Getting Real

With interest rates rising, some investors are suddenly avoiding real estate like a termite-infested house. Last month the average real estate investment trust (REIT) fell 15%. Yet if the past few years have taught us anything, it's that a slug of real estate lends tremendous stability to an investment portfolio. So don't fall victim to the rate jitters. REITs can thrive so long as any interest-rate climb is slow and takes place over an extended period, says Christopher Haley, a REIT analyst at Wachovia Securities. And that's just the scenario many economists anticipate, as the rebounding economy finally generates jobs and pushes up the price of everything from aluminum to zinc. The best REITs focus on apartment buildings, where vacancy rates are poised to start falling next year.

So why have REITs taken such a beating? The trusts, which are publicly traded companies, own things like office complexes, warehouses and shopping malls. They collect rent and pay out nearly all their income as dividends, which makes them well suited to investors who prize income. But as rates rise, REITs face more competition from other securities like bank CDs and bonds, which dampens REIT values. Still, the average REIT now yields 5.7%, way more than the 10-year Treasury bond at 4.5%.

Another reason REITs have hit the skids is that after doubling in value since 1999 (while the S&P; 500 fell 18%), REIT prices got about 20% ahead of the estimated value of the properties that underlie them. The April decline, however, wiped away almost all that premium. REITs may not be cheap, but they're no longer expensive.

That said, there is a scenario in which you might want to sell. Because the run-up in real estate has been so brisk, this asset class may now occupy too much of your overall investment mix. Excluding the roof over your head, a reasonable allocation to real estate is 5% to 10%. In the past 10 years, a portfolio of half bonds and half stocks would have turned $10,000 into $30,056. But a portfolio of 10% REITs, 49% stocks and 41% bonds would have risen to $31,158.

Mall REITs are least attractive at this time because consumers generally spent throughout the recession, keeping retail rents and occupancy rates firm. There is little likelihood of a further strong rise. Office and industrial properties have recovery potential as companies start to hire again, though that will probably unfold slowly.

Apartment fundamentals should improve next year. As mortgage rates have fallen to four-decade lows, more folks have told the landlord to shove it and bought a house. Home ownership is at a record 69%. That trend, along with a weak economy that forced others to double up or move back home with Mom, drove the apartment vacancy rate to 7.1% last quarter, a 16-year high, reports REIS Inc., a real estate research firm. In many markets, rents have been declining.

Now, rising interest rates could shut a lot of people out of the purchase market, even as a stronger economy produces jobs and gives workers the means to own their shelter. REIS estimates that the apartment vacancy rate will top out at 7.2% this year and then ease over the next four years to 6.1%. That shift, along with higher rents anticipated next year, is expected to boost landlord cash flows as much as 7% and lead to healthy dividend growth, offering a compelling reason to own the stocks of apartment REITs such as Avalon Bay, BRE Properties, United Dominion Realty Trust and Home Properties. For a more diversified approach, consider stellar REIT funds like Alpine Realty Income and Growth and T. Rowe Price Real Estate.