For many stock and mutual fund investors, home ownership provides an important alternative avenue of investment that diversifies their overall portfolio. Real estate comprises one of only two asset classes that have outperformed inflation over time. However, homeowners face the same risk as owners of individual stocks: if the value of their home declines, then they can lose big.
Fortunately, investors have an alternative method of participating in the real estate market through real estate sector funds. This article examines the risks and rewards inherent in real estate funds, as well as some of the winners and losers in this category.
What Is a Real Estate Fund?
A real estate fund is a professionally managed portfolio of diversified real estate holdings. Most real estate funds invest in commercial, corporate or rental properties, although they do occasionally dabble in residential investments. This type of fund can invest in properties directly, or indirectly through real estate investment trusts (REITs). Like stock funds, real estate funds can invest domestically, overseas or both.
Real estate funds generally follow the mainstream economy in terms of performance; during periods of inflation and economic growth, real estate will usually post strong returns, while it usually fizzles in periods of recession. Since the late 60s and early 70s, real estate funds have outperformed the stock market in some periods and underperformed it in others. The real estate sector goes through periods of expansion and contraction, just like all other sectors of the economy.
Why Invest in Real Estate Funds?
Real estate funds allow small investors to participate in the profits from large-scale commercial real estate enterprises, such as corporate office parks and skyscrapers. They also provide the usual benefits of mutual funds, such as professional management and diversification. This last characteristic is key for these funds, as most investors do not have a sufficient asset base to participate in commercial real estate in any direct sense, unlike stocks, which may be purchased as individual shares at a much more reasonable cost.
Advantages and Disadvantages of Real Estate Funds
Although real estate funds are usually either growth or income oriented, investors can generally expect to receive both dividend income and capital gains from the sale of appreciated properties within the portfolio. For this reason, tax-conscious investors may be pleasantly surprised when they receive their annual capital gains distributions. Investments in individual properties can also defer capital gains through special rules, and funds that invest in REITs can also benefit from special tax advantages.
As with all other sector funds, real estate funds tend to be more volatile than broader-based growth or income funds. As with any other sector, investors can generally expect to be hit hard in these funds when the real estate market collapses, and should keep a long-term perspective when allocating funds to this sector.
Real Estate Fund Investment Risks
Real estate funds face several kinds of risk that are inherent in this sector of the market. Liquidity risk, market risk and interest rate risk are just some of the factors that can influence the gain or loss that is passed on to the investor.
- Liquidity and market risk will tend to have a greater effect on funds that are more growth-oriented, as the sale of appreciated properties depends upon market demand.
- Conversely, interest rate risk impacts the amount of dividend income that is paid by income-oriented funds
Retail Real Estate Funds: Winners and Losers
There is a wide variety of mutual funds available to investors that invest either mostly or entirely in real estate, but as with funds in any other sector or category, some have performed better than others over time. Especially since 2008's abysmal market.
- The CGM Realty Fund (CGMRX) recovered relatively well since the bottom of the recession in 2009, growing from a low NAV of about 12 bucks in the spring of 2009 to about 30 in 2012.
- The Dryden Global Real Estate A Shares (PURAX) has since its beginning returned a NAV price this in 2012 of about $20, a major improvement since its performance in 2009 where it was priced at around $8.
- Morgan Stanley also boasts competitive offerings in the real estate arena.
- Conversely, Forward Select Income A (KIFAX) realized a net loss of close to -6.00%.
The Bottom Line
The real estate market offers opportunities for both growth and income investors seeking long-term returns outside of the stock market. Real estate sector funds allow the small investor to participate in large-scale enterprises that would normally be far out of reach. Investors should understand the specific risks and rewards presented by real estate sector funds, but those who are willing to stay in for the long haul have historically reaped superior returns and competitive dividend income over time.