Picking the sweet spot in real estate

By Amanda Gengler, Money magazine writer

(Money Magazine) -- First the housing market tanked, eventually sending home prices down 30% from their 2006 peak. Then came warnings that commercial real estate would be the next shoe to drop -- and that the problems could dwarf those in the residential market.

Lately the signs of distress have become starkly visible: Prices of commercial property such as apartment buildings, malls, and offices have fallen more than 40% over the past two years. Rents are down, and vacancies are at their highest levels in more than two decades. Meanwhile, the number of distressed-property sales is expected to rise over the next few years, keeping pressure on prices.

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If you're the adventurous type, that may have you wondering whether this is a good time to add real estate securities to your portfolio. After all, wise investors look for buying opportunities in troubled markets, moving in when the herd is running scared.

The only problem: This time the herd has gotten there ahead of you. While bottom fishing may be a smart strategy for buyers of physical property, the true bargains have already been snapped up in publicly traded real estate investment trusts, which are companies that own commercial property and trade on the exchanges like stocks. And there were plenty of deals to be had:

From 2007 through the beginning of 2009, prices of REITs got pummeled, dropping more than 70%. But since March -- when Money suggested putting 10% of your stock allocation into REITs -- they've shot up 100%, according to the FTSE NAREIT index, handily beating the 60%-plus gain in the S&P 500. Sure, REITs are still 45% below their pre-melt-down days. But you can't call them bargains anymore.

Does that mean you should ditch the idea of investing in real estate altogether? Absolutely not. While you can't count on continued mammoth gains in the near term, a small stake in REITs or the mutual funds that invest in them can provide other valuable portfolio benefits.

Chief among them: diversification and generous income. And if you pick them right, you still have a decent shot at solid price appreciation down the road. The following strategies will help you put real estate in its rightful place in your portfolio.

Stake a small claim for now

The recent stunning performance of REITs and real estate funds may seem baffling given the dismal state of the commercial property market. But the possibility of impending doom had already been factored into prices by early 2009; once doom turned to mere gloom, intrepid investors began moving in.

What changed? The REIT industry made an all-out effort to raise capital, more than $30 billion in all over the past year, by issuing new equity and debt. That eased concerns that some trusts did not have enough cash to survive the downturn and put many REITs in a good position to grab prime income-producing properties at fire-sale prices.

True, there may not be quite as many deals at rock-bottom prices as once believed; banks recently have begun working with some financially troubled property owners to extend their loans rather than force them into foreclosure. "There probably won't be the once-in-a-generation type of distress we thought there would be six months ago," says Michael Knott, a senior analyst at Green Street Advisors.

Still, there should be more than enough opportunities for REITs to profit from -- or so investors clearly believe, given the tear the shares have been on lately.

Coming in on the back end of a 100% advance is far from ideal. Yet most financial advisers suggest you should have a good 5% of your portfolio in real estate now. "You always should have some money in REITs because they are a great diversifier," says Chris Cordaro, a financial adviser in Morristown, N.J.

That's because, REIT prices often move in a different direction than stocks do. Plus, their hefty dividends -- REITs pay out nearly all of their rental income to shareholders -- can provide a much-needed cushion in a roller-coaster market. Average yield on equity REITs recently: 3.9%, vs. 2.4% for dividend-paying companies in the S&P 500 and 1.7% overall.

To avoid buying at or near a peak, invest in regular intervals over the next year or two until your allocation hits that 5% mark. Already own REITs or real estate funds? You may be overweighted. If so, gradually re-balance to bring your holdings back down to 5% of your total portfolio.

Focus on the cash kings

When it comes to investing in REITs, you basically have two choices: equity REITs, which own commercial properties, or mortgage REITs, which make or own loans. With so many potentially troubled mortgages still out there, equity REITs are the better bet now. The ones poised for the best gains in the long run are those in the strongest financial position to buy distressed properties as deals come up, with lots of cash on hand and access to more, says Jack Chee, an analyst at Litman/Gregory Asset Management.

Companies that fit this profile include Simon Property Group (SPG), which owns a large portfolio of high-quality retail spaces in North America, Europe, and Asia. Its tenants sign long-term leases, so Simon hasn't been hit as hard by falling rents and rising vacancies as other companies. Plus, Simon has raised nearly $4 billion in new capital that can be used for future purchases, says Craig Guttenplan, an analyst at the research firm CreditSights.

Other good options include Boston Properties (BXP), which focuses on premier office space in big cities and has raised $1.5 billion, and Realty Income (O), which also has plenty of capital to finance acquisitions.

Go for active management

Investing in individual REITs gives you the opportunity to zero in on a specific location or a particularly promising sector of the commercial market. But that kind of concentration can be risky. A safer way to add real estate to your portfolio is to buy shares in a mutual fund that invests in many different REITs and perhaps some real estate operating companies too. That way you spread your bets among different geographical areas and property types.

You can simply buy an index fund, such as the Vanguard REIT Index (VGSIX) or the Vanguard REIT ETF (VNQ). But analyst John Coumarianos of Morningstar believes it's smarter to go with an actively managed fund that can weed out shakier companies. Among his top picks: T. Rowe Price Real Estate (TRREX), a low-cost fund (expense ratio: 0.75% vs. 1.45% for the category) that focuses on companies with high-quality properties in prime locations.

If you're looking more for growth than income, focus on funds that favor traditional real estate operating companies over REITs. An excellent example: Third Avenue Real Estate Value (TVRVX), a global fund whose manager, Michael Winer, is an expert in investing in distressed properties. One caveat: Third Avenue recently raised its fees for new investors from 1.1% to as much as 1.4%, prompting it to be dropped from the Money 70 list of top low-cost funds. But as a timely play on real estate, analysts say it's still a worthy investment.

Minimize the tax bite

Most real estate trusts and funds offer sizable dividends since REITs dole out 90% or more of their taxable income each year. You'll have to pay Uncle Sam at your ordinary income tax rate on most of those payouts. That's why it's best to hold REITs and funds in a tax-advantaged account such as your 401(k) or an IRA, says Rick Ferri, an investment adviser in Troy, Mich. About 25% of company 401(k) plans now offer real estate funds, according to the Profit Sharing/401k Council of America. Or if your plan is among the 16% that offer a brokerage account option, you can purchase REITs that way. You'll be happier come April.  To top of page

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