NEW YORK (TheStreet) -- Real estate mutual funds have been soaring. During the past year, the funds returned 39%, outpacing the S&P 500 by 25 percentage points, according to Morningstar.The rally has been driven by an improving outlook for commercial real estate, which includes offices, apartments and warehouses. "Many markets are strengthening, and we should have good demand for real estate for at least the next three or four years," says Marc Halle, manager of Prudential Global Real Estate ( PURAX). The positive outlook represents a big change from the turmoil of 2008 when financing disappeared and values of many properties collapsed. At the time, some analysts predicted that the commercial real estate industry would not recover for five years or more. Now the pessimistic forecasts seem to have missed the mark. In recent months, many markets have been reporting improving vacancy rates. At the end of the second quarter, the vacancy rate for offices in central business districts was 14.8%, down from 15% in the first quarter, according to Cushman & Wakefield, a real estate firm. The modest change in vacancies represented an important sign that the cycle was moving up, analysts said. The vacancy rate had bottomed at 9.7% in the fourth quarter of 2007, and then it rose for nine straight quarters. Halle of Prudential says the downturn is proving to be shorter-lived than the last property recession, which began in the late 1980s. In that cycle, real estate prices fell steadily for more than five years. At the time, many markets were overbuilt, and some office buildings were entirely empty. This time, fewer markets are overbuilt because construction has slowed markedly in recent years. Lenders were unwilling to finance most projects from 2007 through 2009. Because it takes several years for projects to be completed, it will be some time before new supplies hit the markets, says Halle. Meanwhile, vacancy rates will continue declining as the economy grows modestly. To profit from the real estate rebound, consider owning hotel shares, says Joe Smith, manager of ING Real Estate Fund ( CLARX), which has returned 10% annually during the past 10 years, outdoing 76% of its competitors. Smith says hotels are among the first properties to turn around when the economy recovers. As soon as bookings increase, hotels raise their room rates. That started in the second quarter. "Hotel revenues tend to increase immediately when there is growth in gross domestic product," Smith says.
Smith likes Host Hotels & Resorts ( HST), which owns upscale properties that operate under such brands as Ritz-Carlton and Four Seasons. He says the stock sells at a discount to the value of the assets. The company should report growing earnings as business travel increases in coming years. Smith also owns Starwood Hotels & Resorts ( HOT), which operates properties under such brands as Sheraton and Westin. Besides showing gains in the U.S., the company is expanding into the fast-growing markets of Asia. Investors should also consider apartments, says Paul Curbo, manager of Invesco Real Estate Fund ( IARAX), which has returned 11% annually during the past 10 years, outperforming 95% of competitors. Demand for apartments is growing as owners leave single-family homes to become renters. With bankruptcies and unemployment increasing in the last several years, 3.5 million households have moved from single-family homes to apartments, according to CoStar Group, a real estate tracker. "We are in the midst of a long-term decline in home ownership," says Curbo. Curbo owns Equity Residential ( EQR), which owns 152,000 apartments in 24 states. He also holds Essex Property Trust ( ESS), which owns units in San Francisco and other markets where demand for apartments is strong. Another reviving area is the industrial sector, which includes warehouses that are used by retailers and other companies that need to store inventory. Warehouses have been benefitting from the continuing increase in global trade, says Brian Jones, manager of Neuberger Berman Real Estate ( NREAX), which returned 5.3% annually during the past five years, beating 99% of competitors. Jones says the volume of trade moving in and out of U.S. ports has been increasing at a double-digit rate this year, an indicator that warehouses will enjoy rising demand. A favorite holding is AMB Property ( AMB), which owns warehouses near busy airports and sea ports in cities such as Miami and Seattle. The stock pays a dividend yield of 4.3%. Another holding is ProLogis, a global warehouse operator that yields 5.3%. Not all real estate companies suffered equally during the downturn. Among the most resilient were operators of self-storage units, says Kelly Rush, manager of Principal Real Estate Securities ( PRRAX), which returned 3.1% annually during the past five years, surpassing 87% of competitors. During boom times, demand for self-storage facilities increases as home owners have more stuff to keep. In recessions, demand remains healthy as people who lose their homes must find a place to temporarily store possessions. Rush holds Public Storage ( PSA), which owns 2,100 self-storage facilities. "It is an efficient operator that is very savvy about developing new properties," Rush says.
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