Real estate investment: Make money with REITs, ETFs, not tenants

After five years of weak property markets, real estate is starting to look a bit more enticing for investors – at least those who appreciate a good, beaten-down bargain.

But like other sectors these days, real estate investment is no sure bet, pros say.

"We're in an extremely challenging environment for real estate firms to operate in," says Abraham Bailin, an analyst with fund-tracker Morningstar specializing in real estate exchange-traded funds (ETFs). "By targeting the largest and most liquid individual [real estate investment trusts, or REITs] across the industry, you're likely to have a higher quality portfolio."

It's easy enough these days to get real estate exposure among one's holdings. Twenty-eight ETFs focus on real estate, either domestic or international. Some 146 individual REITs are publicly traded on US stock markets.

A few trends suggest it might be time to buy. Recent years have pounded prices down in many commercial as well as residential markets. Lower homeownership rates mean more demand for rental properties. And rock-bottom interest rates spell favorable terms for real estate holding companies, where debt is a key expense.

"It's a perfect storm of positives" for apartment-leasing REITs, says Jason Ren, senior stock analyst covering REITs for Morningstar. "But we think that's been priced in" by the market. So REITs specializing in apartments are not cheap, he adds.

In this environment, some investment pros like REITs, especially for clients who don't already have 5 percent portfolio exposure to the asset class. Since REITs are required to pass 90 percent of taxable income to shareholders, their high yields (often ranging from 4.5 to 7 percent) make them useful for boosting overall returns, according to Chris Sadkowski, an investment adviser at Thompson Wealth Management, a fee-only firm in Concord, Mass. He also likes that REITs don't just mirror stock market indexes. He notes how the MSCI US REIT Index outperformed the S&P 500 every year from 2001 through 2006, sometimes by 20 percentage points or more.

Others are bearish. Lou Stanasolovich, president of Legend Financial Advisors in Pittsburgh, says it's time to dump REITs and ETFs that track them. He's not pessimistic because interest rates could climb over time, a long-term risk that Mr. Bailin highlights as a potential drag on REIT yields. Mr. Stanasolovich is bearish because he sees the economy struggling.

"Theoretically, with low interest rates, there should be all kinds of building going on. But there's not. Why is that?" Stanasolovich asks. "There's already too much supply, [which means] real estate prices will continue to fall."

Investors seem to share the bearish outlook. After five straight quarters of net cash inflows, REIT ETFs have seen a net outflow since Oct. 1. Those outflows have helped cool what had been surging stock prices and may have opened the door to potential buying opportunities.

Whether an investor dives in at this juncture might depend on personal risk tolerance and current needs for diversification.

Mr. Sadkowski tends to put his clients into large index funds that offer diversification across real estate sectors and geographic areas. The Vanguard REIT Index Fund, for instance, lets investors enter with a minimum $3,000 investment.

ETFs bring more volatility through the day since they trade like stocks, but they offer diversity akin to those of the big index funds. The largest ETFs tend to have similar holdings to one another, Bailin says. The largest by a factor of nearly four is the Vanguard REIT ETF, followed by the iShares Dow Jones U.S. Real Estate Index Fund.

For those with a stomach for specialization, sources point to health-care real estate (doctors' offices and the like). Mr. Ren notes that all the health-care REITs he covers raised their dividends during the recession. He also sees some opportunity in hotels, although hotel REITs can be a volatile ride.

It's also important to consider where to put them within a portfolio. Experts say the best bet might be a tax-sheltered platform, such as a Roth IRA. The reason: Unlike other types of stocks, which are taxed at the capital gain rate of 15 percent, REIT dividends are taxed as ordinary income.