Don't rush into REITs

(MONEY Magazine) -- You'd think that investors would be leery of companies that own and manage commercial real estate. Vacancy rates remain elevated in office buildings and shopping centers. Except for apartment buildings, rents really haven't grown at all in four years. And given the possibility that the global economy may retrench yet again, things could still get worse before they get better.

Yet last year, nine times as much money poured into funds that invest in real estate investment trusts, or REITs, as did in 2009.

What's behind this rush of investors? The same force that sent tens of thousands of Americans racing into Oklahoma in the great land run of 1889: the hope of nabbing property that could help sustain them.

With bonds paying next-to-nothing interest rates, yield-starved investors are hungry for payouts, and REITs pass along the vast majority of the income their properties generate. The yield on equity REITs, which own and manage commercial holdings, averages just under 4%, though some are paying much more.

By historical standards, that's actually modest. When pitted against the sub-2% yields on 10-year Treasuries, though, or the 3% payout of a total bond market fund, REITs shine.

"It is a hunt for yield," says Mark Luschini, chief investment strategist at Janney Montgomery Scott, noting that investors don't seem to care where they have to go to collect income as long as they're being paid.

Therein lies the problem.

Over the long run, REITs deserve a 5% to 10% stake in your portfolio because they are a good hedge against inflation and help diversify your sources of income.

For instance, while your bonds might be hurt if inflation and interest rates were to rise in an improving economy, equity REIT income could thrive. "We think REITs can grow their dividends at least 6% a year, and if inflation is running at 3%, your purchasing value is not being eroded," says Thomas Bohjalian, a portfolio manager at Cohen & Steers, an investment firm specializing in real estate.

Top picks from top pros

Yet investors who are moving into REITs to boost their income can't turn a blind eye to the risks. Equity REITs have soared 192% since March 2009, double the gains for the S&P 500. And as valuations have risen, yields have started to sink.

If you're thinking of going with other types of REITs that promise even fatter payouts, such as those that aren't publicly traded or that invest largely in mortgages, you have to mindful of their complexities.

So before you rush into this space, get to know the landscape and the funds that will help you avoid the quicksand. Typically, MONEY favors index funds because of their low costs. In this market, though, a better bet, says Ralph Block, author of "Investing in REITs," is a stock picker who can weed out so-so companies.

Publicly traded firms that own and operate commercial properties represent the biggest part of the REIT universe. Yet even this area of the market comes with big challenges.

REITS are riskier than bonds. Trying to substitute commercial real estate for Treasuries or other fixed-income investments would be a big mistake. While bonds have historically been negatively correlated with stocks -- meaning they zig when equities zag -- equity REITs have recently enjoyed about an 80% correlation with the S&P 500.

What's more, to really raise your income, you'd have to add copious amounts of these investments to your portfolio. A 5% to 10% weighting in a REIT fund yielding a little under 4% would only modestly lift the income you get from a bond portfolio yielding 3%.

To really move the dial, you might have to shift as much as a third or more of your portfolio into these investments, which would be way too risky. Had you done that in 2008, you'd have gotten slammed, as REITs lost around 38% that year while a total bond market index fund gained 5%.

These are economically sensitive investments. High unemployment and weak consumers could help push vacancy rates up or rents down.

"It's not enough just to see economic growth," says David Lee, manager of the T. Rowe Price Real Estate fund. "We need people moving into offices and business people checking into hotels."

In the aftermath of the financial crisis, vacancy rates in office buildings shot up from 12.5% in 2007 to 17.6% in 2010, according to Reis, a real estate research firm. They've barely budged since.

REITs are expensive. You could set your sights on areas of the market that have held up in the recent downturn, such as apartments that are benefiting from the housing bust. REITs in these areas, though, aren't paying you much for the risk. Many apartment REITs are yielding just under 3%.

If you want to bet on healthier parts of the market ... Go with Cohen & Steers Realty Shares (CSRSX), which is a member of the MONEY 70, our list of recommended mutual and exchange-traded funds. The managers of this $3.7 billion portfolio currently favor high-end retail properties. In fact, the fund's largest holding is Simon Property Group (SPG), the country's biggest REIT, which owns and operates high-quality regional malls throughout the country.

Aren't shopping centers suffering from the weak consumer economy? Not higher-end properties.

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In fact, customers are opening their pocketbooks in well-located malls, and tenants are willing to pay to keep their shops there, says Bohjalian. He adds: "Higher-end retail continues to do particularly well." Cohen & Steers Realty also favors apartments where leases tend to be shorter, which means tenants can be re-upped quickly at higher rents.

Neuberger Berman Real Estate (NREAX) also currently favors regional malls and apartments. "If particular sectors look attractive, we want to be overweight in those areas," says Steve Shigekawa, co-manager of the fund.

This willingness to concentrate on growth areas helped Neuberger Berman Real Estate outperform the average REIT fund from 2002 to 2007, when the economy was expanding, as well as from 2009 to 2011, says Morningstar analyst Rob Wherry.

If you're not sure which way the economy is headed ... Play it safe by seeking out bargain hunters that spread their bets across the broad REIT universe. Managers Andrew Davis and Chandler Spears of Davis Real Estate (RPFRX), for instance, seek out REITs that not only are cheap but can also stand up to different business climates.

The fund's second-largest holding is Alexandria Real Estate Equities (ARE), which owns buildings that rent to tenants in the life sciences, such as GlaxoSmithKline and Novartis -- neither of which requires a strong economy to thrive.

At T. Rowe Price Real Estate (TRREX), manager Lee focuses on high-quality, undervalued companies that can hold up in various economic environments.

"We look for companies that can manage well in up or down markets," he said. This approach helped the fund beat more than 75% of its peers over the past 10 years -- a period that witnessed one downturn and two rallies in REIT shares.

In times of uncertainty like this, that's the type of record that really stands out.

Find out some REITs to avoid.

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