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Real estate funds no longer living on Easy Street

Leslie Kramer, Special to
Contractors work on a KB Home under construction at the Vicino community in San Jose, Calif.
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Real estate markets have enjoyed quite a comeback since the crisis, and mutual funds that invest in real estate investment trusts (REITs) and other real estate–related stocks have taken advantage. The bargain-basement prices that resulted from the real estate bubble bursting have produced stellar returns for fund managers.

In 2008 the U.S. real estate mutual fund category was down nearly 40 percent, but it came roaring back, up 31 percent the very next year, according to Morningstar data. In 2012 returns were at a still-impressive 18 percent, but 2013 has been striking for another reason: performance that raises the question, Is time running out on the real estate fund rally?

Real estate funds have returned just under 8 percent year-to-date through the end of October. "Prior to 2013, REITs had been among the best-performing categories in the public markets," said Mitch Roschelle, real estate advisory leader at PwC.

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Strong demand for dividend stocks led investors into REITs coming out from the crisis—they are required to distribute at least 90 percent of their taxable income to investors through dividend payments. REIT stock prices rode a rising rent tide and improving fundamentals. "There was a large but slow and steady run up in REIT stocks from 2009 through 2012," Roschelle said, and that continued until 2013.

As the Federal Reserve began talks of tapering its bond buying, the same interest-rate fears that rocked fixed-income funds caused investors to dial down their REIT enthusiasm. During the last three quarters, declines in REITs have been common and asset inflows reversed from more than $1 billion per month to outflows in the hundreds of millions.

The current reprieve from the threat of immediate Fed action, though, may have provided investors that missed out on the initial real estate rebound another chance to chase yield. Outflows from real estate mutual funds decreased from more than $450 million in August to just over $43 million by the end of September.

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David Kathman, senior fund analyst at Morningstar, warned against looking too closely at short-term returns. Instead, he recommends looking at real estate mutual funds as diversifiers. "Real estate funds should be a part of your portfolio that you keep in there to diversify your holdings against inflation and market gyrations because REITs tend to behave differently than other stocks in the S&P," Kathman said.

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For some financial advisors, that's not enough to keep them from moving client money out of REIT funds, while keeping exposure to real estate through private partnerships. Jeff Leventhal, managing director and partner at Hightower Advisor, began investing in REITs for his clients in 2009 (after having sold off the asset class in late 2007). This past summer he pulled clients' money back out.

Leventhal said returns on REITS over the last five years have been stellar, but the environment is changing. "REITs are good at certain periods of time, but now in the investment cycle is not the time," he said, adding that when "interest rates are staying steady or falling, there are some benefits to REITs, but it's our view that interest rates are going up over the next three to five years, so it's not a great place to be." He prefers to invest 5 to 15 percent of client assets in private real estate partnerships due to the tax advantages they offer to high-net-worth individuals.

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Paul Tramontano, co-CEO of Constellation Wealth Advisors, is also investing in partnerships that allow direct access to multifamily apartment units. "We wanted a pure-play on apartment real estate, because we thought that was the way to get the most earnable income stream from our real estate investments," he said. But he isn't sour on REITs, specifically; rather, he sees them as a second-best way to generate real estate returns right now. For investors who don't have access to direct investments, Tramontano still recommends investing in real estate mutual funds or REITs.

"There is still time for investors to take advantage of the real estate recovery," Tramontano said. "We are in the middle of a turnaround in the multifamily real estate market. When the credit bubble burst, prices got silly and very attractive, and although prices have rebounded, we believe market fundamentals support strong investment opportunity for many years," he said.

Jeffrey Kolitch, portfolio manager of the No. 1–ranked Morningstar real estate fund year-to-date, the Baron Real Estate Institutional Fund—which has returned 20 percent this year, said many of the key conditions that are supportive to real estate are in place. Those conditions include improving demand for both commercial and residential real estate—due to rising occupancies and rents, limited construction activity and supply, improving credit conditions for commercial and residential properties and, even if rising, low interest rates. "Real estate performs well when those ingredients are all in place. We are in the midst of a multiyear real estate recovery with a promising outlook," he said.

Maybe the party on Easy Street isn't over, though it has slowed.

By Leslie Kramer, Special to