Real-estate funds look cheap now

By Tim Middleton

With equity markets foundering, the long-suffering commercial-real-estate sector lately has shown the barest glimmer of strength.

Since Dec. 19, when I closed the books for 2007 on my model portfolio of exchange-traded funds, the portfolio has sagged 5.6%. But iShares Cohen & Steers Realty Majors (ICF, news, msgs), the real-estate ETF I hold in that portfolio, is down only 1.4%.

That ETF tracks an index of real-estate investment trusts, or REITs, which allow one to invest in property without owning land. They've inspired some hope lately despite the real-estate slump, but is that hope well-founded?

Barry Vinocur, the editor of REIT Zone Publications, sent his subscribers a bulletin Feb. 1 headlined "Have REITs Turned the Corner?" Vanguard REIT ETF (VNQ, news, msgs), which tracks the most widely followed index in the sector, closed at $63.47 that day, up from $55.08 on Jan. 18.

Since then, however, it has turned down again, to $59.57 as of Feb. 12. Vinocur now says ruefully: "In bear markets you do get rallies, and they can be head fakes. A lot of buy-side vets think Jan. 18 is going to be the low. Unfortunately, I know that market tops and bottoms are only called in hindsight except by fools and liars."

And real-estate investment trusts had rocketed ahead so much in recent years that even their current bear market may not have let out all the hot air. Since peaking one year ago and through Feb. 11, the MSCI U.S. REIT Index ($RMZ.X) -- the Vanguard fund's benchmark -- is down 33.8%. But at that peak, it was up 180% since the start of 2000.

Now, I have no idea whether we've reached a bottom in real estate. But I do know that when securities are on sale for one-third off, they're a lot more attractive than they were at full price. I'm probably early, but I intend to start adding to my REIT holdings in coming weeks.

For one thing, as their prices have fallen, yields have gotten richer. The yield on the MSCI REIT index is currently 5.3%. That's a dividend you get paid just for owning the fund, and it's better than most bank accounts.

Tough times remain

REIT fundamentals remain clouded by the general economic malaise. Landlords don't raise the rents in a recession; indeed, they're willing to make concessions to keep the tenants they have. When employment growth contracts, let alone turns negative, demand for commercial square footage shrinks.

The credit crunch is no friend to a credit-hungry sector either. Privatization deals, which helped fuel the sector's growth in 2006, have evaporated. The biggest of these, Blackstone Group's (BX, news, msgs) acquisition of Equity Office Properties, coincided with the peak of the market one year ago.

"The lack of credit takes the wind out of the sails of REITs," Vinocur says. "It's tough to get a handle on what real estate is really worth."

And the technical attributes of real-estate stocks remain ugly.

Vanguard REIT ETF has tried to rally six times since Oct. 5, when it crested at $76.69. Each time, it has reached a lower high and a lower low. Most recently, on Christmas Eve, it struggled ahead to $64.38, only to collapse by Jan. 18 to $55.08. This month, the recovery that followed that decline has stalled.

Is this a bottom?

Well, I'm no better at calling bottoms than Vinocur -- or than Bernard Baruch, whom Vinocur was quoting with his comment on liars and fools. REIT funds are yielding more than cash, and they're not making any more of the sector's raw material, land.

What's worth a buy

That raises the issue of which REIT funds to buy, and I have some suggestions.

First, forget the Vanguard REIT ETF. I love Vanguard and its low costs, but the iShares ETF performs much better. The index it follows was created by Cohen & Steers, the best REIT money managers, to represent the cream of the market, not the average. Over the five years ending Feb. 12, it delivered average annual returns of 19.2%.

Nearly as good is T. Rowe Price Real Estate (TRREX, news, msgs), which Morningstar praises as an "Analyst Pick" and which returned 19% annually in that period.

Writes Morningstar analyst Andrew Gogerty: "Manager David Lee . . . emphasizes steadier REITs with proven capabilities, and that profile, paired with his experience and the fund's low costs, makes this fund an easy choice."

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The Vanguard ETF hasn't been around five years, but its mutual-fund equivalent, Vanguard REIT Index (VGSIX), advanced an average of 17.8% in each of the same five years.

I'm probably too early in bulking up on real estate, but you never know. Meanwhile, it's a lovely asset class, with lusher dividends than fixed-income securities and a very low -- 30% to 40% -- correlation to equities. That means when your stocks are generally going down, your REITs may very well be making money.

I'm going to bring it back up to 5% of my total investment assets. And if it continues to go down, I'll continue bringing it up.

At the time of publication, Tim Middleton owned shares of the following securities mentioned in this article: iShares Cohen & Steers Realty Majors and T. Rowe Price Real Estate.