REITs Hold Their Ground

Despite rising Treasury yields, real estate funds are outpacing other categories.
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OK, now real estate fund returns are getting downright ridiculous.

The average real estate investment trust mutual fund is up 5% over the past month and 11% year to date, according to fund tracker Morningstar. And that comes on top of a three-year run when annual gains have averaged a stunning 32%.

To put this extraordinary performance into perspective, small-cap growth is the second-best-returning fund category in Morningstar's year-to-date rankings, and it has gained only 2% in the past month and 8.5% so far in 2006. And forget about the

S&P 500

index. Everybody's favorite big-cap benchmark index is up just under 4% since the start of the year.

REITs are often viewed as an investment alternative to bonds because of their healthy dividend yields. But the 10-year Treasury yield, the

supposed nemesis of REITs, is up about 30 basis points since 2006 kicked off, suggesting that REIT investors aren't just focused on yields but also are looking at total returns.

For instance, the 10-year is yielding roughly 4.7%, well above the average 12-month yield of 2.72% for Morningstar's real estate category. Dividend yields on individual REITs are typically 100 to 150 basis points above that of the 10-year Treasury, according to Amos Rogers, portfolio manager for the $162 million

SSGA Tuckerman Active REIT

(SSREX) fund.

"Just when you think yield-based investors would start jumping from REITs to the relative safety of Treasuries, the real story was that they are still piling into real estate funds," says Rogers.

Private Perks

It remains to be seen if the coupon-clipping crowd will stick with their REIT funds after such a pronounced run-up and with safer alternatives growing more attractive. Meanwhile, one set of investors is making their interest in public REITs very well known: private investors.

Fund managers say there is a continuing sense among private-capital players that the public market values public REITs incorrectly. As a result, they are growing more aggressive in their dealmaking.

To view Gregg Greenberg's video take of this article, click here

.

One such acquisition was announced earlier this month when national office building owner

CarrAmerica

(CRE)

was purchased by an affiliate of private equity giant Blackstone Group in a deal valued at $5.6 billion. Under the terms of the deal, Blackstone will pay $44.75 per share for the REIT. The price represented a 9% premium to where CarrAmerica's shares closed March 3, the last trading day before the deal was announced, and the REIT's shares had already been run up amid speculation of a pending buyout.

The premium paid for CarrAmerica suggests that other publicly traded REITs are undervalued, and the buyout shrinks an already small pond of publicly traded REITs, thereby increasing the value of the entire group.

According to the National Association of Real Estate Investment Trusts, or NAREIT, the aggregate market cap for the roughly 150 publicly traded equity REITs is around $300 billion. That's $50 billion less than the market cap for

Dow

component

General Electric

(GE) - Get Report

.

"All the dedicated money gets recycled back into a smaller space," says Bob Gadsden, portfolio manager for the $724 million

Alpine Realty Income and Growth

(AIGYX) fund, who adds that strong fundamentals are also playing a role in REIT's never-ending surge.

"REIT fundamentals have improved with the economy, and space is tightening up," says Gadsden. "On a valuation basis, we are cautious, but on a fundamental basis, these are the strongest we've seen in four years."

Unfortunately for REIT investors, higher interest rates are also the byproduct of faster economic growth. And with the possibility of the Fed raising its overnight lending rate as high as 5.25% sometime in 2006, it remains to be seen if the demand for REITs spurred by private investors can overcome the pressure of elevated Treasury yields.

"The looming question remains rates," says Rogers. "With Treasury yields climbing, is there enough capital appreciation left in REIT shares to make it worth your while?"

Right now the so-called smart money seems to think so. And judging from the deal flow, they want it all to themselves.