The party's over for REIT funds. Now what?

(Money Magazine) -- Subprime lenders are tanking. Home-builder profits are evaporating. The typical real estate mutual fund, which delivered superb gains over the past six years, fell nearly 6 percent in the past three months.

Face it - the stocks of home builders aren't going anywhere (except maybe down some more). And share prices of real estate investment trusts, which can own all sorts of properties, seem to have peaked.

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So does that mean it's time to bail? Or is this when you want to make a big contrarian bet on a housing rebound?

The quick answers are no and no. But that doesn't mean you should do nothing.

If you've loaded up on real estate funds over the past few years and you haven't cut back already, get going. They shouldn't be more than 10 percent of your portfolio.

As for playing an eventual housing resurgence, it's not a bad idea - but only if you're investing money that you won't need for years.

Warns Scott Simon, head of mortgage-backed securities at PIMCO: "Given the huge oversupply of homes and tightening credit standards for borrowers, real estate will underperform fixed-income assets and inflation for the next three to five years."

Whether or not Simon's timing is spot on, there's no question the housing headwinds are stiff. Here's the tack to take:

"These stocks have become too pricey," says Chris Cordaro, an adviser in Chatham, N.J. After a huge run-up in price, the average yield on REIT stocks has fallen from nearly 6 percent in 2003 to just 3.7 percent in May.

If you've owned REIT funds for several years and haven't rebalanced regularly, you're way beyond your original target. So cut back even if you have to take a capital-gains tax hit.

Unlike domestic REITs, foreign real estate equities still have room to rise as fast-growing economies push up property values overseas, says Pittsburgh financial adviser Lou Stanasolovich.

To take advantage, move no more than half your REIT money into a fund that buys both U.S. and overseas stocks, such as Third Avenue Real Estate Value (Charts), a Money 70 pick with a large foreign stake.

Where most fund managers see disaster, contrarian investors see opportunity. Money 70 managers Ron Muhlenkamp of Muhlenkamp (Charts) and Wally Weitz of Weitz Hickory (Charts) both amassed large stakes in mortgage finance stocks last year.

The industry worsened, and the funds' returns have suffered. But the managers are prepared to wait, even for years, until Wall Street sees things their way.

These funds often follow a lousy year with chart-topping results. If you're patient, stash 5 percent of your portfolio with Muhlenkamp and Weitz.

Most core bond funds invest in top-quality issues that are unlikely to be damaged by the subprime mess.

Even funds with large stakes in mortgage-backed securities, such as bond index funds or intermediate government funds, mainly hold issues backed by agencies such as Freddie Mac and Fannie Mae, which have little credit risk. (To find the credit ratings for your bond fund's portfolio, check its Web site.)

And keep up your bond fund allocation. If the housing slowdown ends up hurting economic growth, a top-quality bond fund will offer great shelter.