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 has 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 comprised largely 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 over the past five years.
Still, the slide in real estate funds represents a buying opportunity for investors who think that the market has already 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.
Real estate funds tend to be popular among investors looking to diversify their portfolio with holdings that traditionally are not tied to the performance of the stock market.
REITs are attractive to investors seeking high yields because their tax structure requires them to pay out most of their income as distributions to shareholders. But REITs also require a lot of money to operate. When interest rates rise, that drives the cost of borrowing up, which could translate into smaller dividends.
In addition, if Treasurys pay higher interest rates, that makes REITs relatively less attractive to investors.
Still, as an industry, the outlook on commercial real estate remains positive. The National Association of Realtors projects a modest decline in the vacancy rate, and gains in average rents next year for apartments, as well as office, retail and industrial space.
That should benefit commercial property owners, though a further rise in interest rates could hurt property owners who tend to lock in tenants for leases of a decade or longer, such as medical labs. They have less flexibility to adjust pricing.
On the other end of the spectrum, REITs that own hotels, self-storage facilities and apartments typically rent out space for periods of a year or less and have the most flexibility to adjust prices.
The most liquid way to invest in the publicly traded commercial real estate market is through U.S. exchange-traded funds, which are comprised entirely of REITs.
Woodham recommends Vanguard REIT ETF (VNQ). Its index is one of the broadest, with about 120 REITs. And it's among the most affordable, charging an expense ratio of 0.1 percent.
She also likes Schwab US REIT ETF (SCHH). It holds more than 80 REITs and is the cheapest among the exchange traded funds with an expense ratio of .07 percent.