Real estate funds have lagged the market rally, but a few funds have done well.


One of the classic lines about real estate is that it will always rise in value because they aren't making any more of it. But it's not an argument that holds up for long. Real estate booms and busts have been part of the American financial landscape since the early 1800s, when a 50-acre farm was considered "cozy." And they're not making asbestos insulation any more, either, and it's not getting one bit more valuable.

The market for residential real estate, however, has been fairly good. The S&P Case/Shiller home price indices have gained about 12% in the past 12 months, buoyed by relatively low prices and mortgage rates.

But funds that invest in real estate stocks have been laggards, with the average fund rising just 7.5%, vs. 24.6% for the Standard and Poor's 500 with dividends reinvested. What gives? Quite a bit, starting with the fact that Wall Street expects interest rates to rise, pushing up mortgage rates and making real estate less affordable. But some real estate funds have done quite well this year, and they're worth looking into.

Most real estate mutual funds don't invest in residential real estate. Instead, they invest in real estate investment trusts, or REITs, which buy and sell commercial properties — hotels, apartments, office buildings, even storage units. By law, REITs have to pay out most of their taxable income as dividends, which means that they often have higher yields than Treasury securities.

How much higher? Currently, the 10-year Treasury note yields 2.52%, and the average money market mutual fund yields just 0.01%. The average equity REIT has a dividend yield of 3.68%, so it's no wonder they've been popular with income investors.

But REITs, like utility stocks and other income investments, tend to fall when investors think interest rates will rise. At the moment, you could unearth a hermit in the wilds of Borneo, and he would tell you, quite confidently, that interest rates are going to rise. Higher interest rates on an ultrasafe investment, such as a Treasury security, make other income investments less attractive. This belief, in turn, has hurt REIT shares.

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Whether it has hurt REITs enough to classify them as bargains remains to be seen. "Relative to the cost of financing, commercial real estate is still very cheap," says Scott Hastings, equity analyst for real estate securities at Delaware Investments. But, he concedes, it's not as cheap as it once was.

A few real estate funds have stood out, however. One is Baron Real Estate (BREIX), which has gained 19.5% this year, according to Morningstar, which tracks the funds. When you outperform the pack by a large margin, you have to do something different, and in this case, the strategy has been simple: Avoid REITS. Manager Jeff Kolitch says the fund has just 13% of its assets in REITs, its lowest ever. "We've always pursued a broader, more diversified approach to real estate," he says.

Several of the fund's choices play on the surge in residential real estate: Lowe's, for example, which should fare well as people fix up their homes, either for resale or their own enjoyment. Another theme in the fund is the aging of the Baby Boom generation: It owns shares in Brookdale Senior Living and Capital Senior living.

The fund even owns shares of SBA Communications, which owns cellphone towers. "The company acts like a landlord, leasing out space to mobile carriers," Koltich says. "The whole world is going wireless, and it has more exciting growth than office space."


Another standout real estate fund has been REMS Real Estate Value Opportunity (HLPPX), which is a more traditional real estate fund that tends to hunt for undervalued stocks in the sector. "Real estate is generally fairly valued, but there are pockets of opportunity that we can take advantage of," says John Webster, president and director of research at REMS Group.

Webster thinks the residential real estate boom is still in the early innings, despite the potential for rising mortgage rates. And, he says, while the markets in coastal urban areas, such as New York, San Francisco, Boston and Washington, D.C., are fairly rich, institutional investors are turning toward Sunbelt markets, which offer better opportunities at lower prices.

Real estate funds typically don't come cheap. REMS Real Estate Value Opportunity is a small fund with $25 million in assets, and it charges 1.75% in expenses each year. Baron Real Estate Retail, with $430 million in assets, charges 1.35% a year. For those who simply want pure exposure to real estate stocks, Vanguard REIT Index fund (VGSIX) has a 0.24% expense ratio. It's up 9.4% this year.

Whatever you do, be extremely wary of non-traded REITs, which come with high upfront fees — as much as 15% — and have very limited liquidity. "Investors think it's great, because it seems like they're getting a stable 6% return forever," says Delaware's Hastings. But when they go to sell, they can find that the shares they thought were worth $10 are worth $7.

Real estate can often be a good addition to your portfolio. It's not terribly well correlated to stocks, and can give reasonable amounts of income to cushion downturns. This is not a time, as in 2009 or 2010, when prices are in the cellar. But prices aren't goofy yet, either. If you do decide to invest in a real estate fund, do so gradually by adding a set amount each month to your fund. Set a limit on how much of your portfolio you want in real estate. You don't want to have all your money in REITs when the neighborhood goes to the dogs.

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