The Market-Beating Secret for This Year and Beyond

Yesterday, the S&P 500 index closed just a fraction of a point higher than it did on the last day of 2010. For investors who'd prefer slightly bigger gains than the S&P's 0.0135% jump, you'd have been better served following the money flows into one of the hottest sectors of the market: real estate investment trusts.

But why have REITs captured the attention of the investing world? Below, we'll reveal the secret of REIT success -- and why that success may be in jeopardy. But first, let's take a look at what investors have already done to capitalize on the trend.

Jumping on the REIT bandwagon
Whenever an investment is outperforming the broader market, you can count on investors taking notice. That's certainly been the case with REITs. As a recent Wall Street Journal article reported, a broad index of property REITs had returned 7% as of the end of October, beating out the S&P's 1% gain at the time.

Nor is this simply a case of investors chasing short-term performance. Over much longer periods of time, REITs have done far better than the overall stock market. Since late 2001, for instance, REITs have enjoyed the double-digit percentage average annual returns that stock investors came to count on in the 1980s and 1990s, weighing in around 11%. That figure beats the average annual return for stocks by a whopping 7 percentage points.

Some of the returns are extremely surprising, especially given public perceptions about the state of the real estate market right now. But in many sectors of the REIT universe, you can find encouraging news:

  • Retail mall REITs have produced some phenomenal returns. Simon Property Group (NYS: SPG) is up 35% in the past 12 months, while Tanger Factory Outlet Centers (NYS: SKT) has jumped about 25%.

  • Office operator Boston Properties (NYS: BXP) is up more than 20% on strength in high-value office space.

  • Health-care related REITs have also performed quite well, with Health Care REIT (NYS: HCN) and HCP (NYS: HCP) both up double-digit percentages.

That combination of attractive features and strong returns has pushed many investors into the REIT market. An estimated $6 billion in new money has flowed into REITs so far this year, already beating out last year's 12-month figure and quintupling 2009's rock-bottom activity. So what's behind the strength in the REIT space? Several factors are working in REITs' favor.

Cheap leverage
Lately, talking about REITs raises discussion of top-yielding mortgage REITs ARMOUR Residential (NYS: ARR) and Invesco Mortgage Capital (NYS: IVR) , with their ultra-leveraged business models that have so effectively capitalized on the Federal Reserve's gift of guaranteed low future interest rates. When the rate environment encourages leverage, those companies that borrow the most will do the best -- at least in the short run. Most REITs aren't nearly as leveraged as their mortgage REIT cousins, but they still take advantage of debt financing to acquire properties.

Buying fear
In addition, with nervousness about the real estate market discouraging property purchase activity, REITs can capitalize on healthier rental rates. That extra income gets passed through to shareholders and rewards REITs for taking on the risk of buying properties in scary times.

Misperceptions of risk
According to the Journal article, REITs have often moved up and down with the stock market with nearly perfect correlation, especially during the crisis-ridden period of the past few years. Yet while REITs do have some equity-like characteristics -- real estate often moves in line with inflation, as do some stocks -- they have plenty of differences as well. It's entirely possible that real estate and stocks will see their returns diverge in the future, as they did for much of the past decade.

Hunger for income
Perhaps most importantly, REITs are giving investors exactly what they want right now: healthy income. With REITs required to pay out the lion's share of their income in dividends, shareholders can count on getting nice payments from their shares as long as the REIT is making a profit.

Should you own REITs?
So the big question is to what extent you should have REITs in your portfolio. There's nothing wrong with having part of your overall asset allocation assigned to REITs. In fact, if you'd done so 10 years ago, you'd be quite happy with the results -- although they certainly took you for a bumpy ride along the way.

What's dangerous, though, is jumping into any type of investment when it's red hot. Be sure to take a close look at any REIT you're interested in to make sure you understand exactly what type of exposure you're getting -- along with the inevitable risks involved. If you pick the right REITs, though, they could keep helping you beat the market in the years to come.

REITs are just one type of dividend-paying investment that offers a good combination of growth prospects and current income. If you want still more ideas, you won't want to miss The Motley Fool's latest special free report, which reveals the names of 11 rock-solid dividend stocks. Click on the link and claim your free report while it lasts.

At the time thisarticle was published Fool contributor Dan Caplinger always tries to scope out the secrets. You can follow him on Twitter here. He doesn't own shares of the stocks mentioned in this article. Motley Fool newsletter services have recommended buying shares of Health Care REIT. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't keep secrets from you.

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