Real estate funds lead the pack, but can it last?

The housing market might be coming back, with home prices rising and mortgage rates at record lows. But there's greater strength in commercial real estate. Check out the recent investment returns of stock mutual funds that specialize in companies owning income-producing property, from office buildings to hotels.

Real estate funds have posted an average annualized return of 33 percent over the past three years, according to Morningstar. That's the top performance among the fund categories it tracks. Year-to-date, the funds are up nearly 17 percent. That's about double the average return for diversified stock funds.

What's more, the stocks that these funds invest in — known as real estate investment trusts, or REITs — are required to distribute at least 90 percent of their taxable income to shareholders in order to escape corporate taxes.

The average dividend yield of a benchmark REIT index is 3.2 percent, compared with the 2.1 percent yield of the Standard & Poor's 500 index.

Real estate funds and REIT stocks have defied the broader trends in the market and the economy recently, said Rob Wherry, a Morningstar analyst who tracks real estate funds. But investors should be cautious about making sizable investments in REITs, given the outlook for slow economic growth.

REIT stocks have performed better than the S&P 500 in recent years because the decline in commercial real estate wasn't as severe as the residential market crash.

The outlook remains favorable, with commercial occupancy climbing and rents increasing in most markets, said Jason Yablon, who oversees REIT investments both in the U.S. and overseas and co-manages the Cohen & Steers Emerging Markets Real Estate Fund (APFAX).

Yablon expects that commercial property companies will post earnings growth in the high single digits in percentage terms this year. "That's strong against this backdrop of slow growth for the overall economy," he said.

Despite the strong outlook, REITs face risks from the European debt crisis and the looming congressional battle over cutting the U.S. debt burden.

If a government bond default appears probable in Spain or Italy, U.S. banks could further tighten lending. REITs would have a harder time raising cash from banks and through the stock market to finance new projects. With interest rates low, their borrowing costs are modest.

Any failure by Congress and the president to reach a long-term debt deal after the November election could trigger automatic budget cuts so severe that they could drag the economy into recession. A shrinking economy would hurt REITs, which depend on a healthy job market to maintain a flow of income from office and industrial properties.

Source: http://www.statesman.com/business/real-estate/real-estate-funds-lead-the-pack-but-can-2420584.html