REITs Are Looking Up

Even though real estate itself remains a taboo phrase in the investment community, real estate investment trusts continue to do quite nicely, thank you.

Of course REITs aren't quite the same as going out and buying a property yourself and hoping the value grows. Instead, they use pooled investor money to manage income-generating property and mortgages. 

And returns have continued to come along well, despite the problems in the overall real estate industry. REITs benefitted greatly during the real estate boom of recent years, as well as the Federal Reserve's aggressive interest rate-cutting over the past six months.

The Morgan Stanley REIT Index, while down 4.17 percent so far this year, has still outperfomrmed many of the major stock indices. In the past three years, the REIT index has a return of 8.9 percent, compared to 3.4 percent for the Standard & Poor's 500 index and 4.44 percent for the Dow Jones Industrial Average.

"REITs are a wonderful asset class to have in a portfolio because their long-term returns are the highest of the major asset classes if you go back to their origination in 1962," says John Merrill, chief investment officer at Tanglewood Capital Management in Houston. "Yet they have a more modest risk. From a risk-return standpoint they've just been an outstanding asset class."

Part of what makes REITs so attractive is indeed, as Merrill notes, the low level of risk they offer because of their diversified makeup in what has become a volatile real estate market. Another reason, though, is that while residential real estate prices have slumped on a national level, the commercial side continues to thrive.

In particular, REIT's weighted with apartment building holdings are doing especially well as more and more people opt to rent than buy while real estate prices fall.

"Given that people still can't afford to buy and the real estate market is basically on hold, people are going to rent and wait it out," says Michael Cohn, of Atlantis Asset Management. "That bodes very well for the apartment REITs."

Not everyone, hoever, is sold on REITs. Chris Mayer, managing editor at Capital & Crisis, warns of yields that are gravitating towards those paid by lower-risk Treasury notes and believes companies like Brookfield Asset Management are better in this climate because they are guaranteed a return in fees for the assets they manage.

Many analysts remain bullish about REITs, despite signs of a softening commercial real estate market

Apartments, Offices in Vogue

Cohn recommends Apartment Investment Management and Colonial Properties , two apartment building-oriented REITs that could be undervalued. Colonial has bounced off its 12-month low hit in early January and gained 21 percent since then.

"What you have to do is to be selective in the market," he says. "I would stay away from things like the mall REITs and the ones that are dependent on consumer spending."

Mike Watts, senior vice president at JF McKinney, is looking at office REITs now, and advocates a geographically diverse strategy. "My thoughts are that REITs are a good investment vehicle, but they're not passive vehicles," says Watts.

Most analysts favor long-term investments rather than shuffling money in an out as the market vacillates. Like the broader stock market, REIT analysts also endorse larger-cap funds with stability.

That means companies like ProLogis , AMB Property and Boston Properties outside the residential space, and apartment REITs like BRE Properties and Avalon Bay , according to Anatole Pevnen, editor of REITcafe.com.

Pevnen's site compiles a volatility index that shows REITs have had a higher volatility level than stocks over recent weeks, which translates to risks for buyers looking only at the short term.

"When you look at REITs the timing is very important. If your investment horizon is the next three to six months it's questionable as to whether now is a good time," Pevnen said. "If your investment horizon is five to ten years there's usually not a bad time. You have to look at where you are in that time span."

Mayer's strategy is to play it safer with the asset managers, and he lists Jones Lang LaSalle and Brookfield Asset Management as his favorites.

He also dislikes REITs because of the high dividends they must pay to investors -- 90 percent of taxable profits.

"They have to continue to go back to the market and raise capital because they have to pay out most of their dividends," Mayer said. "It's not a good time to have to raise capital."

© 2009 CNBC.com