T. Rowe Price Real Estate Fund

N-CSRS 1 srref.htm T. ROWE PRICE REAL ESTATE FUND T. Rowe Price Real Estate Fund - June 30, 2008

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT OF REGISTERED

MANAGEMENT INVESTMENT COMPANIES

Investment Company Act File Number: 811-08371

T. Rowe Price Real Estate Fund, Inc.

(Exact name of registrant as specified in charter)

100 East Pratt Street, Baltimore, MD 21202

(Address of principal executive offices)

David Oestreicher

100 East Pratt Street, Baltimore, MD 21202

(Name and address of agent for service)

Registrant’s telephone number, including area code: (410) 345-2000

Date of fiscal year end: December 31

Date of reporting period: June 30, 2008

Item 1: Report to Shareholders

Real Estate Fund

June 30, 2008

The views and opinions in this report were current as of June 30, 2008. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.

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Manager’s Letter

Fellow Shareholders

It was a tale of two quarters in the first half of 2008, as positive returns achieved during the first quarter were subsequently wiped out during the past three months. Turmoil in the financial markets continued to produce challenging headwinds for financials and the economy, burdened by the added possibility of an environment of stagflation—an economic state of little or no growth combined with detrimental inflationary pressures.

Following 2007’s disappointing correction in real estate securities, 2008 began with promise, as the fund achieved a positive total return of 2.50% during the first quarter. Unfortunately, the deepening housing crisis weighed heavily on the markets, and the fund concluded the first half with a return of -3.99%. (The return for the Advisor Class was lower, reflecting its different fee structure.) The concerns relating to the broad market and the broader economy as a whole were reflected in a -11.91% first-half return for the S&P 500 Index. The fund’s major benchmarks, the Dow Jones Wilshire Real Estate Securities Index and the Lipper Real Estate Funds Index, were down 3.41% and 1.74%, respectively. (In our last letter to shareholders, we made a reference to the linked performance benchmark.

HIGHLIGHTS

• The real estate sector was a tale of two quarters during the first half of 2008, with the stocks getting off to a good start before posting a loss in the second quarter.

• The fund outpaced the broad market but lagged its benchmarks because of our underweighting of healthcare REITs. Long-term results, however, continue to compare favorably.

• The recent correction in real estate stocks has presented many appealing investment opportunities, and we have been positioning the portfolio to take advantage of shifting market dynamics.

• Softening demand for commercial real estate has led to another leg down in our sector of the equity market, but we intend to remain disciplined in our investment strategy and maintain our long-term perspective.

The benchmark has now reverted to its original name, shown in the Performance Comparison table, and an explanation of the so-called linked performance benchmark is given in the footnote to the Growth of $10,000 chart following this letter.)

DIVIDEND DISTRIBUTION

On June 25, 2008, your fund’s Board of Directors declared a second-quarter income dividend of $0.18 per share, payable to shareholders of record on that day. For the Advisor Class, the income dividend was $0.17 per share.

MARKET ENVIRONMENT AND STRATEGY

To borrow a famous line from politics: “It’s the economy, stupid.” And right now the economy does not feel great. The U.S. Bureau of Labor Statistics released data indicating six consecutive months of declining job creation, with a resulting half-point increase in the rate of unemployment to 5.5%. So while we have been sanguine about the relatively low levels of new construction supply in commercial real estate, we have been disappointed by the lack of evidence to indicate improving demand fundamentals. That said, the market tends to be forward-looking, and by the time a recovery is evident, we expect it will already have begun to be reflected in the stocks. Thus, with the correction of the past year, combined with the Fed’s interest rate reductions and the passage of time, we have been keenly awaiting a recovery.

So far, though, the markets have continued to worsen, highlighted by high-profile collapses such as that of Bear Stearns. The company was founded in 1923 and survived several harsh periods, including the crash of 1929 and the Great Depression. However, the current credit crisis and a loss of confidence in Bear Stearns forced its sale to JPMorgan Chase. Meanwhile, the price of commodities, particularly oil, continued to climb to new heights, pinching consumers and businesses. The Fed’s efforts to inject liquidity seem to have had little tangible impact to date—like pushing on the proverbial string.

Most commercial property subsectors posted negative returns during the first half of the year. One notable exception was the apartment real estate investment trust (REIT) category. Ironically, some apartments appear to be benefiting from the current housing crisis, as landlords are reporting fewer departures to single-family homes. We think this has provided a nice boost to renter demand because we would ordinarily have expected greater vacancies as a result of the recent job losses. Lodging properties, on the other hand, do appear to be experiencing increased vacancy pressures from the slowing economy, as the protracted downturn has led to lower expectations at these companies, and investors punished this subsector to a much greater degree than most other property types.

