Real estate: too hot to handle?

In the second quarter, REIT funds climbed 13 percent, and for the five-year period ending in June, they have boasted annualized returns of close to 20 percent, trouncing all other fund sectors but gold, according to fund tracker Lipper Inc.

Mutual Funds Quarterly Small markets. Big profits. Real estate: too hot to handle? Mutual Fund performance (PDF, 128K) You will need Adobe Acrobat to view this file.

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So far this year, fresh money has poured into REIT funds at near-record levels. With $49 billion spread among some 234 real estate funds, assets in the sector have almost doubled since the end of 2003, according to Lipper. Among sector funds invested in stocks, only healthcare/biotech has amassed more.

But a growing number of analysts are warning that REIT shares are overvalued. The average dividend yield on REIT stocks is just under 5 percent, more than double the yield of stocks in the Standard & Poor's 500 index. But REITs are more vulnerable to any abrupt uptick in interest rates, analysts agree. As a result, investors should temper their expectations. The last time REIT fund inflows reached current levels was in early 1997, followed by two years of poor performance. "Investors shouldn't be fooled by the sizzling REIT returns of recent years," warns Morningstar analyst William Rocco. "Returns won't continue at that pace."

REIT shares, he notes, have benefited from investor appetite for higher-yielding securities, a shaky stock market, and unusually low cost of capital, which makes real estate cheaper to buy.

"A hunt for yield has been driving investor decisions, and if long-term interest rates resume their rise, REIT stocks may well decline," says Andrew Davis, comanager of the Davis Real Estate Fund. Currently, the spread between the REIT yield and the 10-year Treasury note is less than one percentage point, the narrowest in five years.

The shape of the yield curve - the spread between short- and long-term rates - is a key determinant of profits in this capital-intensive business, where most property acquisitions are leveraged with debt financing. Partly because of this slim spread, as well as rising short-term interest rates, Mr. Davis says his fund is finding fewer investment opportunities than a year ago. "You shouldn't go into a REIT fund unless you're willing to hold on for four or five years," says Davis.

The valuations of most REITs are raising red flags among a growing body of analysts.

"REIT valuations look very overextended," says Andrew Engel, coportfolio manager of the Leuthold Core Investment Fund. By one key measure, the average REIT share tracked by Leuthold is trading at a premium of 11 percent above its estimated net asset value, based on underlying property values. That's up from a median discount of 2 percent over the past eight years. Another valuation gauge - the ratio of REIT share prices to "adjusted funds from operations," a rough measure of cash available for distribution - is equally troublesome, says Mr. Engel. Currently, the ratio stands at almost 17, some 40 percent above the average over the past eight years.

The yield advantage of REITs over stocks, moreover, is far slimmer than it was two years ago, when REIT payouts averaged near 7 percent. Non-REIT companies are steadily boosting dividend payouts, thanks to a change in the 2003 tax law that lowered the maximum tax rate on dividend income. REIT dividends are not eligible for the tax break.

Unlike with residential real estate, the commercial property market is generally healthy, with few pockets of speculative excess, says Ken Campbell, managing director of ING Clarion Realty. With moderate cash flow growth "along with dividend yields of close to 5 percent, that should spell decent total returns."