic trends. While the slowing economy has not yet materially affected the Self Storage sector, it is likely to slow on a lagged basis as individuals reduce their discretionary spending. As we have pointed out in previous market discussions, the Apartment sector—where the Fund remains overweight—possesses a level of liquidity that most other property sectors lack at the moment. Strong demand (homeownership rates are dropping), still favorable spreads between renting versus owning, and valuations are additional positives for the sector. These factors are currently outweighing negatives such as slowing fundamentals, supply concerns (especially in the form of condominiums and single-family rentals) and slowing job growth.

Lagging sectors include Lodging (Hotels), Industrial, Office, and Retail (both malls and shopping centers). Hotels are suffering on the demand side, as the weakening economy has affected both corporate and leisure travel. Pro Logis and AMB dominate the industrial sector globally, and both are seeing a slowdown in development pipelines. Within Retail, both malls and shopping centers are suffering from the negative sentiment surrounding weaker consumer spending. In addition, those shopping center companies with large development pipelines are seeing a slowdown in the lease up and delivery of those projects.

We remain most positive on the Retail sector—especially malls—despite the continued negative sentiment surrounding the group from stressed consumer spending and slowing retail sales growth. The story remains the same. We like the long-term nature of mall leases, the lack of meaningful new supply, and the continued healthy demand for 'A'-quality mall space from tenants.  All the mall names held in the portfolio possess largely 'A'-quality portfolios—meaning those with well above average sales per square foot. We have become increasingly positive on the shopping center sector as well. We especially like the defensive characteristics of the grocery store anchored centers in this environment, as opposed to big-box power centers. Although not immune to an economic slowdown, shopping centers with quality grocery stores should prove somewhat more recession resistant given the necessity for food and other typical tenants at these centers.

Outlook

The prospects for property shares have been, and we expect will continue to be, shaped largely by the economic downturn and the state of the credit markets. The group is likely to stammer along until better clarity develops with respect to the depth and breadth of the economic and financing environment. As fundamentals continue to weaken, development margins tighten, lease up times lengthen, and capital costs continue to rise, the risk is that earnings growth estimates will continue to come down. Continued capital rate expansion also remains a risk for the sector, though the dearth of transaction activity is providing limited data points for determining appropriate market-cap rates.

Positives such as the lack of supply and the state of balance sheets within the industry should not to be overlooked, however. Going into this downturn new additions to supply have been modest, and lower than they were leading into the last recession. With financing hard to come by supply has been further kept in check, which should position the industry well for a quicker recovery when that recovery does come. It is worth emphasizing again that an overwhelming majority of publicly traded real estate companies possess healthy balance sheets. Given this strength, many firms should be in a position to deploy assets and capitalize on the more-attractive pricing that is likely to present itself in the future.                                                                    

Fortis Investments

As of September 30, 2008, Pro Logis comprised 3.33% of the portfolio's assets and AMB Property – 2.67%.