The real estate sector is being pegged as a pullback candidate, but that hasn't stopped new money from pouring into these funds.

Real estate mutual funds have quietly built a strong track record, having outpaced all domestic equity funds over the past five years with a 10.12% return, according to Chicago-based fund tracker Morningstar. On a three-year basis, they've posted an average return of 11.12%, besting all other stock fund groups with the exception of bear market funds.

During the tech boom of the late 90s, real estate really did not perform well because they were capital-starved. When the dot-coms collapsed, however, the fundamentals came through, and the sector really took off. They benefited from a shift from growth to value, and in 2002, investors poured a record-high $3.4 billion into real estate funds. So far this year, they have maintained that hot streak with an 18.11% gain, which ranks third best in the domestic equity category. REITs garnered $315 million in assets in June, ending a seven-month streak of accelerated inflows. Although that number was down from the $440 million they took in during May, it still managed to top inflows for technology funds, which took in $275 million in June.

As new money continues to come in, some analysts are concerned that investors are getting in at the wrong time. The fundamentals at the property level are bad, while the fundamentals in the broader economy are improving.

Yield Junkies'

"The group is very overpriced," said David Schulman, a real estate analyst at Lehman Brothers of New York. "We're sort of scratching our heads as to why they're doing so well. Our only explanation is that people have become yield junkies looking for stocks that deliver good returns, with the average REIT delivering a 6.3% return."

Schulman maintains a negative rating on the sector and anticipates a meaningful pullback in prices. If real estate stocks went down 15% to 20% from current levels, it would not be surprising, he said.

Previously, Prudential Securities analyst James Sullivan downgraded the REIT sector to market underperform from market perform, citing valuation concerns. "Unless we receive stronger evidence of a rebound in earnings expectations, we would expect REIT share prices to decline over the second half of this year, Sullivan wrote in a client note.

Another concern is that the Bush administration's new tax bill will make REIT dividends less attractive by lowering income taxes on non-REIT dividends to 15%, while REIT investors must continue to pay as much as 35% on theirs. But given REITs' high dividend yields, ranging up to 9% in some cases, the tax bill has not had a significant impact. Dividend yields have been a key catalyst in luring investors into the REIT sector, as disheartened investors sought refuge during this stormy economic period.

Patrice Derrington, manager of the $31 million Victory Capital Real Estate Fund, is optimistic that real estate will continue to do well. "Real estate is actually leveraged to take advantage of the emerging rebound in the economy," she said. She also believes that contractual rent flows provide good visibility. These factors, combined with relatively constraint supply, are enough to justify current stock price valuations, she said.

Currently, she sees value in the beaten-up hotel industry. Specifically, she has recently bought shares of Hotels Four Seasons, Host Marriott and Starwood. The three hotel chains comprise roughly 8% to 9% of the portfolio.

Sam Lieber, chief executive officer and portfolio manager at Alpine Woods Investments, said that REITs are still undervalued and that there are opportunities in the shopping center, apartment and retail groups. Lieber believes that the U.S. economy will recover very slowly and that interest rates will remain low. He also anticipates there will be a few IPOs over the next 12 to 18 months and there will continue to be opportunities for companies to raise additional capital.

Continued low interest rates, combined with a sluggish economy going forward, would make REITs still look good relative to other investments. The benchmark 10-year Treasury note, often used as a comparison because average REIT leases tend to last 10 years, was trading at a yield of 3.10% on June 13. That sent the "yield junkies" flocking to REITs. In recent weeks, however, the 10-year yield has soared to 4.29%, likely to prompt investors to move cash away from real estate to more high-risk sectors such as technology.

Lieber concedes that REITs' operating income has taken a substantial hit but said that a number of companies have been able to compensate for that by refinancing their debt, keeping their cost of capital low, and consolidating their operations. This enables them to maintain their bottom line even though their top line is shrinking due to vacancies or lower rents. Lieber's $54 million Alpine Realty Estate Equity Fund is up 38% year-to-date.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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