Real estate funds got pounded, but a few are worth a look

Owning a real estate fund last year was a bit like buying a dream house — provided your dreams included a three-headed dog in the basement and a toaster that shrieks at midnight.

This year, however, real estate funds seem to have exorcised their demons. But commercial real estate still has a ways to go before it climbs out of purgatory.

The average real estate fund plunged 39.6% in 2008, and 29.6% from January through March, according to Morningstar, which tracks the funds. Although most funds were clobbered last year, real estate funds were particularly shocking.

After all, real estate funds invest primarily in real estate investment trusts, which, in turn, invest in commercial property: office buildings, apartments, shopping malls. By law, REITs have to pay out nearly all of their income to investors. Wall Street often viewed REITs as tame dividend plays, best suited for conservative, income-oriented investors.

No longer. REIT share prices tumbled, and many slashed their dividends. As the credit crunch intensified, investors worried that some REITs wouldn't get the financing they needed for continuing operations. "The whole REIT story — low volatility, high dividends, stable cash flows — has been shot to heck," says Sam Lieber, manager of Alpine U.S. Real Estate fund.

In recent months, however, REITs and the funds that invest in them have been going like a house on fire, soaring 29.5% in April, their best monthly gain since Morningstar started tracking them in 1985. One reason REITs have done well: Several have managed to raise capital, says Paul Curbo, manager of AIM Real Estate fund. A REIT that can raise fresh cash can, potentially, start looking for bargains in the beaten-up commercial real estate market.

The question becomes whether there is value in the ruins of commercial real estate. The current nationwide office vacancy rate is about 16%, according to consultant Torto Wheaton Research. That's a lot of empty space, and it means that landlords must slash rents to get new tenants. High vacancy rates and lower rents, in turn, could spell doom for some commercial landlords.

Considering that unemployment now stands at 9.4%, office landlords aren't likely to find a lot of new tenants anytime soon. And, says Alpine's Lieber, banks have many commercial loans on their books that could soon come back to haunt them.

Many commercial loans have been packaged into collateralized mortgage-backed securities, which makes it more difficult to refinance problem loans. "It's an accident waiting to happen," Lieber says.

If that's the bad news, what's the good news? The stock market looks forward, and Wall Street has started to look past the current hideous market to a slightly less scary future. "The commercial real estate market usually bottoms after REITs bottom," says Brett Johnson, chief investment officer of Grubb & Ellis. "I'm not surprised to see REITs rally before the fundamentals improve."

And REITs do sport decent dividend yields. The average REIT yields 5.54%, according to the National Association of Real Estate Investment Trusts. In contrast, the 10-year Treasury note yields 3.44%.

But REITs are no longer the screaming bargains they were in March. "We believe they are fairly valued," Johnson says. "But as we move out of this environment, we believe there are a number that are poised to do well."

Which ones? All three managers favor REITs with lots of cash and a proven ability to find deals in tough times. Alpine's Lieber likes Ventas vtr, which invests in health care properties. The company had $46 million in cash at the end of June. Both Curbo and Johnson like Simon PropertiesSPG, currently sitting on a cool $2.6 billion in cash.

If you're not in the mood to pick REITs, then consider a real estate fund.

Do you need a real estate fund in your portfolio? Although there's some evidence that real estate is a good diversifier, it's not essential for your overall financial health. If you want decent income over time, however, and you're willing to take some lumps over the next few months, a real estate fund might give you some concrete returns over time.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. His book, Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is Twitter: