Is It Time to Buy REITs?

When everyone's hyping an investment, it's a good idea to stay clear. But after the hysteria ends and everyone moves on to the next big thing, smart investors will check out the wreckage to look for bargains.

Real estate investment trusts (REIT) certainly qualify as a once-hyped investment that has fallen from grace. Just a year ago, the Fool's Rule Your Retirement newsletter interviewed REIT expert Ralph Block to discuss whether returns that had exceeded 30% annually from 2004 to 2006 could continue. Since February, however, the Vanguard REIT Index ETF (AMEX: VNQ  ) has fallen more than 20%, and REITs that focus on certain sectors, like mortgage REITs Thornburg Mortgage (NYSE: TMA  ) and Apartment Investment & Management (NYSE: AIV  ) , have gotten hurt far worse.

More than mortgages
With the housing slump in full force, anything with the words "real estate" in it has gotten the cold shoulder from most investors lately. Just this past Tuesday, REIT shares got slammed in the wake of the Fed's decision to cut rates by only a quarter point. Apartment managers AvalonBay Communities (NYSE: AVB  ) and Equity Residential (NYSE: EQR  ) have fallen 9% and 12%, respectively, in just three days.

It's important to remember, however, that not all REITs focus on residential real estate. Many REITs focus on various aspects of commercial real estate management, from retail store and shopping mall REITs like Simon Property Group (NYSE: SPG  ) to business office space REITs such as Vornado Realty Trust (NYSE: VNO  ) . So far, business conditions in these other sectors have held up fairly well, although some fear that the housing slump will spread to commercial real estate over time, especially if credit availability remains tight.

Think long-term
In the interview, Block argued that much of the strong performance from REITs in recent years resulted from investors reevaluating the value of real estate investments. In an environment where bond yields were extremely low and credit was freely available, the much higher payouts offered by REITs were too good to last. As a result, even after REIT prices ran up, they still compared favorably with other income-producing investments.

Now, even after a significant drop, there's still no guarantee that REITs have hit bottom. Low interest rates should once again provide some support, but if investors expect that the properties REITs own will lose value, they won't be in a hurry to buy a depreciating investment.

For average investors saving for long-term goals like retirement, however, holding a small fraction of your assets in REITs has some benefits. REITs add diversification to the income-producing side of your portfolio, while also including the potential for long-term price appreciation that real estate offers. Unless you think the U.S. real estate market is in line for a long-term decline -- like the drop in Japanese land prices from 1990 to 2005 -- investing in REITs through a mutual fund or ETF makes sense to me.

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