Watch for Falling REITs

As frightening as stocks were during the bear market, the performance of real estate investment trusts was even scarier. Standard & Poor's 500-stock index plunged 55% from October 9, 2007, through March 9 of this year. The MSCI U.S. REIT index started its collapse eight months earlier, and from peak to trough it plummeted 74%.

But since stocks began their remarkable ascent on March 10, REITs have shown that, as is often the case, the harder you fall, the bigger your recovery. From March 9 through September 17, the MSCI U.S. REIT index soared 109%, outpacing the S&P 500's spectacular 59% jump (REITs, however, are still down 44% from their February 2007 peak).

Mike Winer, the savvy manager of Third Avenue Real Estate Value fund (symbol TAREX), warns that high-yielding REIT shares have come too far, too fast. He is finding the best real estate bargains in overseas stocks and in discounted bonds.

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REITs are companies that invest in real estate and must pay out most of their profits to shareholders-hence, the high yields. Winer's fund owns just three REITs today, and Vornado Realty (VNO) is the only one of those he'd buy at current prices. The rest of his stock holdings are real estate operating companies -- ordinary companies that retain most of their earnings, which can be used to expand, to build up financial strength or both. Last March, Winer says, REITs were trading at about half the net value of their real estate holdings. Now, they trade at a premium. That's not a good sign.

REITs face tens of billions of dollars in mortgages coming due over the next several years. Even though publicly traded REITs have raised $16 billion in equity from investors this year, Winer says they still need much more cash. The problem: Lenders aren't especially eager to refinance mortgages, largely because the value of REIT properties has dropped so much. "We've only seen the tip of the iceberg so far," Winer says. "Even if financing is available, it will only be at 50% to 60% of appraised value."

I'm not as pessimistic about REITs as Winer is. The new money they've raised helps. What's more, the financially strongest REITs will likely be survivors of a brutal real estate shakeout. Somebody will pick up defaulted commercial properties for a song, and it's likely to be (among others) the cream of the REITs. Says Winer: "Publicly traded REITs may end up doing okay, but there are going to be haves and have-nots." I couldn't agree more.

But Winer is finding better values elsewhere. About two-thirds of his stocks are overseas, and he's also holding 13% in cash and 10% in bonds. Most of his foreign stocks are in Asia. "Companies in Japan, Hong Kong and Singapore have much lower debt levels," he says. "They're much more conservatively financed, and they don't have to deal" with massive refinancing.

Winer anticipates a lot more opportunities in distressed debt. When LandSource Communities filed for bankruptcy reorganization in June 2008, he snapped up $60 million in secured bank loans. When the company emerged from bankruptcy as Newhall Land Development, a privately held firm, in July 2009, Third Avenue received a 12% equity stake in the company.

When it comes to real estate funds, the Third Avenue product is about as unconventional as they come. Well, vive la différence. Over the past 12 months through September 17, the fund lost 1.6%. Meanwhile, the MSCI index took a 21% shellacking. Over the past ten years through August 31, Third Avenue returned an annualized 10.5% -- an average of two percentage points per year better than the index. Equally impressive: The fund has delivered those returns with about 25% less volatility than the benchmark. The fund's annual expense ratio is 1.12%, and the initial minimum-investment requirement is $10,000 ($2,500 for retirement accounts).

Winer, 54, spent his career in commercial real estate before becoming a stock analyst 15 years ago. Although Third Avenue is unlikely to lead the pack during a REIT bull market, I still it's the best real estate fund in the marketplace. Winer, who's assisted by four analysts, knows how to find bargains. That should be a big plus in the months to come.

For many years, REITs were a no-brainer. They delivered superior returns and helped provide diversification. Unfortunately, those days are gone. Identifying successful real estate investments is likely to be a tricky, albeit rewarding task. Third Avenue offers a low-risk way to win at real estate investing.

The only negative: The yield is puny, at 2.3%. The fund is managed for total return-as are all first-rate mutual funds.

Steven T. Goldberg (bio) is an investment adviser.