Retail REITs suffered from investor fears of a deepening credit crisis and a further weakening of consumer demand, particularly in the face of rising gasoline prices. Fundamentals for existing properties appear to be weathering the slowdown better than new developments, as retailers operate current locations while reducing plans for new store expansion. Still, we were surprised by the relative magnitude of the price correction in shopping center REITs that cater to necessary activities, such as grocery shopping. Industrial REITs and, to a lesser extent, office REITs were also weak during the first half of the year, as downward revisions of gross domestic product (GDP) growth resulted in downward forecasts for earnings growth at most companies.

Unfortunately, our historical aversion to healthcare REITs continued to hurt our relative performance this period as the economic downturn has persisted. It feels to us as though healthcare REITs have become the “comfort trade” in our sector due to the perception that they are resistant, or perhaps even immune, to recessions. The healthcare subsector appears to be sporting increasingly rich valuations versus other commercial property types. While we haven’t been fans of the assets, nor the tenant and industry concentration of healthcare REITs, we do acknowledge that the lack of exposure here has hurt our recent results, though our long-term results without them remain quite strong (see the Growth of $10,000 chart and the total return table following this letter).

We saw a glimpse of the potential of our holdings in a favorable market, as the fund had a strong relative showing during the positive first quarter. While we remain optimistic about an economic recovery, we are nonetheless cognizant of risks in the market, which we will discuss in more detail along with some of our portfolio positioning in this respect—positioning that we feel reduces risk yet still offers promising reward potential.

PORTFOLIO REVIEW

While the recent uncertainty, volatility, and illiquidity spawned by this crisis have been painful, they do present some uncommon investing opportunities, such as the General Growth Properties (GGP) Exchangeable Senior Notes (bonds). We appreciate the quality of GGP’s assets, specifically the company’s super regional malls. However, the tight lending environment has placed unusual pressure upon several GGP securities. While the GGP convertibles have a stated maturity in 2027, they can be put (sold) back to the company in 2012 at par. We have been buying these securities at discounted levels that imply double-digit compounded returns until the 2012 put date. This would be an equity-like return from a debt instrument that is senior in the capital structure to the common stock, and we find the convertibles to be a compelling risk-adjusted investment opportunity. Indeed, we’ve trimmed some of our GGP common stock holdings to purchase more of the convertible notes. (Please refer to our portfolio of investments for a complete listing of holdings and the amount each represents in the portfolio.)

In a normal environment, we would be comfortable with the prospects for the refinancing strategies of most REITs. Unfortunately, the recent environment has not been normal in any sense of the word, and lenders are becoming increasingly tight with their funding. Even in cases in which companies appear to be making sound strategic progress, refinancing has become more challenging. Many lenders are demanding higher equity levels in assets as a condition for refinancing. Pressures such as these can raise companies’ cost of capital and, with this in mind, we eliminated our positions in Brandywine Realty Trust and Developers Diversified.

With continued pressure on retail REIT stocks during this correction, we added to shares of regional mall companies Macerich Company and CBL & Associates Properties. We also added to retail shopping center landlord Regency Centers. We believe the company’s infill shopping centers can remain resilient even in the event of a continued downturn because of its tenants that supply necessities, including grocery stores and pharmacies.

While we have continued to trim Host Hotels and Resorts following the departure of the company’s CEO, we added to the lodging sub-sector with a new position in Gaylord Entertainment. Gaylord owns large convention hotels such as the Gaylord Opryland and the Gaylord Texan. We recently toured the newly opened Gaylord National close to Washington, D.C., and we believe it will be a very successful development for the company. We like Gaylord’s business model, which appeals to large user groups. The company tends to have good visibility on rooms reserved months in advance, regardless of the current economic conditions. Although reservations can be cancelled, the penalties to do so becoming increasingly large as the date nears.

Fear of protracted job losses contributed to weakness in office REITs, especially those with exposure to Manhattan and the financial services industry. We viewed the weakness as an opportunity to add to Vornado Realty Trust and SL Green Realty. We acknowledge the potential for interim weakness in demand in New York City, but we also note the relative lack of new supply in this extremely high-barrier market. In part to take advantage of buying into the weakness in U.S. REITs overall, we eliminated our position in Mitsubishi Estate.

OUTLOOK

Low supply is but one side of the fundamental equation, and continued pressure from softening demand for commercial real estate has led to another leg down in the stocks. We believe it is sensible to remain disciplined in one’s investment strategy and to maintain a long-term perspective. As we review our portfolio of holdings, we feel confident about the companies we have selected. Additionally, the unwelcome price correction has nonetheless resulted in an increasing array of real estate stocks with attractive dividend yields that we believe will be rewarding to patient investors.

