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Even in bull markets, some sectors get crushed Average real estate investment trust yielded 3.65% at end of January Rising economy could push REITs higher

Two-thirds of Americans rate themselves as above-average drivers, according to a survey by Allstate, which accounts for the frequency of cars fished out of culverts, fish ponds and living rooms across the nation.

A similar percentage probably consider themselves above-average investors, which accounts for the number of sectors that experience short-term 10% to 20% declines, even during a rip-roaring bull market. Everyone thinks he can get out of the way of the next wreck.

For those who hold themselves to be opportunistic investors, those declines can be fine buying opportunities — which brings us to real estate funds, a sector that investors drove into the bushes last year. Although the funds have recovered, they still represent decent value, and a good place to add money this year.

One of the more remarkable facets of last year’s 29.6% gain in the Standard and Poor’s 500-stock index is how many fund categories took at least a 5% haircut over any given three-month period in 2013. Funds that invest in gold-mining stocks, for example, slammed into a 34% drop the three months ended June 2013. Commodity funds careened into a 11% decline during the same three months.

Real estate funds slid 8.5% the three months ended August 2013, and international real estate funds skidded 10%. All told, the MSCI U.S. Real Estate Investment Trust index fell 18.7% from May through August.

What caused the real estate wreck? Real estate funds invest primarily in real estate investment trusts, or REITs — which, in turn, invest in commercial real estate, such as apartment buildings, office buildings, shopping malls and even storage units.

By law, REITs have to pay out at least 90% of their taxable income to shareholders in the form of dividends. As a result, REIT yields tend to be higher than most ordinary stock dividends and higher than most 10-year Treasury yields.

Last month, the average equity REIT yielded 3.65%, according to the National Association of Real Estate Investment Trusts, an industry trade group. The 10-year Treasury note closed January at 2.67%, making REIT yields look like Ferraris in contrast.

So what caused REITs to back up so much in 2013? Had you asked the average investor where interest rates were going in early 2013, most would have said, Up. And rising rates can be tough for REITs. When rates rise, mortgage costs go up, making it more difficult to purchase new buildings, and more expensive to hold them. Furthermore, rising rates make REIT dividends look less attractive than other, riskless investments — such as 10-year Treasury notes.

The conviction that rates had nowhere to go but up was what caused the REIT wreck, says Robert Gadsden, manager of Alpine Realty Income & Growth, an institutional fund that has beaten 95% of its peers the past five years, according to Morningstar, which tracks the funds. It was terrified investors selling REITs, not fundamentals, that caused the downturn, he says.

REITs have soared about 7% so far this year, vs. a loss of 0.5% for the S&P 500. The reason? People have realized that interest rates have one other direction to go, which is down. The 10-year T-note yield has fallen from 3.03% Dec. 31 to 2.75% now.

REITs are also tied to the economy, and especially employment. As employment rises — and it has, albeit slowly — demand for office space and other commercial real estate rises. In the absence of new supply, that benefits existing real estate, Gadsden says. There are a lot of local markets and types of real estate where landlords can push higher on rental rates.

Currently, REITs are neither cheap nor dear. REIT yields are normally about 1.1 percentage points above the 10-year Treasury yield. As of Thursday, they were about 1.2 percentage points higher than the 10-year T-note, Gadsden says. Valuations aren’t rich on that level, he says.

REITs are reasonable on another measure, says Jim O’Donnell, chief investment officer of the Forward funds. Analysts typically look at REIT prices vs. their funds from operations, or FFO. About 18 times FFO is cheap, and 22 times FFO is getting expensive. We’re in the middle of that range, he says.

Hotel REITs are on the cheaper end of the spectrum, Gadsden says. And so are many office buildings. Not surprisingly, the best earnings are from areas that are seeing job growth: San Francisco, Seattle, New York City. Where there’s job growth, there’s pressure on supply, and people want to be there, he says.

Another round of rate anxiety could hit REITs again. But O’Donnell says rate shock is usually abrupt and front-loaded, meaning that REITs behave reasonably well in a rising rate environment — after the initial smack, that is.

And if rates rise gradually as the economy improves, REITs could produce total returns — dividends plus capital gains — above 10% this year, says Gadsden. To me, that’s a good thing to have in a portfolio as a diversifier, he says.

For many investors, REITs provide a decent dividend cushion in the event of a downturn. And, because the real estate cycle is somewhat different from the stock cycle, they provide an extra bit of diversification. But REITs are still stocks, and when the stock market falls, you can expect your REIT to fall, too.

As always, you’re better diversified if you buy through a low-cost fund. The less you pay to fund management, the more of your REIT return you keep. While REITs won’t keep you from getting bumps in your portfolio, they can help you avoid going completely over a cliff.