Although the short-term performance of real estate mutual funds will hinge largely on the direction of interest rates, performance is expected to be relatively stable in the longer term, with the potential to trend higher once the economy maintains a strong footing.

In fact, Canadian real estate mutual funds have performed well this year, but “they have not been attracting new money over the last little while as investors have been sitting on the sidelines waiting to see what will happen with interest rates,” says Derek Warren, assistant vice president and portfolio manager with Lincluden Investment Management in Mississauga, Ont., and manager of CIBC Canadian Real Estate Fund. Specifically, there are expectations that the U.S. Federal Reserve Board will hike interest rates sometime soon.

To put the performance of Canadian real estate mutual funds that invest in the domestic and global markets in perspective, the top 10 performing real estate funds — according to Morningstar Canada data and excluding different classes of the same fund — produced gains ranging from 21.4%-25.6% for the one-year period ended Oct. 19. For the three-year period ended on that date, the gains ranged from 16.6%-16.9%; and for the five-year period, the increase ranged from 11.2%-16%. Each of the funds had a three-year double-digit standard deviation, indicating a high level of volatility.

“[These gains are] partially due to [the mutual funds’] exposure to the global real estate [market], whose fundamentals are more attractive, especially in certain parts of Europe and Asia,” says Ahad Ali, alternative investment analyst with Octane Capital Inc. in Toronto.

However, higher interest rates will lead to higher debt servicing and financing costs, which will affect the bottom lines of real estate companies and real estate investment trusts (REITs) that mutual funds hold in their portfolio, says Ali. As well, “potentially lower earnings could also negatively impact the price of these investments and, in turn, the net asset value of the funds that hold them.”

In addition, real estate investments will also distribute lower income or dividends in a rising interest rate environment, which is a concern to real estate mutual fund investors who depend on the income that the funds distribute, he says.

Nevertheless, the potential impact of higher interest rates might be overblown, Ali says, as it’s not anticipated that there will be a sharp increase in interest rates. Rather, “the increase will be less than moderate and, as such, the increase in cost will not be significant in the near term.” Once these concerns dissipate, real estate mutual funds should experience stable growth.

Looking ahead, the performance of real estate, in general, and real estate mutual funds, specifically, is also dependent on the outlook for the economy as a whole. That’s because “real estate companies have the ability to raise rents in a good economy,” says Warren, and demand for real estate will also rise. Conversely, demand for real estate will fall in a weak economy, reducing occupancy rates and the potential for higher rents.

Depending on the strength of the economy, certain sectors will perform better than others, providing an advantage to investing in real estate mutual funds, albeit with less liquidity than investing in a REIT that trades publicly.

Compared with REITs — which invest in a specific segment of the market, such as office or industrial space — mutual funds hold diversified portfolios of companies that derive their earnings directly from real estate and other related businesses as well as REITs. Theoretically, a diversified portfolio offers enhanced protection from volatility compared with investing in a REIT, but Warren recommends holding investments in real estate mutual funds for a minimum of three years.

In the current uncertain environment, Warren focuses on investing in larger, well-managed companies with stable cash flows that are operating in primary markets with prime locations and which have a good mix of retail and commercial tenants.

It’s worth paying attention to these companies’ balance sheets, he adds, while Ali cautions that “typically, higher interest rates will have the greatest impact on the balance sheets of companies that are highly leveraged.”

Still, Warren believes that “real estate is ready for a rally in the short term” and suggests that “now is a good time to invest in real estate mutual funds.”

This is first article in a three-part series outlining the opportunities for clients interested in investing real estate.

Next: The outlook for real estate investment trusts