What are we to make of REITs? These trusts, which trade as equities and are essentially collections of real property, or mortgages, became widely reviled when the real estate bubble collapsed in late 2008. Domestic and global REIT mutual funds plunged 39.6% and 46.6%, respectively, according to Morningstar. But REITs joined the S&P in regaining a lot of ground last year, delivering an average return of 20% in 2009.

Despite huge vacancy rates in malls, office buildings and multifamily housing complexes, many REITs in the $250 billion market performed well, particularly in the second half of the year, when they returned just slightly less than the S&P. Domestic and global REIT mutual funds were up an average of 31% and 37%, respectively, according to Morningstar.

THREE PICKS
Nobody expects those kinds of returns in 2010. After all, many experts warn that a commercial property crisis could still be in the offing, and housing prices are still falling in most areas. So what kind of investment are REITs now? As we move into 2010, "there is reason to be cautious about REITs," says Andrew Gogerty, Morningstar's REIT mutual fund analyst. "I think it's prudent to have your REIT portfolio allocation held to about 3% to 5% of a fund, instead of 5% to 10%, where you might have had it."

REIT mutual funds typically are "pretty widely diversified" across the various property types-including multifamily apartments, commercial office space, retail malls, healthcare and industrial facilities-so advisors don't have to worry too much about the economic picture for specific property categories. "Most bank clients probably can't really play those individual markets anyway, unless they go into ETFs," says Gogerty.

He recommends three REIT mutual funds, based on their long-term track records. His top pick is T. Rowe Price Real Estate Fund (TRREX), a broadly diversified portfolio of higher-quality REITs that boasted trailing returns for 2009 of a whopping 57.87%, with a five-year annualized return of -1.1% (thanks to the market crash). He also likes J.P. Morgan U.S. Real Estate A Fund (SUSIX), which is more concentrated, with only 20 to 30 stocks in its portfolio, a trailing 2009 return of 53.23% and a five-year annualized return of 0.32%.

Finally there's First American Real Estate Securities A Fund (FREAX). "They do more trading than the other two funds, but their execution has been spot on," says Gogerty. This fund actually reaches beyond the REIT universe to invest directly in some operating companies-notably Hilton Hotels, he says. The FREAX load-adjusted return for 2009 was 51.26% and the fund's five-year annualized average return was 2.21%.

THREE STRIKES
T. Rowe Price fund manager David Lee takes a very long view with TRREX. He says that 2010 probably won't live up to 2009's performance, since commercial property markets are still slumping, but that historically REITs have recovered before the underlying property cycle. Furthermore, even if, as he anticipates, commercial property markets continue to decline this year, that can cut two ways.

A REIT's holdings may sink in value, but it can pick up of distressed projects on the cheap. For example, REIT Equity Residential "got some New York City apartment complexes at distressed prices," says Lee. Between March and December of 2009, 60 individual REITs, representing about half of the 127 REITs listed on the New York Stock Exchange, raised a total of $20 billion in equity and $7 billion in unsecured debt. this gave them the capital they needed to pick up such distressed properties.

Ultimately, it's all going to come down to the economy, says Lee. "We're talking about physical assets, and at the end of the day, what those assets need is jobs growth. So if we see the economy start to rebound, and jobs start to come back, so will the REIT market. And we think that's a matter of when, not if."

John Wenker, co-lead manager of the real estate department at First American Funds, and co-lead manager of the First American Real Estate Securities Fund, agrees: "2009 was a great year for us, but then, if you make 50 cents after you've just lost a couple of dollars, you feel good, right?" Good future REIT performance will depend on three things, or as he puts it, "You need a decent economic environment. Oops! Don't have that. You need jobs. Oops! Don't have that. And you need capital availability, and right now, that looks kind of tough too."

Wenker notes that while REITs rode the stock market surge in 2009, by mid-February publicly held REITs had fallen about 10% from December highs. "The easy money in REITs has been made," he says. REIT mutual fund performance going forward will be "much more muted," and linked to the general state of the economic recovery.