Real estate fund investors build house of rising returns

You've been mocked. You've been humiliated. You've been insulted.

If it's any comfort, lots of other people are trying to sell their homes, too.

But real estate mutual funds are faring surprisingly well in the worst real estate market in decades. One reason: Real estate funds invest in commercial properties, which march to a different drummer than the residential market. Will the commercial real estate rally continue? Probably — but it wouldn't hurt to move in slowly.

Real estate funds invest primarily in real estate investment trusts, or REITs — which, in turn, invest in apartments, offices, storage facilities and other commercial real estate. Real estate funds have gained an average 6% this year, vs. a 5.3% loss for the Standard & Poor's 500-stock index with dividends reinvested.

REITs have high dividend yields, which make them popular in uncertain markets — like, say, this one. The average REIT yields 5.17%, according to the National Association of Real Estate Investment Trusts, a trade organization. In contrast, 10-year Treasury notes yield 4.04%, and the S&P 500 yields just 2.01%.

Dividends help cushion your portfolio in market downturns. And REITs, by nature, are dividend machines. REITs must pay out at least 90% of their taxable income to investors through dividends.

Inflation fears help REITs, too. The consumer price index, the government's main gauge of inflation, has gained 3.9% for the 12 months through April. Food and energy prices have soared far more, raising fears of a burst of persistent inflation.

People tend to buy real estate, gold and other tangible assets when the value of paper money declines. "In the long term, physical property has offered a hedge against inflation," says Joe Rodriguez, lead manager of the AIM Global Real Estate fund.

Finally, REITs are also doing well because Wall Street hit them with a wrecking ball last year. The average REIT fund fell 14.7% in 2007, according to Morningstar, the mutual fund tracker. "The REITs' elastic band got stretched so far in one direction last year that there was nowhere to go but up," says Alec Young, strategist for S&P.

Apartment REITs have fared best this year. As banks have tightened their lending standards, more people have had to rent instead of buying their own home — and that helps apartment REITs. Continually falling home prices also spur rentals: People figure they can buy later at a lower price. And, with foreclosures going up, former homeowners have to rent. "They have to live somewhere," Rodriguez says.

Associated Estates Realty Corp. (ticker: AEC), is one of the top-performing REITs this year. The apartment REIT has soared 46% this year, including reinvested dividends. AEC's net rent rose 3.1% in the 12 months ended March, and 4.1% for its Midwest holdings.

The biggest problem with REITs is that they're economically sensitive — that is, they fare best when the economy is roaring, office buildings are filled, and shopping centers hum. Unfortunately, the economy is barely meowing at the moment, which is why Rodriguez likes health care REITs. "Whether the economy is anemic or boring, you still have to go to the doctor or the dentist," he says.

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