Will the Dramatic Run-Up in Real Estate Funds Last?
Andrew Leckey

Investors are chasing yields and former homeowners are moving into apartments.

That combination has provided the one-two punch in 2010 of real estate investment trusts (REITs), those dividend-producing investments that trade as stocks and use investor capital to purchase properties.

Real estate funds are up 19 percent this year and 46 percent over the past 12 months, according to Lipper Inc. In particular, foreclosures, tougher lending, home-price worries and high unemployment have prompted a boom in apartments.

For example, Equity Residential (EQR), a giant apartment-building REIT, is up 44 percent this year. It has nearly 500 properties with 140,000 apartments primarily in the New York metropolitan area, District of Columbia, South Florida, Boston and Los Angeles areas.

"The bottom fell out of the REIT market in 2008, but starting in March 2009 investors were no longer nervous about whether REITs were going to be able to pay their mortgage debt," said Brad Case, economist with the National Association of Real Estate Investment Trusts in Washington, D.C. "REIT prices started going up because there was no longer a worry about liquidity."

REITs have almost no exposure to the residential housing market, which has definitely been a good thing for them, and the low interest-rate environment is also a plus.

"The lower that interest rates are, the better it is for REITs, since most are heavily-leveraged properties financing with floating rate instruments," said Jeff Tjornehoj, senior research analyst with Lipper in Denver. "So the cost of borrowing goes down while the cash flows they take in remain constant."

For a basic REIT investment, he points to Vanguard REIT Index Fund (VGSIX), up 18 percent this year and up 45 percent over the past 12 months. Its 99 holdings follow the Morgan Stanley Capital International U.S. REIT Index. The fund has a low annual expense ratio of .26 percent.

Keep in mind that REITs have had a strong run-up that is unlikely to continue at this pace and that their dividend yield is currently low. A faltering economy could hurt them. If Treasury yields increase, investors seeking income might abandon them for the safer yields of government bonds.

"People are exasperated, can't tolerate earning zero percent on bonds and are wary of the stock market, as well," said John Coumarianos, senior mutual fund analyst with Morningstar Inc. in Chicago. "With REITs paying around 3 percent (in dividend yield) right now and an REIT fund having a 1 percent expense ratio, you're getting 2 percent."

While 2 percent is better than zero percent, he said, keep in mind that an REIT is not a risk-free investment.

"REIT yields are not there right now, which means long-term return won't be there either," added Coumarianos. "Investors should not delude themselves into thinking that because it is a hard asset an REIT is safer than owning a common stock such as Johnson and Johnson or IBM."

With those caveats in mind, here are the real estate funds currently recommended by Morningstar:

T. Rowe Price Real Estate Fund (TRREX)

Up 51 percent over the past 12 months, has a large-capitalization, low-turnover portfolio of 39 holdings. Its largest portfolio holding is Simon Property Group, the giant regional mall and outlet center REIT that is up 22 percent this year. That REIT owns or has interests in nearly 400 properties with 261 million square feet of space in North America, Europe and Asia.

JP Morgan U.S. Real Estate Fund (SUSIX)

Up 53 percent over the past 12 months, invests primarily in blue-chip REITs with strong balance sheets. It made a strong move into rental properties going into 2010. The largest of its 25 holdings is Equity Residential, noted previously here, and its other large apartment holdings are Essex Property Trust (ESS) and AvalonBay Communities (AVB).

Third Avenue Real Estate Value Fund (TAREX)

Up 15 percent over the past 12 months, makes unusual moves to protect its investors, such as currently holding 20 percent of its assets in cash. Portfolio manager Mike Winer knows how to navigate the bankruptcy process as an investor and often buys bonds of REITs instead of their stocks. His 25 holdings aren't heavy in REITS but rather real estate operating companies (REOCs), which reinvest earnings in the business rather than provide dividends as an REIT does. That, however, means a lower yield.

When any investment is doing as well as REITs, the question is how long good times will last.

"I don't know that the REIT market is going to collapse, but we have seen some shakiness in sectors of the real estate market, such as a 9 percent decline this year in industrial REITs," said Tjornehoj.

Meanwhile, apartment REITs are up 29 percent and hotel REITs up 19 percent this year, he added. Maintaining that pace is unlikely.

"The real estate funds ran up last year but the fund flows weren't as big as they are this year," said Coumarianos. "So investors, in classic form, have put most of their money in after the run-up and missed the run-up."

Those who might usually keep an REIT allocation in their portfolios of five to 10 percent should now be around five percent because having a margin of safety makes sense, he concluded.

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