As always, we thank you for your continued support and confidence.

Respectfully submitted,

David M. Lee
President of the fund and chairman of its Investment Advisory Committee

July 25, 2008

The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program.

RISKS OF INVESTING

The fund’s share price can fall because of weakness in the stock market, a particular industry, or specific holdings. Stock markets can decline for many reasons, including adverse political or economic developments, changes in investor psychology, or heavy institutional selling. The prospects for an industry or company may deteriorate because of a variety of factors, including disappointing earnings or changes in the competitive environment. In addition, the investment manager’s assessment of companies held in a fund may prove incorrect, resulting in losses or poor performance even in rising markets.

Funds that invest only in specific industries will experience greater volatility than funds investing in a broad range of industries. Due to its concentration in the real estate industry, the fund’s share price could be more volatile than that of a fund with a broader investment mandate. Trends perceived to be unfavorable to real estate, such as changes in the tax laws or rising interest rates, could cause a decline in share prices.

GLOSSARY

Beta: A measure of the market risk of a portfolio showing how responsive the fund is to a given market index. By definition, the beta of the benchmark index is 1.00. A fund with a 1.10 beta is expected to perform 10% better than the index in up markets and 10% worse in down markets. Usually, higher betas represent riskier investments.

Capitalization rate: A ratio, shown as a percentage rate, that estimates the present value of an income-producing asset. Riskier investments have higher capitalization rates and lower present values.

Lipper indexes: Fund benchmarks that consist of a small number of the largest mutual funds in a particular category as tracked by Lipper Inc.

MSCI REIT Index: A total return index composed of the most actively traded real estate investment trusts, designed to be a measure of real estate equity performance.

Price/earnings ratio (or multiple): A valuation measure calculated by dividing the price of a stock by its current or projected earnings per share. This ratio gives investors an idea of how much they are paying for current or future earnings power.

Real estate investment trusts (REITs): Publicly traded companies that own, develop, and operate apartment complexes, hotels, office buildings, and other commercial properties.

Performance and Expenses

GROWTH OF $10,000

This chart shows the value of a hypothetical $10,000 investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes.

AVERAGE ANNUAL COMPOUND TOTAL RETURN

This table shows how the fund would have performed each year if its actual (or cumulative) returns had been earned at a constant rate.

FUND EXPENSE EXAMPLE

As a mutual fund shareholder, you may incur two types of costs: (1) transaction costs, such as redemption fees or sales loads, and (2) ongoing costs, including management fees, distribution and service (12b-1) fees, and other fund expenses. The following example is intended to help you understand your ongoing costs (in dollars) of investing in the fund and to compare these costs with the ongoing costs of investing in other mutual funds. The example is based on an investment of $1,000 invested at the beginning of the most recent six-month period and held for the entire period.

Please note that the fund has two share classes: The original share class (“investor class”) charges no distribution and service (12b-1) fee, and the Advisor Class shares are offered only through unaffiliated brokers and other financial intermediaries and charge a 0.25% 12b-1 fee. Each share class is presented separately in the table.

Actual Expenses
The first line of the following table (“Actual”) provides information about actual account values and expenses based on the fund’s actual returns. You may use the information in this line, together with your account balance, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During Period” to estimate the expenses you paid on your account during this period.

Hypothetical Example for Comparison Purposes
The information on the second line of the table (“Hypothetical”) is based on hypothetical account values and expenses derived from the fund’s actual expense ratio and an assumed 5% per year rate of return before expenses (not the fund’s actual return). You may compare the ongoing costs of investing in the fund with other funds by contrasting this 5% hypothetical example and the 5% hypothetical examples that appear in the shareholder reports of the other funds. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period.

Note: T. Rowe Price charges an annual small-account maintenance fee of $10, generally for accounts with less than $2,000 ($500 for UGMA/UTMA). The fee is waived for any investor whose T. Rowe Price mutual fund accounts total $25,000 or more, accounts employing automatic investing, and IRAs and other retirement plan accounts that utilize a prototype plan sponsored by T. Rowe Price (although a separate custodial or administrative fee may apply to such accounts). This fee is not included in the accompanying table. If you are subject to the fee, keep it in mind when you are estimating the ongoing expenses of investing in the fund and when comparing the expenses of this fund with other funds.

You should also be aware that the expenses shown in the table highlight only your ongoing costs and do not reflect any transaction costs, such as redemption fees or sales loads. Therefore, the second line of the table is useful in comparing ongoing costs only and will not help you determine the relative total costs of owning different funds. To the extent a fund charges transaction costs, however, the total cost of owning that fund is higher.