Investors pouring cash into real estate funds

NEW YORK -- Investors seeking alternatives to low-paying money market funds and bonds have been pouring money into real estate funds, which offer a fatter payout. While advisers say the investments offer long-term promise, they caution that real estate shares aren't without substantial risks and might be overpriced.

Real estate funds are often called REIT funds because they primarily invest in shares of real estate investment trusts, companies that develop and manage properties. Properties in REIT funds can include apartments and office complexes, hospitals and malls.

Many experts expected a decline in REIT shares after President Bush in May signed into law a dividend tax cut which excludes REITs. While taxes on most dividends are reduced to 15 percent, investors still must pay tax rates as high as 35 percent on their REIT income.

52-week high

But investors continue to snap up real estate shares, pushing inflows to $1.7 billion in the first half of this year, according to AMG Data Services. That figure is down from $2.7 billion during the same time last year, but remains on pace to match all of 2002's inflow of $3.4 billion, the highest level since 1997.

In addition, the Morgan Stanley REIT index hit a 52-week high Monday, and is currently up about 18 percent since the beginning of 2003, compared to a gain in the Standard & Poor's 500 stock index of about 14 percent.

"The interest is being driven by income-hungry investors. People have seen the yield on their bonds and money market funds come down and the prospects for continued gains have people looking to other sources," said Dan McNeela, an analyst with fund tracker Morningstar Inc.

But he added, "REITs are not good alternatives to money market funds because ... the REIT sector is much more volatile in comparison. Investors have to be willing to take some risks to enter into a real estate fund, even though a high dividend yield is available."

Indeed, REIT dividends currently yield about 6.4 percent, three times that of the typical S&P 500 stock's yield on an after-tax basis, making them attractive investments despite the tax cut, according to the National Association of Real Estate Investment Trusts. Money market yields, meanwhile, are hovering near zero and the benchmark 10-year Treasury note is less than 4 percent.

Real estate funds also have been one of the few bright spots during the three-year bear market, returning about 4 percent last year while most others posted losses.

"This is part of a long-term adjustment process. People are looking at the investment in a new light. They see it as offering high income and stable dividend yields," said Michael Grupe, NAREIT's senior vice president of research and investment affairs.

'They're very overpriced'

But advisers caution that jumping into REITs now, when prices appear to be at a peak, might be ill-advised. While REITs are typically strong performers in an economic downturn, they tend to lag the overall market by 6 to 18 months in an economic recovery.

"I wouldn't be rushing into them. They're very overpriced," said David Shulman, senior REIT analyst at Lehman Brothers.

He notes that office vacancies remain quite high, while many apartment buildings are empty as prospective tenants take advantage of low interest rates and buy homes instead.

Shopping malls continue to show good growth due to strong consumer spending, but their shares now may be overvalued, Shulman said.

"REITs are trading 115 to 120 percent of net asset value," he said. "Most every stock is trading above their price target."

Many advisers suggest investors consider devoting 5 percent to 10 percent of their portfolios to real estate funds, with a strategy of holding for the longer term. If investors are concerned about stocks being overpriced, a dollar-cost averaging approach of buying fixed dollar amounts each month or quarter could help minimize risk, they said.

Morningstar's McNeela likes funds such as Third Avenue Real Estate Value, which strives to find underpriced properties although it doesn't pay a high dividend. Investors looking for more income might prefer Security Capital U.S. Real Estate, which isn't afraid to make big sector bets with often good results, he said.

"REITs make a good case for a majority of investors as a good diversifier in both the stock and bond market," McNeela said. "There are some good long-term trends in the real estate industry, and investors can look to take advantage of that."

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On the Net

www.amgdata.com

www.lehman.com

www.morningstar.com

www.nareit.com