NEW YORK (TheStreet) -- Real estate funds have been racing ahead. This year, the funds have returned 13.8%, compared to 7.0% for the S&P 500, according to Morningstar. The strong performance may seem unlikely, at a time when housing markets remain deeply depressed, but the real estate funds do not hold single-family homes. Instead, they invest mainly in Real Estate Investment Trusts, which own portfolios of commercial properties, such as offices, apartment complexes and hotels. Markets for those assets have been improving dramatically.The positive outlook is connected to simple supply and demand. In recent months, demand for hotel rooms and offices has been picking up, but there has been little new supply of properties, says Jon Cheigh, portfolio manager of Cohen & Steers Realty Shares ( CSRSX - Get Report). "We are not seeing office buildings or hotels being built," says Cheigh. As demand for real estate increases, institutional investors have begun bidding to buy prime properties. Sales of commercial real estate have jumped 150% in the past year, according to CoStar, a real estate tracker. The growing demand from investors is helping to boost prices of properties. Make no mistake, REITs no longer sell at bargain levels. Cheigh of Cohen & Steers says that in boom times, REIT shares can sell for 25% premiums to the value of the properties in their portfolios. In hard times, prices can drop to 25% discounts. At the moment, he estimates that REITs command a 5% premium. Despite the small premium, investors can obtain decent returns from REITs in the future because cash flows and dividends will increase, Cheigh says. "We expect that U.S. REITs will increase their dividends approximately 10% per year for the next five years," he says. Whether real estate funds continue soaring, they can be intriguing vehicles that can help to diversify portfolios. A top choice is Neuberger Berman Real Estate ( NREAX - Get Report). During the past five years, the fund has returned 5.3% annually, outdoing 95% of peers. The fund favors office REITs with properties in coastal cities, such as New York and San Francisco. Because construction in those cities is especially difficult, supplies are likely to remain constrained.
Portfolio manager Steve Shigekawa says he is particularly keen on Boston Properties ( BXP - Get Report). The REIT owns high-quality offices in Boston, New York and Washington, D.C. Shigekawa also likes REITs that own luxury malls. While some mid-priced malls are struggling, upscale properties have been reporting strong sales as well-heeled customers continue to shop. A holding is Taubman Centers ( TCO - Get Report), which has been reporting double-digit sales growth. Another solid fund is Cohen & Steers Realty, which has returned 3.7% annually during the past five years, outdoing 87% of peers. Portfolio manager Jon Cheigh has overweighted apartments. He says demand for apartments is connected to the number of people aged 18 to 30. When the number of such young people increases, demand grows for apartments. That will happen in coming years as the Echo Boomers -- children of Baby Boomers -- finish high school and enter the job market. "For the next 10 years, the number of potential renters will increase," he says. To capitalize on growing demand, Cohen & Steers owns UDR ( UDR - Get Report), a REIT that owns mid-priced apartments. Many of the properties are aimed at young professionals and blue-collar families. Construction of commercial properties began to show signs of slowing during the boom years of 2005 and 2006. With construction of single-family houses and condos soaring, builders faced rising costs for supplies and wages. That made it uneconomical for some developers to start offices and hotels. Then, as the financial crisis unfolded, all kinds of construction ground to a halt. When will new commercial properties begin to appear on the market? Not for some time. It can take up to five years to complete an office building in a major city. Since few developers started projects in 2007 and 2008, the supplies of new buildings will be limited in 2012 and 2013. The outlook for office markets in central business districts seems particularly promising. In the second quarter of this year, there were no new office completions, according to Cushman & Wakefield, a real estate firm. But the amount of space being leased by tenants jumped sharply. As a result, the national vacancy rate fell to 13.9% from 14.6% in the first quarter.
Hotel markets are also enjoying a sharp revival as construction remains low and vacancy rates drop. The picture is even improving in troubled markets like Phoenix, which suffers from vacancy rates that are much worse than the national average. In the second week of July, hotel occupancy in Phoenix jumped 17% from the year before, according to Smith Travel Research. With demand improving, average room rates in the city increased 13% to $82.95.
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