By Ben Baden

Real estate funds are up about 17 percent so far this year

Believe it or not, there's a rally in real estate -- commercial real estate, that is. So far this year, real estate funds, which invest primarily in real estate investment trusts (REITs), have returned about 17 percent. And over the past year, they've gained almost 40 percent, according to Morningstar.

Some experts say investors have flocked to REIT funds for their yields. Some traditional investments like money market funds are yielding practically zero because interest rates are so low. After the subprime mortgage crisis, all real estate investments were punished, but the news is improving somewhat in the commercial real estate sector. More people are renting instead of buying, and earnings growth is expected to pick up in the near future, says Marc Halle, managing director for Prudential Real Estate Investors. Vacancies are slowly diminishing -- meaning that in the future landlords are going to be able to charge more for rent, which is good for their bottom line, he says.

There a few important things to know about investing in real estate funds. A REIT owns a collection of commercial real estate properties, all with tenants who pay rent. REITs are not required to pay corporate income taxes, but they must pay out 90 percent of their net income as dividends to shareholders. This means that REIT funds generally have fairly high yields. Most investment advisers suggest putting no more than 5 and 10 percent of your total assets in these sector-specific funds, says Morningstar analyst John Coumarianos.

[See Schwab Center for Financial Research. REIT funds generally offer an attractive yield, but that yield comes with additional risks. Sorensen also points out that many investors have a large portion of their net worth already invested in their homes.

It's important to differentiate: Commercial real estate and residential homebuilding have little to do with one another, Halle says. Also, real estate isn't a commodity like gold or oil. The quality of the properties varies from region to region, Halle says. "It's location, location, location," he says. Fund managers select REITs based on where the properties are located and by which industries look most attractive. They invest in them by buying the stocks of each of these REITs, which are made of a group of properties.

What that in mind, here are three of U.S. News's top-ranked real estate funds.

This fund is run by Ken Heebner, who is best known for managing the high-flying CGM Realty's portfolio turnover is close to 200 percent, according to Morningstar. Over the past 10 years, the fund has returned an annualized 18 percent, which places it in the top 1 percent of its category. But at times, his funds give investors a wild ride. In the past, CGM Realty has ranked near the bottom of its category one year and at the top the next. The portfolio only holds between 20 to 25 stocks, and Heebner can invest up to 20 percent of the fund's total assets outside of the real estate industry, according to the fund's prospectus. (Earlier this year, copper and silver producer companies made up about 15 percent of the portfolio, according to Morningstar.) The fund's annual fees are 0.93 percent.

This fund is also fairly concentrated. Comanager Brian Jones says the fund generally holds about 30 to 40 REIT stocks. "We do think that having fewer names and having a less index-like portfolio is an advantage," Jones says. He says the fund is able to generate more alpha -- or risk-adjusted returns -- from their high-conviction picks. The team believes that the economy will continue to grow -- albeit at a slow rate -- and that job creation will also be modest at best. As a result, management has overweighted certain speciality sectors that are experiencing demand, like data center buildings where companies store servers. The managers are avoiding areas like office and apartment properties that are highly dependent on job growth. Jones says there has also been a pick-up in global trade, so commercial warehouse properties look attractive. "We think there are areas that will recover faster than other areas of the economy," he says. The fund has returned about 5 percent, on average, over the past five years. The fund comes with annual expenses of 0.99 percent.

This fund's manager, Mark Snyderman, will invest in a combination of real estate stocks, bonds, and corporate mortgage-backed securities (CMBS). "We try to create a mix that creates higher yields and dividends for the investors of the fund than just real estate stocks can do," he says. Currently, the fund is heavy on real-estate oriented bonds and CMBS and light on stocks. Snyderman says he added to the fund's holdings in CMBS over the past year because those securities are offering a higher yield than bonds. Because the fund invests in a mix of stocks, bonds, and CMBS, it will generally hold up better during downturns than its peers. But it also tends to lag a bit when real estate stocks rally. "If you lose a whole lot less money than your competitors in the bad times, your long-term performance ends up being a lot better," he says. Over the past five years, the fund has returned an annualized 3 percent. The fund's annual fees are 1 percent.

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