Expect Less from Real Estate Stock Funds

- Alan Lavine and Gail Liberman

Don't bet the ranch on these mutual funds, which primarily invest in office, industrial, retail and apartment rental properties. The real estate market is softening nationwide.

Over the past three years ending in February 2003, the average real estate stock fund grew at a 13.34 percent annual rate. By contrast, the average domestic stock fund registered an annualized loss of -13.68 percent, according to Morningstar Inc., Chicago. This year to date ending in March, real estate stocks funds are up 3 percent.

Real estate stock funds are continuing to perform well. But how long will the string of positive returns continue? Although the real estate market is strong, it faces a number of risks if the economy does not improve. Morningstar analyst Dan McNeela does not expect real estate stock funds to do as well in 2003 as they have over the past few years--particularly if the economy doesn't improve.

"Office REITs continue to suffer from increasing vacancies and lower lease rates," McNeela says. "Apartment REITS face stiff competition from the housing market due to low mortgage rates. People are buying homes instead of rentals. The hotel sector looks volatile and vulnerable. Regional malls and shopping centers could face problems if consumer spending slows."

Richard Imperiale, manager of the Forward Uniplan Real Estate Investment Fund, Milwaukee, Wis., agrees that there are more risks in the REIT sector compared with a couple of years ago. His analysis shows real estate stocks in a worst-case and best-case scenario could return between 9 percent and 18 percent respectively over the next year.

"Demand across most real estate categories is subdued as a result of a slow economic environment," he said. "This makes it more difficult for REITs to grow their rental revenues and expand their properties."

Leo Wells, president of the Wells Real Estate Funds, Atlanta, says not all office and apartment rentals are having problems. The strongest REITs, for example, are not leveraged and have high-quality tenants that carry investment-grade bond ratings.

Wells said he is raising over $2.5 billion this year in office and industrial rentals with Fortune 500 tenants because there is a strong demand for REITs and real estate limited partnerships.

He also is seeing strong cash flow into his S&P Real Estate Index Fund. Financial advisers are putting about 2 percent of their clients' assets into the fund. But he expects them to increase that percentage to five percent or more.

Keeping a small percentage of your investments in real estate stocks can actively boost your return and reduce your risk on the down side. Research by Ibbotson Associates, Chicago, shows that from 1972 to 2000, a basket of investments that contained real estate stocks outperformed one that did not. Plus the basket that held real estate was 25 percent less volatile.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).