Wells Fargo's notes tied to iShares real estate ETF designed to catch up to REITs, sources say

By Emma Trincal

New York, July 11 - Notes tied to real estate funds or indexes have not been plentiful so far this year, but the trend could be reversing soon, sources said while commenting on an upcoming deal.

Wells Fargo & Co. plans to price 0% enhanced growth securities due February 2015 linked to the iShares Dow Jones U.S. Real Estate index fund, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus double any fund gain, up to a maximum return of 40% to 45%. The exact cap will be set at pricing. Investors will receive par if the shares fall by up to 15% and will lose 1% for every 1% that the shares decline beyond 15%.

Only 14 deals based on this fund have priced so far this year, and the majority of them were small in size, mostly under $1 million.

One exception was Citigroup Funding Inc.'s $40.93 million of 0% jump securities due Aug. 27, 2012 linked to the fund, which priced in February. So far, it is this year's biggest deal linked to this fund, according to data compiled by Prospect News.

"New deals in this sector play don't surprise me. I think we're going to see more," said Carl Kunhardt, wealth adviser at Quest Capital Management.

Strong performance

The iShares Dow Jones U.S. Real Estate index fund is an ETF that tracks the Dow Jones U.S. Real Estate index.

The index itself measures the performance of the real estate sector of the U.S. equity market.

The ETF is composed of a variety of real estate-related stocks including real estate investment trusts. REITs invest primarily in income-producing real estate or real estate-related loans.

While the residential real estate market continues to be depressed, the prospects for the commercial real estate sector are brighter, sources noted.

"The fundamentals of commercial real estate are improving. The problems they faced during the recession of 2008 were more related to credit markets and refinancing risk than to supply and demand," said Jason Ren, senior equity analyst at Morningstar, who covers the sector.

Year to date, the iShares Dow Jones U.S. Real Estate index fund is up 10%, outperforming the S&P 500, which is up 5%.

The ETF posted solid gains in 2009 and 2010 as well. It was up 29% in 2009 and 22.15% in 2010.

Bouncing back up

"I've talked to a couple of managers on the public REITs we review," said Kunhardt.

"The recovery is in process now. We're seeing improving valuations over and above the estimates of the appraisals being carried on the balance sheets of these properties."

He said that the notes, which offer two-times leverage on a three-and-a-half-year period, would be suitable for investors who expect low single-digit annual returns from the fund.

"It's a mildly bullish bet on real estate, and I don't disagree with that outlook," he said.

He said that the real estate sector has become "so undervalued" that getting a 10% rate of return today is much more achievable than when the market was at its peak.

He said he is comfortable with the 15% buffer for the same reason - an "oversold" market.

"Most people argue that we've already bounced off the bottom. So you have a muted risk of further downward pressure," he said.

"Part of the gloomy news in real estate is that you're looking at metropolitan areas like Las Vegas, Reno, Chicago, most of Florida. You had a bubble there and prices collapsed. But for the regular middle America, if you look at St. Louis, Kansas City, Concord, Charlotte or Dallas, house values have fallen but not more than 5%."

Entry point

However, given the strong bull market seen in REITs over the past two years, investors need to consider whether the timing is right to enter the sector and what their return expectations should be, he said.

"You'll see more of those REITs-linked notes because investors always look at recent performance," he said.

"All 2007 and 2008 you read about massive losses, but then real estate was up in 2010, topped the list of asset classes in 2011.

"People want to jump back in real estate, and when there is demand for an asset class, the financial industry always finds ways to accommodate investors."

The notes, structured around mildly bullish expectations, may offer a good opportunity at the present time, he said.

"Is it a good time to jump in? Well, 2009 and 2010 are gone. You're not going to get the same returns. But I don't think it's too late, especially with this leveraged structure that enables you to be slightly less bullish," he said.

He said that while he is cautious about leverage in general, he can see himself recommending the product to more aggressive investors, providing they understand the risk.

Commercial versus residential

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the underlying fund performed very well because it has little exposure to the residential real estate sector.

"Back in 2008, 2009, people were saying that the next shoe to drop would be commercial real estate. It hasn't happened," he said.

"Residential real estate had a big dip because it had a big run up. In Las Vegas where they were up 100%, they're now down 50%, back to where they were before."

On the other hand, demand for shopping malls, apartment rentals, commercial real estate, storage and other non-residential services has held up well, he noted.

Some of the top holdings in the fund may even benefit from a distressed residential market, he said, pointing to Equity Residential, which operates apartment rentals, or Public Storage, a storage company that benefits from people in transition between residences.

Complementary

Kalscheur said that the notes would make sense for an investor with no prior real estate exposure seeking to gain access to an asset class with little correlation to the S&P 500.

However, for those who have a strongly bullish take on real estate, the notes would not be suitable, he said.

"We have active holdings in real estate already. I see these notes as a great complement to an actively managed fund in real estate such as a mutual fund or a direct real estate fund like Cohen & Steers. It's a great complement as it has a buffer.

"But I'm a little bit too bullish on real estate for this particular investment.

"If you're mildly bullish, this would be a great position. If you don't already have an exposure to real estate, then it would be a good opportunity. You're tied to a broad-based index; you have downside protection; and Wells Fargo is a pretty solid name. It sounds reasonable."

Wells Fargo Securities, LLC is the underwriter.

The notes will settle in August.

The Cusip number is 94986REP2.

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