The debate over the housing bubble aside, real estate funds are one of the few bright spots in the mutual fund industry.

Over the past three years ending in February, the average real estate stock fund returned an average 13.34%, while the average domestic stock fund registered an annualized loss of 13.68%, according to Morningstar, Chicago. This year to date ending in March, real estate stocks funds are up 3%.

"Money is flowing into real estate funds today because of high absolute returns and yields of 4% to 7%," said Morningstar analyst Dan McNeela. "Real estate as a distinct asset class has come of age." That has borne out in total assets in real estate funds, which have more than doubled from $8 billion at the beginning of the bear market in March 2000 to $16.4 billion at the end of February, according to Lipper, New York.

As real estate stock fund performance soared, more investment companies have launched funds. The number of funds has increased 35% from 125 at the end of 2000 to 169 today.

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. Registered reps have put 2% of client assets into the fund, but the amount is increasing.

47% of U.S. Wealth

"Real estate makes up 47% of U.S. wealth," Wells said, "but investors have almost 60% in equities." You are going to see a greater allocation to real estate stocks because financial advisers want more diversification. There is also good dividend being paid in the office and industrial sectors."

Research by Ibbotson Associates, Chicago, shows that REITs' low correlation to stocks and bonds is a key factor for diversification. Their research shows that REITs lower risk and raise returns on a portfolio of securities.

Ibbotson found that the correlations of REIT stock returns with returns of other common stocks declined significantly over 30 years. The correlation of REIT returns with stocks is .25, while long-term bonds have a .16 correlation to real estate stocks.

By combining assets that have low correlations with each other, investors can achieve high returns per unit of risk. A portfolio that included REITS registered a higher annual return with less risk as measured by the standard deviation. For example, Ibbotson's research shows that a portfolio that included 35% bonds, 45% stocks, 10% T-bills and 10% REITS grew at a 12% annual rate of return and had a 10% standard deviation from 1972 through 2000.

By contrast, a portfolio that consisted of 40% bonds, 50% stocks and 10% Treasury bills grew at an 11.8% annual rate with a standard deviation of 11.2%.

REITS, however, are not risk-free. During economic recessions, real estate, like other investments, may not perform well. Other times, investors shun real estate for investments with better earnings. For example, in 1998 and 1999, real estate stock funds lost nearly 20% each year.

Wells said financial advisers are using real estate stock funds instead of individual REITs because of their professional management and diversification.

"All REITS are not created equal," Wells said. "You have to look at what is inside the REIT and real estate funds. What is the quality of the tenants of the individual REITS? Is there leverage? Is the fund or individual REIT diversified by industry, tenants and expiration of leases?"

Real estate stock funds are continuing to perform well, up 3% through the first quarter of 2003. 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.

McNeela of Morningstar 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 said. "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 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 minus 9% and 18% 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."

Copyright 2003 Thomson Media Inc. All Rights Reserved.,

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