NEW YORK ( TheStreet) -- Since the financial crisis, real estate has ranked as the top mutual fund category tracked by Morningstar. During the past three years, real estate funds have returned 22.4% annually, compared to 13.5% for the S&P 500.
The big gains can be traced to a rally in REITs (real estate investment trusts), the primary holdings of real estate mutual funds. REITs invest in portfolios of commercial properties, such as offices and malls. As the economy has improved, investors have begun wagering on a revival of property markets. REITs have held special appeal because they pay rich dividends, an asset that many investors have come to crave in today's low-yield environment.
Can REITs continue rallying? Perhaps, but the valuations have begun to look stretched, says Jeffrey Kolitch, portfolio manager of Baron Real Estate (BREFX). Over the years, REITs have sold for an average of 15 times operating earnings, he says. The current figure is around 22.
"By many measures, REIT prices are bumping up against the highest price levels that we have seen," says Kolitch.Kolitch's views are noteworthy because his fund is red hot. During the past year, the fund has returned 44.8%, compared to 26.3% for its average peer. Baron has enjoyed an edge because it casts an unusually wide net. While rivals focus solely on REITs, Baron owns a range of real estate shares. Besides REITs, the fund holds brokers and other companies that service the real estate industry. Baron can also own homebuilders and businesses that depend on residential markets. With demand for homes increasing lately, residential stocks have surged, outpacing REITs and other shares that focus on offices and commercial properties. The rally in residential shares has helped Baron to outpace all its rivals. Kolitch says that his fund has an important advantage because it can shift between sectors of the real estate markets. During the times when REITs look expensive, Baron can look elsewhere. Kolitch concedes that his fund may not be the best approach for all real estate investors. Many of his stocks pay little or no dividends, so the Baron fund ranks as one of the lowest-yielding choices in its category.