NEW YORK (TheStreet) -- Since the financial crisis, real estate has ranked as the top mutual fund category tracked by Morningstar. During the past three years, real estate funds have returned 22.4% annually, compared to 13.5% for the S&P 500.The big gains can be traced to a rally in REITs (real estate investment trusts), the primary holdings of real estate mutual funds. REITs invest in portfolios of commercial properties, such as offices and malls. As the economy has improved, investors have begun wagering on a revival of property markets. REITs have held special appeal because they pay rich dividends, an asset that many investors have come to crave in today's low-yield environment. Can REITs continue rallying? Perhaps, but the valuations have begun to look stretched, says Jeffrey Kolitch, portfolio manager of Baron Real Estate ( BREFX). Over the years, REITs have sold for an average of 15 times operating earnings, he says. The current figure is around 22. "By many measures, REIT prices are bumping up against the highest price levels that we have seen," says Kolitch. Kolitch's views are noteworthy because his fund is red hot. During the past year, the fund has returned 44.8%, compared to 26.3% for its average peer. Baron has enjoyed an edge because it casts an unusually wide net. While rivals focus solely on REITs, Baron owns a range of real estate shares. Besides REITs, the fund holds brokers and other companies that service the real estate industry. Baron can also own homebuilders and businesses that depend on residential markets. With demand for homes increasing lately, residential stocks have surged, outpacing REITs and other shares that focus on offices and commercial properties. The rally in residential shares has helped Baron to outpace all its rivals. Kolitch says that his fund has an important advantage because it can shift between sectors of the real estate markets. During the times when REITs look expensive, Baron can look elsewhere. Kolitch concedes that his fund may not be the best approach for all real estate investors. Many of his stocks pay little or no dividends, so the Baron fund ranks as one of the lowest-yielding choices in its category.
"If an investor is purely seeking income, we are not the right fund," says Kolitch. "Our principal objective is capital appreciation." Kolitch argues that the outlook for real estate stocks remains bright. He is particularly keen on residential markets. Housing construction fell from 2.2 million units in 2006 to 478,000 in 2009. Recently the annual pace has rebounded to 760,000. Kolitch says that construction will continue climbing because 1.2 million households are formed annually. "We are in the early stages of what will be a multiyear recovery of the residential housing market," he says. "Cycles typically last six or seven years." Homebuilders were among the first stocks to jump when construction activity began reviving. In the past year, stocks of leading builders such as Lennar ( LEN) and Toll Brothers ( TOL) more than doubled. Kolitch owned some of the homebuilders, but recently sold them because he figured that they had become too rich. Instead he owns companies that provide equipment and supplies for homebuilding. A holding is Owens Corning ( OC), a maker of insulation and roofing supplies. The stock has jumped about 30% in the past year, but Kolitch says that the shares will continue running as the housing recovery unfolds. Why have suppliers like Owens Corning lagged behind homebuilders? Kolitch says that homebuilders are a pure play on new construction, so they rally hardest when the cycle turns. Suppliers like Owens Corning get some of their sales from remodeling, which doesn't depend on new home construction. Another supplier he likes is Stanley Black & Decker ( SWK), the maker of power tools. He figures that the shares trade for 10 time next year's earnings, a modest price for a dominant supplier. Kolitch has about 20% of the fund in companies that operate senior living projects, such as assisted living facilities and nursing homes. Holdings include Capital Senior Living ( CSU) and Brookdale Senior Living ( BKD). The senior companies will get a big boost from revived home sales, Kolitch says. In order to afford assisted living, he points out, many residents must first sell their homes. That has been hard to do in recent years. But now that residential markets are reviving, there will be stronger demand for senior facilities. This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.