Although residential real estate markets have struggled, commercial real estate investments have continued to prosper.Proving an army of doomsayers wrong, real estate mutual funds and real estate investment trusts have outperformed the Standard & Poor’s 500 for seven consecutive years and could be poised to run their winning steak to eight this year.

The average mutual fund investing in real estate-related stocks gained about 33 percent in 2006, topped in performance only by emerging markets funds, according to Lipper Inc. The three-year annualised return of 25 percent and 10-year annualised return of 15 percent also are impressive.

Development of new properties has been cautious and gradual, pension funds are looking to diversify their holdings, and large investors are aggressively taking real estate investment firms private. For example, Blackstone Real Estate Partners, an affiliate of the Blackstone Group, agreed in November to acquire billionaire Sam Zell’s Equity Office Properties Trust in the biggest takeover ever of a real estate company.

“Residential real estate is driven by emotion and consumer sentiment, while commercial real estate is driven by economics,” said Alexander Goldfarb, analyst with UBS Securities in New York. “Retail investors, both domestic investors and foreign investors from places like Dubai, have been looking for yield after the collapse of the tech boom.”

Yet even the boldest prognosticators acknowledge it will pay to be a little careful in 2007. Despite a lack of ominous signs, any segment this hot for this long has to start cooling down sometime. Expect some slowing during 2007, along with greater volatility due to privatisation rumours and deals.

Returns of the real estate mutual funds paralleled the 2006 returns of the MSCI U.S. REIT Index. Traded on exchanges like a stock, a REIT invests in and owns properties such as shopping centers, offices, apartments and industrial facilities. There are more than 200 publicly traded REITs that provide dividend yields comparable to bonds.

Although REITs are the primary holdings within real estate mutual funds, the funds also often hold stock of companies that provide products and services to the real estate industry.

“For 2007, we see strong earnings growth and yields that should deliver REIT total returns to investors in the low- to mid-teens,” said Barry Vinocur, editor of Realty Stock Review in Novato, Calif., who suggests that individuals keep 10 percent to 15 percent of their personal assets in REITs. “There’s a massive global reallocation under way of dollars moving into real estate as graying societies increasingly focus on assets that can deliver solid income.”

Among individual REITs, Vinocur recommends the shares of Developers Diversified Realty Corp. (DDR), Regency Centers Corp. (REG) and Kimco Realty Corp. (KIM) in shopping centres; Simon Property Group (SPG) in large malls; Boston Properties Inc. (BXP) in offices; Ventas Inc. (VTR) in health-care properties; and Vornado Realty Trust (VNO) in widely diversified properties.

“Think about how much money is in pension funds and what would happen if they increase their real estate allocation by just one percent, creating a huge amount of capital,” Vinocur said. “We estimate there is around $100 billion earmarked globally for investment in commercial real estate.”

Not all REITs or real estate funds are alike, which makes it important to scrutinise the prospectus of any one you’re seriously considering. Some experts believe it would make sense to avoid the very hottest areas altogether for a while.

“While the office building and shopping centre REITs look just fine, the hotel and health-care properties that have been delivering incredibly high returns would appear to be more troublesome,” said Andrew Clark, senior research analyst with Lipper in Denver. “I would advise those investing in a real estate fund to check the prospectus first to see how heavily the fund’s portfolio is weighted in those two segments.”

Vinocur agrees that hotel REITs, though fully recovered from the severe downturn that followed the 9/11 terrorist attacks, tend to be cyclical in nature. Because there are differences of opinion on where they are in the current cycle, he recommends sticking with dominant or “destined-to-be-dominant” hotel companies rather than attempt to time the overall market for them. His favourite established REIT in this area is Host Hotels & Resorts Inc. (HST).

Three top-performing real estate funds that also look promising for 2007, according to Lipper, are:

[bul] Phoenix Real Estate Securities “A” (PHRAX), up 35 percent in 2006, thanks to holdings of Simon Property Group, ProLogis Trust and Host Hotels.

[bul] T. Rowe Price Real Estate Fund (TRREX), up 36 percent in 2006, helped by a portfolio with Boston Properties, Archstone-Smith Trust and Equity Residential.

[bul] Cohen & Steers Realty Focus “I” (CSSPX), up 32 percent in 2006, boosted by its holdings of Vornado and AvalonBay Communities.

“Someday REITs will hit an air pocket and you definitely shouldn’t bet the farm on them,” said Vinocur, whose favourite real estate mutual funds are the Vanguard REIT Index Fund (VGSIX) and Vanguard REIT Index Exchange-Traded Fund (VNQ). “But if you have enough money to have a portfolio, some of that portfolio should definitely be allocated to commercial real estate.”

(Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, P.O. Box 874702, Tempe, Ariz. 85287-4702, or by e-mail at andrewinv(at)aol.com.)