Why Aunt Minnie should invest in malls, hotels...

Shareholders of real estate mutual funds have had a glorious time for four years - until April, when the showers fell and ruined their financial garden party.

On April 2, the Labor Department reported a solid gain in jobs during March. Some investors saw higher interest rates and inflation ahead and dumped their real estate investment trusts (REITs). Shares plummeted, on average, about 20 percent.

That plunge hurt. But it also set the stage for a broad reconsideration of REITs. Should investors unload them before more damage is done? Or is this the time for newcomers to buy in?

By most measures, REITs have performed extraordinarily well for a conservative investment. While investors in equity mutual funds suffered the consequences of a bear market in corporate stocks, collapse of the Internet bubble, and a recession, investors in REITs, directly or through a mutual fund, did well.

They enjoyed an average 51.2 percent return over the 12 months ended March 31, and a compounded 17.5 percent annual return over the 60 months to March 31, according to Lipper, a New York firm tracking mutual funds.

Even after their April tumble, REITs are still up about 26 percent from a year ago. And they now return on average about 5.8 percent, up from 5.0 percent April 1. That compares favorably with a 10-year Treasury bond yield of about 4.4 percent now, up from 3.9 percent on April 1.

Some individual REITs provide a yield close to 8 percent - 7.9 percent for Equity Office Properties Trust, for instance.

Now that their shares are cheaper and their returns higher, REITs are again becoming an attractive investment, analysts say. "There are not so many places to get a good yield," as REITs do now, says Daniel McNeela, an analyst at Morningstar, a Chicago firm that tracks mutual funds.

"The happiest days are past" for REITs, adds Donald Cassidy, an analyst at Lipper. But today they're "a bit of a bargain."

One big advantage of owning REITs is diversification. As the past few years show, REIT shares often don't track the Standard & Poor's 500 or other stock indexes. So they can help stabilize a portfolio.

April's sell-off was sparked by investors who suspected REITs were in a small bubble, with the value of their shares exceeding the value of the properties they own. The interest-rate scare provided an excuse to sell.

"Their valuation never approached the bubble in technology stocks in the late 1990s," says Mr. McNeela. "They are still a worthwhile holding for investors. But check your asset allocation. See if they take up too much space in your portfolio."

Nor do REITs automatically fall when interest rates rise. An analysis by Louis Taylor of Deutsche Bank Securities in New York finds little historic correlation between REIT prices and interest rates.

As usual, prices will depend on supply and demand for REIT shares. Mr. Taylor saw in late April renewed "genuine buying interest" in real estate stocks from "dedicated investors" with excess cash.

The bullish view is that as the economic recovery picks up steam, owners of property will prosper. With higher interest rates, fewer consumers will be able to buy houses and will have to live in apartments. So landlords can raise rents.

Furthermore, economic growth will stimulate the demand for office space, reducing vacancy rates and allowing higher rents.

Since REITs, in order to avoid corporate taxation, are required by law to pass on some 90 percent of their profits to their shareholders, dividends would automatically grow. But not until 2005, suspects Paul Reeder, an analyst at SNL Financial in Charlottesville, Va.

"It is now a more persuasive time to step into the market than a month ago," he says. "But don't expect any sharp recovery for REIT stocks." He sees as most likely "a choppy performance" this year before prices reach equilibrium.

REITs vary in their nature. Some invest primarily in apartments; others in office buildings, shopping centers, industrial buildings, hotels, and so on.

Most real estate mutual funds select a portfolio of stocks from a mix of these REIT companies, providing the extra safety of diversification. Vanguard goes further with an index fund designed to track the performance of the entire REIT industry, composed of 175 publicly traded companies with about $248 billion in total assets.

In addition to 200 open-end funds that invest in these 175 REITs, there are 19 closed-end REIT funds. Unlike open end funds, these 19 funds do not redeem their shares. Instead, they are bought and sold on a stock exchange at a price set by demand and supply. At present, the shares trade at an average discount of 8.8 percent from the value represented by the shares in their portfolio.

Moreover, closed-end funds don't need to keep cash on hand to redeem shares. Free of this risk, most of these funds leverage their investment with borrowed money. The result of all these factors, notes Mr. Cassidy, is that these funds yield 8 to 9 percent - extraordinary given today's low interest rates.

For those interested in directly investing in REITs, Taylor recommends putting money in mall REITs, predicting a 5 to 8 percent annual rise in their dividends for the next five years. He suggests Simon Property Group, Macerich Co., and Mills Corp.

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