Play the REIT Rebound

It's no surprise that real estate investment trusts have stunk over the past year. Their problems extend beyond those afflicting the overall stock market.

REITs invest in commercial and residential property, so shrinking businesses, shuttered stores and accelerating layoffs are bound to cripple profits. The Dow Jones Composite REIT index surrendered 47% over the past year through January 23 (the figure includes hefty dividends). By contrast, Standard & Poor's 500-stock index plunged 36%.

But the crummy economy is only part of the story for REITs' sorry performance. "They're very much driven by what's going on in the credit markets right now," says Steve Buller, manager of Fidelity Real Estate Investment Portfolio (symbol FRESX).

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Why should REITs be so tied to conditions in the bond market? By regulation, REITs must pay out 90% of net income to shareholders. So REITs typically have to borrow to finance purchases of new property-usually, the more aggressive a REIT grows, the more money it needs to borrow. As credit markets have seized up, it's become increasingly difficult for REITs to roll over debts as they become due.

Despite the darkening financial crisis, REITs actually made money for much of 2008. From the beginning of the year through September 12, the Friday before the collapse of Lehman Brothers, REITs gained 2%, compared with a loss of 14% for the S&P 500. But from the time of Lehman's implosion, after which lending fell off a cliff, through January 23, REITs plunged 47% (while the S&P index sank 33%).

But since mid November, credit markets have shown some signs of thawing. REITs have responded by performing better, to put it mildly: From November 20 through January 23, the REIT index gained 31%. As credit markets return to normality, REITs stand to benefit further.

Buller, for one, is banking on a recovery. In 2008, he says, he avoided or underweighted REITs that had high debt levels and a lot of debt coming due soon. Recently, he's begun to tiptoe into more-leveraged companies, in anticipation that they could sparkle in a rally. "In some sense, this is a bet that we'll begin to see more clarity in the credit markets," he says. In addition, he says, the REITs with the strongest and safest balance sheets tend to be the most overvalued now.

Fidelity Real Estate is a fine choice for playing the sector. Five REIT analysts help Buller to dissect each company's earnings growth and cash flows, and to assess whether management has a track record of good decision-making. The team looks for securities that are cheap relative to their peers and pay out hefty dividends.

The fund returned 5.5% annualized over the past ten years through January 23, matching the gains of the Dow Jones REIT index. The fund yields 8.7%. At 0.88%, annual expenses are below average.

Neuberger Berman Real Estate (NBRFX) is another good option. Like Buller, managers Steve Shigekawa and Brian Jones look for cheap stocks of well-managed companies. But they place more emphasis on big-picture factors, such as regional job markets, how easily new building supply could enter a given market, and what sectors of the REITs market might come into favor next.

Shigekawa is cautiously optimistic about 2009. REITs will benefit, he says, if banks expand their lending. And like Buller, he's beginning to move the fund into companies with more debt, as well as into sectors, such as lodging and industrial REITs, that are more susceptible to the weak economy. "We expect occupancy rates to decrease and rents to be pressured in 2009, but the market has already priced a lot of that in," he says.

Shigekawa has managed the fund since the beginning of 2006. Since then, it's lost 12.25% annualized, beating the Dow Jones REIT index by an average of four percentage points per year . Despite losing 32% in 2008, the fund won some bragging rights because it still did better than 98% of its competitors.

The fund's Trust shares are available without a load, although the 1.51% expense ratio is above average for the category. The fund yields 4.2%.