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Real estate funds lead the pack, but can it last?

Thursday - 7/19/2012, 5:36pm  ET

By MARK JEWELL
AP Personal Finance Writer

BOSTON (AP) - The housing market may finally be coming back, with home prices rising again and mortgage rates at record lows.

But there's far greater strength in commercial real estate. Check out the recent investment returns of stock mutual funds that specialize in companies owning income-producing property, from office buildings to hotels.

Real estate funds have posted an average annualized return of 33 percent over the last three years, according to Morningstar. That's the top performance among the fund categories it tracks. Year-to-date, the funds are up nearly 17 percent. That's about double the average return for diversified stock funds.

What's more, real estate funds provide dividend income. The stocks that these funds invest in _ known as real estate investment trusts, or REITs _ are required to distribute at least 90 percent of their taxable income to shareholders in order to escape corporate taxes. REITs generate income from properties they own, and often operate.

Funds that specialize in REITs typically hand out quarterly payments, representing the total payout from the fund's holdings. Investors can either take dividends as cash, or reinvest by purchasing more fund shares.

REIT yields are attractive at a time when ultra-low interest rates make it hard for investors to earn much unless they're willing to take on additional risk. The average dividend yield of a benchmark REIT index is 3.2 percent, substantially higher than the 2.1 percent yield of the Standard & Poor's 500 index.

The recent strength of REITs has not been lost on investors. Real estate funds attracted $2.9 billion in new cash through June of this year, while investors have pulled out of nearly all other stock fund groups.

Real estate funds and REIT stocks have defied the broader trends in the market and the economy recently, says Rob Wherry, a Morningstar analyst who tracks real estate funds.

But investors should be cautious about making any sizable investment in REITs now, given the outlook for slow economic growth.

"Investors should not expect these kind of strong returns going forward," Wherry says.

ROBUST MARKET

REIT stocks have performed better than the S&P 500 in recent years because the decline in commercial real estate wasn't as severe as the residential market crash. Offices, industrial properties, hotels and apartments weren't overbuilt to the same degree as homes, and commercial leases and rents have held up better than home prices.

The outlook remains favorable, with commercial occupancy climbing and rents increasing in most markets, says Jason Yablon, who oversees REIT investments both in the U.S. and overseas, and co-manages the Cohen & Steers Emerging Markets Real Estate fund (APFAX).

Yablon expects commercial property companies this year will post earnings growth in the high single digits in percentage terms. "That's strong against this backdrop of slow growth for the overall economy," he says.

POTENTIAL RISKS

Despite the strong outlook, REITs face risks from the European debt crisis and the looming congressional battle over cutting the U.S. debt burden.

If a government bond default appears likely in Spain or Italy, U.S. banks could further tighten lending. REITs would have a harder time raising cash from banks and through the stock market to finance new projects. With interest rates low, their borrowing costs are currently modest.

And any failure by Congress and the president to reach a long-term debt deal shortly after the November election could trigger automatic budget cuts so severe that they could drag the economy into recession. A shrinking economy would hurt REITs, which depend on a healthy job market to maintain a robust flow of income from office and industrial properties.

If the economy weakens, health care REITs -- which own medical office buildings, nursing homes and assisted living centers -- would best withstand a downturn. Medical care is a necessity, and owners of these properties typically sign long-term leases that can lock in expected income for years.

TOP OPPORTUNITIES

If the economy improves, hotel REITs are likely to outperform. That's because hotels can raise daily room rates if a strong economy boosts demand.

Given the current risks, co-managers Kay Herr and Jason Ko of the JPMorgan Realty Income fund (URTAX) favor REIT stocks that they believe have high-quality management teams and property portfolios. Those traits are likely to help REITs weather any downturn, they say.

Their current favorites include Simon Property, the fund's top holding, and Boston Properties, in the top 10.

They like Simon because of its ownership of upscale malls and outlet centers catering to moderately high-income shoppers. Ko believes their spending is likely to hold up relatively well if the economic recovery stalls.

The two managers like Boston Properties because of its ownership of high-end office buildings in downtown New York, San Francisco, Washington and Boston. Such offices will continue to be in demand as employers seek out highly skilled workers.

Many employers are far more concerned about having access to the best talent than about finding low-cost office space.

Says Herr: "It's a knowledge-oriented economy."

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Questions? E-mail investorinsight(at)ap.org


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