REIT Funds Rush Ahead

Real estate plays have benefited from bond market strength.
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If you want to know why real estate funds have been flying, just hold a mirror up to a Treasury bond chart.

Over the last month the average real estate fund has risen 4.7%, according to fund tracker Morningstar. Shares of the

iShares Cohen & Steers Realty Majors Index

(ICF) - Get Report

exchange-traded fund have done even better, rising 7.5% since early April. Meanwhile the

S&P 500

has fallen nearly 1%.

Fund managers link the monthlong REIT rally to a sharp drop in bond yields. They started falling as investors worried about an economic slowdown after the April 1 release of disappointing March payroll numbers. The REITs' run finally petered out last week after April payroll numbers surged past expectations, pushing bond prices back up -- and yields back down.

REIT watchers say the correlation is no mistake.

"REITs generally move on three things: interest rates, equity market fund flows and underlying sentiment toward real estate," says Sam Lieber, portfolio manager for the $535 million

(EUEYX)

Alpine U.S. Real Estate Equity fund. "Right now interest rates seem to be the biggest factor, as REIT indexes are a mirror image of the 10-year Treasury."

Even after the furious spring rally, real estate funds remain down 2% this year. Still, it's hard to feel sorry for fundholders. The asset class has returned 18.47% annually over the past five years, making it the best-performing category at Morningstar.

REIT shares were ignored during the tech bubble as investors chased after growth companies. After the bubble's collapse, however, investors about-faced and poured their investment dollars into steady, income-producing assets such as REITs.

The 12-month yield on the average real estate fund is 3.15%. Because of price appreciation in the underlying shares, that's not as juicy as it used to be. But it's still fairly compelling in the current low-yield environment, where a one-year CD yields just above 3.25% and offers no chance of the double-digit total returns REIT funds have been raking in since 2001.

As long as the

Fed's

move up is orderly, fund managers say, the run-up in REITs won't be doomed by rising rates. In fact, most real estate fund managers would welcome higher rates, provided they are a function of an expanding economy that will allow landlords to raise rents. Higher lending costs also makes renting preferable to home-buying for many people, thus increasing the value of rental properties owned by REITs.

For its part, the ICF is a fairly concentrated 38-stock REIT portfolio whose top five stocks include

Equity Office Properties Trust

(EOP)

,

Simon Property Group

(SPG) - Get Report

,

Vornado Realty Trust

(VNO) - Get Report

,

Boston Properties

(BXP) - Get Report

and

Public Storage

(PSA) - Get Report

.

Real estate fund investors anxious over potentially higher rates also need to remember that any move upward is starting from an abnormally low level, says Mike Torres, portfolio manager for the $34 million

(LLUKX)

Adelante U.S. Real Estate Securities fund.

"We've had such a dramatic decline in rates that the Fed is just slowly taking excess liquidity off the table," says Torres.

Investors should also consider that interest rates are still well below where they were last year at this time, even after the recent jump up on the April jobs report.

"People got scared early in the year that interest rates were going to start rising and they took profits," says Lieber. "But when it became obvious that rates were not going to sprint away, people came back for the yield and the improving fundamentals."

To watch Gregg's video take on the REIT phenomena, click here

.