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Rising interest rates weigh down real estate funds

| Sunday, Dec. 1, 2013, 12:01 a.m.

One look at the lackluster gains of real estate mutual funds this year might give the impression that commercial property owners are struggling through a relapse of their post-financial crisis woes.

But demand for office, retail and other commercial real estate has been steadily improving along with the economy, boosting occupancy and rental rates for many owners. And many economists project more of the same next year.

Even so, a surge in interest rates this summer and concern they could increase further next year have spooked investors, dampening the funds' returns. Real estate sector equity funds have delivered an average total return of 1.93 percent so far this year, trailing only precious metals equity funds, according to Morningstar.

The funds, which are often composed of real estate investment trusts holding commercial properties, are still up an average of nearly 6.1 percent from a year ago and have delivered an annualized return of 19.3 percent during the past five years.

Still, the slide in real estate funds represents a buying opportunity for investors who think that the market has factored in a further rise in interest rates.

“REITs are finally looking fairly valued,” said Abby Woodham, fund analyst at Morningstar. “They could, of course, go down further, but the valuation is much more attractive now than it has been for quite some time, so it's not all doom and gloom.”

What remains to be seen is how the market weighs the positive growth trends in commercial real estate against the risk of interest rates rising further.

Interest rates began rising in May on speculation that the Federal Reserve was preparing to pull back on its economic stimulus, which includes $85 billion in monthly bond purchases to keep interest rates low. The yield on the 10-year Treasury note rose from 1.63 percent at the start of May to nearly 3 percent by early September.

But the central bank surprised investors in mid-September when it said that it wanted to see more evidence of improvement in the economy, and it decided to maintain its bond purchases. The central bank meets again in December, but most economists don't expect any changes in the bond program until March. The yield on the 10-year Treasury ended trading at 2.75 percent on Friday.

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