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.

S&P REIT analyst Robert McMillan likes high-end shopping-mall REITs, which sound like an economically sensitive sector if there ever was one. He argues that retailers sign long-term leases and tend not to shutter stores lightly. His favorite: Simon Property Group (SPG), a widely diversified retail REIT.

For most people, a real estate mutual fund is the best way to invest in real estate securities. But there's a surprising amount of variety in real estate funds. For example, CGM Realty fund, run by star manager G. Kenneth Heebner, has rocketed to a 325% gain the past five years. In large part, that's because Heebner defines real estate very broadly, including companies with very large land holdings.

When stocks of home builders were soaring, Heebner loaded up on them, nimbly moving out before they collapsed. Currently, the fund has a big interest in raw materials. CGM Realty's largest holding in December, the latest data available, was the Mosaic Company, which makes fertilizer. In fact, its four largest holdings, accounting for 44% of the fund's assets, are industrial materials companies.

Morningstar classifies Pimco Real Estate Real Return as a real estate fund, although it invests in complex derivatives that match the Dow Jones Wilshire REIT Index. The rest of the fund's assets go to inflation-indexed bonds and other bonds.

If you're thinking about wading into REITs or real estate funds, take your time. If the economy slows dramatically, REITs will hit your portfolio like a ton of bricks. But if you start adding to real estate securities now — and reinvest the dividends — you could have concrete returns when the economy recovers.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is