Real Estate Funds Still Belong in Long-Term Portfolios

"I do not believe the public understands how much potential risk lies in the valuation of these securities," says Brad Stark, a co-founder of Mission Wealth Management in Santa Barbara, Calif.

But experts agree that investors who base their decisions on the current bad news are setting themselves up for disappointment. New Century aside, the U.S. real estate market is a sprawling $436 billion behemoth, with publicly traded real estate investment trusts — vehicles that allow companies to avoid taxation as long as they pass along their profits to shareholders in the form of a dividend payment — specializing in a range of property investments, from residential to commercial and office space. Globally, the capitalization of real estate securities is probably three times that size, according to Cohen & Steers, the well-respected investment shop. Sure, after a five-year run, some of these funds are cooling off in a spectacularly short time span. Wise shareholders hopefully already trimmed their exposure and took profits when times were good. But to bail on the whole sector is a mistake.

For this week's fund screen we went looking for real estate funds that have performed well regardless of any short-term trend. Remember, even though real estate funds don't get the attention that large-cap or index funds do, they are nevertheless an important long-term holding of any well-diversified portfolio. And since real estate doesn't have a high correlation with equities this holding will help generate returns when the stock market is flat. We suggest putting 5% to 10% of your retirement account in a fund that invests across the real estate spectrum. (This is down from our 15% recommendation in earlier stories.) We would also advise finding a fund that has a seasoned manager at the helm. After all, you want to place your bet on somebody who has weathered a market down turn in the past.

Real estate investors should be satisfied with the run they have had till now. During the last month the category is down 0.9%. But Lipper says over the trailing three- and five-year time periods real estate funds have chalked up average annual returns of around 21%. The only domestic fund categories that came close to eclipsing those gains were gold and energy. Investors chased that performance, sinking $38 billion into some of the industry's largest real estate funds over the last five years.

The question now is whether real estate has hit bottom. Although many home builders thought a recovery would come early this year, recent single-family housing data suggest declining sales may continue for many more months. According to A.G. Edwards, there are about 200,000 excess homes on the market. BB& T Capital Markets expects Toll Brothers, a bellwether in the industry, to turn in earnings of $1.51 a share this year, down from $4.17 last year.

While some good fund managers believe home builders are cheap — click here to see who they are — bad news for one sector could mean an uptick for others. Many REITs don't have big exposure to the residential real estate market. And while it could be the perfect time to scoop up a home on the cheap — if you can afford it — many prospective buyers who are rethinking their decision to take out a mortgage could choose to rent instead. That could bode well for REITs that buy apartment complexes. Similarly, the economy still seems to be in decent condition and many corporations are carrying record levels of cash on their books. Those details work in favor of commercial and office space REITs.

In addition, the rest of the world is starting to embrace real estate investing. In just the last seven years countries like Britain, Hong Kong, Japan, Taiwan, France and Israel have created REIT-like structures. Another 11 are considering making similar moves, says Cohen & Steers. This hasn't gone unnoticed in the mutual-fund world. Just last month Dimensional Fund Advisors launched an international real estate fund. In December State Street started offering the SPDR Dow Jones Wilshire International Real Estate (RWX) exchange-traded fund, which has 70% of its assets in Australia, Japan, Britain, Canada and Singapore. It also invests in everything from malls and office space to strip shopping and industrial centers. "About two years ago I started in the international space because valuations here were getting high," says Elliot Herman, a partner with PRW Associates in Quincy, Mass. "Overseas opportunities were looking better." We suggest putting a small percentage of your overall real estate holdings into an international offering.

Fans of Cohen & Steers Realty (CSRSX), one of the best real estate mutual funds on the market, will be disappointed to see that it didn't make our cut. Why? It requires a $10,000 minimum investment, double the amount we like to see. (Still, if you have that much to invest, this is a great choice.)

One fund that did make it was Fidelity Real Estate Investment (FRESX), run by manager Steve Buller since 1998. Buller and his four analysts look for investments with strong earnings and cash flow growth coupled with good management. One of his largest holdings is Vornado Realty Trust (VNO), which owns 20.4 million square feet of space in 44 properties in New York City in addition to another 18 million square feet in Washington, D.C. The company also owns various retail centers and strip malls. It has made a name for itself by buying properties on the cheap and redeveloping them. It has one of the highest occupancy rates in the industry. Buller's $9 billion fund charges a cheap 0.82% annual expense ratio. The Fidelity fund has also returned an average annual 15% a year over the last decade, almost two percentage points better than the category average. We wouldn't put a "for sale" sign on a fund like that.