News Room
A Surprising Shelter
Real-estate funds have been top performers this year. Can it continue?
 
By Jane Hodges
September 2, 2010

Making money in real estate? Surprising but true.

Despite continued bad news about the economy and real estate's role in it, mutual funds and exchange-traded funds in the real-estate sector have rebounded during the past year.

Indeed, real estate has been the top-performing U.S.-stock fund category this year, through August, with a 13.7% total return, according to Morningstar Inc., compared with a negative 4.6% for the Standard & Poor's 500-stock index over the same period. Real estate is the winning category for the past 12 months as well.

But will the strong performance continue? A lot depends on how the economy fares. Over the past month or two, economists and government officials have expressed concern that the recovery is stalling.

"Real estate is a leveraged play on the U.S. economy," says Timothy Strauts, an ETF analyst with Morningstar. "If we go back into a recession, real estate will fare worse" than the broad stock market, but if the economy "continues to slowly grow, real estate will continue to lead," he says.

Real-estate funds typically invest in commercial real estate and multifamily, not single-family, housing. They also tend to concentrate on real-estate investment trusts, or REITs, which own stakes in office, industrial, storage, retail, hospitality and apartment properties, as well as related service companies.

Uncertain Outlook

Across these different sectors, signals are decidedly mixed. Christopher Cornell, an economist at Moody's Analytics, says his company's data suggest commercial real estate is essentially flat right now. The company's commercial real-estate index as of June was down roughly 41% from its peak in October 2007, but was up 4.2% from its all-time low set in October 2009.

Retail is faring worst among the areas that make up commercial real estate, he says. Moody's retail index for the second quarter fell 11% from the first period, and was down 14% from a year earlier, hurt by lackluster consumer spending.

Apartment properties, however, were up 4% on a quarter-to-quarter basis and 2.5% year over year, as home seekers decided to rent rather than own. Office space, too, showed a 4% gain between quarters, but was down 4.7% year over year.

To Mr. Cornell, the overall data point to "a recovery story."

A second-quarter survey of institutional investors by PricewaterhouseCoopers and Korpacz Realty Advisors tells a similar story. The respondents said they regarded commercial real estate as still lagging behind a broader U.S. economic recovery. The report forecasts continuing weakness in retail real estate into next year due to elevated vacancy rates, low lease prices and reduced consumer confidence.

But self-storage, medical and apartment markets are showing strength, the report says, and the warehouse market, though soft, has improved as well.

In the past, conventional wisdom held that real-estate holdings ran countercyclically to the broader economic cycle, and that it was wise to devote from 5% to 15% of an investor's portfolio to the sector. Many financial advisers still recommend a holding in the low end of that range.

Teresa Jacobsen, an adviser and certified public accountant at UBS Financial Services in Stamford, Conn., recommends "modest exposure" to real estate, no more than 5% for aggressive investors.

But Rick Ashburn, an adviser and principal at Creekside Partners in Lafayette, Calif., says he currently doesn't recommend holding any real-estate funds, ETFs or REITs. Investors with the stomach for it, he says, should buy properties directly when they promise at least an 8% return. He says his firm "will make the occasional industry bet, but only if there is a compelling cheap opportunity"—and he says real-estate stocks don't qualify after their recent gains.

Broad Choices

For anyone considering adding real estate to a portfolio of funds, there are plenty of options: Morningstar counts about 75 domestic real-estate mutual funds. Among ETFs, there are 15 domestic real-estate options.

"What you want is an investment diversified across the REIT space," says Brenda Wenning, of Wenning Investments in Newton, Mass., who recommends about a 10% allocation in real estate. "You want apartments, storage, other baskets of real-estate securities," she says. She suggests two ETFs: iShares Cohen & Steers Realty Majors and iShares Dow Jones US Real Estate. Both contain a mix of mall, storage, hospitality, health-care, apartment and other real estate.

Ms. Jacobsen, the UBS adviser, says Pimco Real Estate Real Return Strategy appeals to her for its strong performance over one-, three- and five-year periods: 54%, negative 1.1% annualized and 2.5% annualized, respectively. But the fund's use of derivatives, she says, may be inappropriate for investors unfamiliar with them.

Andrew Gogerty, a fund analyst at Morningstar, is recommending T. Rowe Price Real Estate and J. P. Morgan U.S. Real Estate. He likes the former for its careful selection of larger real-estate stocks, such as Simon Property Group, AvalonBay Communities and Public Storage. He likes the J.P. Morgan fund for its subsectors, such as malls, apartments, storage, health care and hotels.

Among ETFs, only iShares FTSE NAREIT Residential Plus Capped Index holds a five-star rating from Morningstar. Mr. Strauts likes the fund's concentration on rental housing and storage, given the distressed residential housing market. It's also loaded up on health care, which Mr. Strauts says is somewhat immune to downturns. As of Aug. 30, the fund had 46% of assets in apartments, 37% in health care, 15% in storage, and the rest in manufactured homes or other holdings.

Mr. Strauts finds the ETF's three-year annualized return of negative 1.5% impressive compared with declines of 10% or more over the same period for iShares' three other domestic real-estate sector ETFs.

Global View

Another option: real-estate funds that look past U.S. borders.

As of July 31, the global real-estate funds tracked by Morningstar had an average 12-month yield of 6.3%, more than double the average 2.9% yield of U.S. real-estate funds. Over time, the dividend income is typically "the majority of your return if you're holding money in REITs," says John Coumarianos, a fund analyst at Morningstar.

But international real estate has been on a wild ride in recent years. After surging in the early part of the past decade, the category plummeted 60% from the beginning of 2008 through February 2009. Then it roared back 88% from March 2009 through July 2010.

Global real-estate funds contain REITs with less of a debt burden than U.S.-based REITs and they invest in new markets that still promise future gains, says Mr. Coumarianos.

Among global funds, he currently recommends Third Avenue Real Estate Value. It has more than 20% in cash and invests mainly in Asian real-estate developers. It also holds some distressed debt. But some Asian countries, he says, have resolved a recent debt crisis and are carrying less debt.

Morningstar tracks 11 international real-estate ETFs. Mr. Strauts recommends iShares FTSE EPRA/NAREIT Developed Europe Index, which is concentrated in Britain and France, and iShares FTSE EPRA/NAREIT Developed Asia Index , with holdings in Hong Kong, Japan, Australia, Singapore, and China. Another option: SPDR Dow Jones International Real Estate, containing a mix of Asian and European assets.

"These are interesting investments," Mr. Strauts says, "and they get you out of the U.S."