If you look around your neighborhood or the area where you work, you've probably noticed some vacant office buildings and empty windows. But what you may not have seen is commercial real estate's latest rally—at least on Wall Street. Real estate funds, which primarily invest in real estate investment trusts (REITs), are the best-performing fund asset class so far this year. Year-to-date, real estate funds are up about 18 percent, and over the past year they've gained 46 percent, according to Morningstar. Is there still room for REITs to run? It depends on who you ask.
A REIT owns a collection of commercial real estate properties, all with tenants who pay rent. REITs are not required to pay corporate income taxes, but they must pay out 90 percent of their net income as dividends to shareholders. This means REIT funds generally have fairly high yields.
REITs are currently offering a higher yield than more traditional income investments, says Morningstar analyst John Coumarianos. "I guess people are so exasperated with earning nothing on money market [funds], so they're opting for the 2 to 3 percent [yield] that they're getting on a REIT fund," he says.
Although real estate funds have had a good run, Coumarianos believes that now isn't a good time for investors to jump into them. He believes investors have piled into REIT funds because of their attractive yields, but they don't understand the risks associated with investing in real estate. "You're just not getting a lot in return for what you're paying for REITs right now," Coumarianos says.
Marc Halle, managing director for Prudential Real Estate Investors and manager of the Prudential Global Real Estate fund, says he believes the outlook for the commercial real estate sector looks fairly optimistic over the next two to five years. "The fundamental concern is: Can we maintain some growth in the U.S. economy—around 2.5 to 3 percent growth—and can we create some jobs?" he says. "If we do, there is an enormous pent-up demand for real estate."
Halle says REITs should experience earnings growth over the next year or two, and sees properties with shorter lease durations, like hotels, recovering first, followed by those with longer lease durations, like retail and office buildings. "As fundamentals improve, those dividend yields are actually going to improve," he says. (If their income soars, REITs must offer more dividends to stay in line with regulations). He believes some individual REITs could see double-digit yield increases.
Halle acknowledges that a 50 percent return over the past year is quite a rally, but says, "REITs still trade at a 45 percent discount to their peak levels. We've recovered pretty dramatically from the bottom, but there's still a long way to go."
Brad Sorensen, director of market and sector analysis for the Schwab Center for Financial Research, says the REIT rally isn't over, but the days of double-digit returns are.
After the subprime mortgage crisis, all types of real estate investments were punished. Many experts thought that commercial real estate would be the next big bust. "The headlines were all so bad with the housing market," Sorensen says. "REITs don't have a ton to do with the housing market, and expectations there were so depressed. The reality has been better than expected."
Sorensen isn't suggesting that there will be any major REIT selloff in the near future. "We think a lot of the reality is matched up with expectations now, so we see a more modest [return] in line with market returns going forward," he says. He believes investors should expect low single-digit returns annually instead of the double-digit returns that the category has posted over the last year or so.
Corrected on 08/05/10: An earlier version of this article misspelled the name of Brad Sorensen.