REITs still performing well

Analysts have been nervously writing yearend epitaphs for real estate for the last couple years, but the sector has kept outperforming the overall market. Despite worries that real estate funds are due for a breather after six strong years, smart investors are likely to hang on for the long haul.

Real estate stocks do not move in lockstep with the rest of the market, and that makes them good portfolio diversifiers, said Dan McNeela, senior analyst with fund-tracker Morningstar Inc. Another point in their favor, particularly relevant to investors looking for income, is that a significant portion of their total return comes from dividends.

It’s become common for investors to plunk 5 percent, 10 percent, or even more, of their equity portfolio in real estate funds. But rising valuations have led McNeela and other analysts to recommend cutting back to the lower end of that range, although industry fundamentals seem to be improving by some measures.

“We’re cautious, considering how well real estate funds have performed since the beginning of 2000,” McNeela said. “As much as some of the fundamentals look to be improving in real estate sub-sectors — for example, we’ve had sustained job growth, and that leads to greater demand for office and apartment space — we think price appreciation has largely outstripped the rate of change.”

Last year, the NAREIT Equity REIT Index, tracked by the National Association of Real Estate Investment Trusts, surged 12.2 percent, compared to a ho-hum 4.9 percent return for the Standard & Poor’s 500. That follows a period of strong gains that had analysts fretting about the sector’s outlook as early as two years ago, after REITs posted an astonishing 37 percent return for 2003. Concerns intensified as the economy picked up steam and the Federal Reserve tightened interest rates, but REITs surged 31 percent in 2004.

The same issues were cited at the beginning of 2005, and while their performance cooled in comparison to the previous two years, REITs still managed to outperform most segments of the market.

It’s easy to capture investors’ attention with these short-term numbers, said Michael Grupe, NAREIT’s vice president and director of research, but they do not reflect the whole story. In fact, REITs have outperformed the S&P 500 over the past 10-, 15- and 30-year periods, as well, albeit by a less dramatic margin — about 2 percentage points a year.

All of which underscores that “it’s very, very difficult to try to outguess what the market is going to do,” Grupe said. “The best strategy is to earn market returns and to diversify your portfolio. If you have 5 percent in real estate, fine. But you don’t want zero percent.”

When deciding how much to allocate and what to look for in a fund, it’s important to distance yourself from stories about overheated residential markets, McNeela said. A good real estate fund will offer broad geographic diversity and different property types, such as shopping malls, hotels and apartments.

While index and exchange traded REIT funds are attractively priced and may seem like reasonable choices, they have not performed as well as many actively managed funds, McNeela said.