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Real Estate Funds Riding High

Sidestepping the homebuilders, they've posted stellar gains.

The cooling residential housing market has taken its toll on homebuilders as new orders fall and cancellations rise. Yet mutual funds that specialize in real estate are still flying high, benefiting from their exposure to commercial property through holdings in real estate investment trusts.

Real estate funds are the top-performing sector this year, returning an average 25.87% through Friday, according to Morningstar. Their annualized returns also top the charts for the past three years at 25.08%, and the past five years at 23.13%.

With some notable exceptions, such as the $260 million


Alpine U.S. Real Estate Equity fund, real estate funds have little or no exposure to homebuilders such as

KB Home

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Toll Brothers

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Pulte Home

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In some cases, that's a matter of principal. David Lee, manager of the $2.12 billion

(TRREX) - Get T. Rowe Price Real Estate Report

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T. Rowe Price Real Estate fund, has never owned a homebuilder. "Most people already have exposure to residential real estate through their home of their mortgage," he said. "We try to offer them something different."

Investors tend to look to real estate and other 'alternative' asset classes as a means of diversifying their portfolios. For that reason, real estate fund managers typically try to generate returns that have a low correlation to the equity market.

That broader goal doesn't necessarily preclude investments in homebuilders, however.

Joe Rodriguez, manager of the $1.8 billion

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AIM Real Estate fund, believe these stocks have a role to play in the portfolio, assuming they're priced attractively. "We do look at them from time to time, but we want them to perform a very specific role in the portfolio and only when we feel their risk-adjusted returns warrant consideration," the fund manager said. Rodriquez hasn't owned a homebuilder stock in about a year and a half. While prices have come down quite a bit in the interim, he still believes it's too soon to jump back in.

Slower home sales are actually benefiting some real estate funds as more people opt to rent, pushing rents higher and boosting profits at apartment REITs. "There's a saying in the stock market: you don't want to catch a falling knife," said Lee. "The same mentality occurs in home ownership -- people are still leery of buying homes at this point. To a certain extent, this has increased the length of time people spending rental units."

Equity Residential

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, an apartment REIT, is the fund's fifth-largest holding, according to Morningstar.

While there's been some talk that rents could soften in some markets if large blocks of unsold condominiums are converted to rental units, neither fund manager is worried. Rodriguez notes that condos aren't a nationwide phenomena; so any impact from conversions is likely to be limited to a few markets such as Las Vegas and South Florida, where a large percentage of units were sold to investors. And even in these markets, he believes professional apartment managers have a leg up in marketing their units.

Rodriquez's only concern about apartment REITs is that they are overvalued. He's been underweight the sector, relative to his peers, for the past nine months or so, and overweight in office and retail REITs. The fund's top holding is shopping mall REIT

Simon Properties

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, although it also has big stakes in Equity Residential and

Vornado Realty Trust

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, a fully integrated REIT, according to Morningstar.

Rodriguez also has been moving money overseas, where he thinks real estate investments are more attractive, on a risk-adjusted basis, than in the U.S. He said approximately 5% of the fund's holdings were outside the U.S., as of its latest public filing. AIM Real Estate can allocate as much as 25% of holdings overseas, but the manager is unwilling to push it that high because he figures investors who want more exposure can opt for

(AGREX) - Get Invesco Global Real Estate A Report

AIM Global Real Estate

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Allison Bisbey Colter joined in 2006 from the New York office of Dow Jones Newswires, where she spent the previous seven years covering consumer finance, mutual funds and hedge funds. Prior to that, she worked in Europe for Dow Jones covering transportation from London and Italian capital markets from Milan. She is a graduate of Wesleyan University, where she received a B.A. in government.