Real estate funds work

NEW YORK – Real estate has been one of the stock market’s strongest sectors the past two years, leading to stellar returns for funds focused on this asset class. Some analysts think that performance may be coming to an end, but most agree real estate deserves a place in your portfolio for the long haul.

Real estate funds were up an average of 30 percent last year, but slipped nearly 6 percent during the first five weeks of 2005. While rising interest rates have raised concerns, few believe rates will climb high enough or fast enough to seriously damage the real estate industry. With yields on long bonds lagging, demand for real estate is likely to remain strong.

“If you’re over-weighted on real estate, I’d reduce it, but I wouldn’t get rid of it altogether,” said Don Cassidy, senior research analyst with fund tracker Lipper Inc. “Our scenario is neither a recession nor a super-hot economy with strongly rising interest rates. Something in the middle seems the more likely course. And in that kind of environment, real estate makes sense.”

There are essentially five ways to invest in real estate. You can buy investment property outright, and suffer all the responsibilities and headaches of being a landlord, or you can invest through securities – individual real estate investment trusts, REIT mutual funds or exchange traded funds, or REIT closed-end funds.

REITs, which are traded like stocks, pool the capital of many investors to purchase and manage income-producing properties such as apartments, hotels, office buildings and malls. Unlike actual real estate, REITs are highly liquid. You can sell anytime, and since they trade like stock, there’s no investment minimum as there would be with a mutual fund. In addition, REITs are required by law to pass at least 90 percent of their income back to investors in the form of dividends, making them very popular as the bond market has lagged.

The biggest problem with REITs is that it can be very difficult and expensive to build a portfolio that is diverse in terms of geography and property type. Mutual funds and exchange traded funds (ETFs) that invest in REITs can offer more diversity and less risk. The trade-off is that a portion of the dividend yield will go toward management fees. Closed-end funds that invest in real estate may offer a higher yield, but there are trade-offs there as well, including higher costs and risks associated with leverage.

If you don’t hold any real estate and are concerned about buying at the top of the market, you can dollar-cost-average through a mutual fund. But look closely at fund portfolios; most real estate mutual funds concentrate on REITs, but others branch into other types of stocks such as hotel chains and homebuilders, which can dilute your exposure.

A broader question is how much of your portfolio should be devoted to real estate in the first place, said Dan McNeela, a fund analyst with Morningstar Inc. First, consider real estate’s role in the overall equity market; there are about 150 publicly traded REIT stocks available, with a total market cap of just $275 billion. For most people, it doesn’t make sense to have real estate make up more than 5 percent to 10 percent of a portfolio.

“Real estate funds can suit a large audience of investors. They have a favorable risk-return trade-off over time, and that nice yield component helps make them very stable,” McNeela said. “It provides good diversification, and that makes it a good building block for a portfolio, as long as you remember real estate is very small segment of the overall market.”