Many investors restrict their real estate investments to a home, but an allocation to the commercial real estate sector, which may consist of shopping malls, office buildings, apartment complexes, and other properties, can enhance diversification, provide income, and could help protect your savings from inflation. According to David Lee, portfolio manager of the T. Rowe Price Real Estate Fund (TRREX) and the T. Rowe Price Global Real Estate Fund (TRGRX), many complex factors influence the performance of real estate companies and real estate investment trusts (REITs).

UNDERSTANDING REITs
Real estate investment trusts typically fall into one of two categories: Equity REITs, which own and operate income-producing real estate; and mortgage REITs, which lend money to owners and operators of real estate either directly, or by buying loans or mortgage-backed securities. Equity REITs currently make up the vast majority of the REIT market and offer convenient access to commercial real estate investments. By law, REITs of both types are required to return at least 90% of their taxable income to shareholders, often resulting in attractive dividends yields.

Equity REITs paid an average dividend yield of 3.4% through September 2012, as measured by the FTSE NAREIT ALL REITS Index—well above the 2.3% average dividend yield of stocks in the S&P 500. REITs also offer inflation-hedging potential: When inflation rises, rents, property values, and dividends may increase as well.

Perhaps the greatest benefit REITs offer is the ability to increase the diversification of a broader portfolio. REITs had a correlation of just 56% with the S&P 500 between January 1991 and July 2012, meaning only about half the returns in the sector could be explained by movements in the overall market. Of course, past performance cannot guarantee future results.

One reason for these diversification benefits is that the performance of individual REITs often reflects distinctive factors in regions where they operate or property types they manage. Consider Hong Kong-focused REITs, which may benefit from their proximity to ongoing expansion in China or falter if concerns intensify about an economic slowdown in the mainland. Likewise, REITs focusing on a particular property type, such as retail or industrial properties, can be subject to the fundamental forces affecting that part of the economy. Diversification cannot assure a profit or protect against loss in a declining market.

THE CURRENT REIT ENVIRONMENT
In the United States, uncertainty about the strength of the economic recovery has resulted in limited new supply as developers remain wary of new construction—a positive scenario for REITs and their shareholders. Elsewhere, a decline in homeownership rates in the U.S. has supported demand for apartment rental properties. Low interest rates have created a favorable environment for many real estate companies, which have taken advantage of inexpensive refinancing to finance their debts. A gradual recovery has supported REITs' financial performance and stock returns. Says Lee, "A general lack of new supply, combined with modest demand and low interest rates, has been a favorable environment for owning real estate."

REITs have fared well around the globe, despite the continuing headwinds from the European debt crisis and softening growth in China. "We are hopeful about eventually seeing viable resolutions to the global financial crises overhanging the markets," Lee says. "That could lead to revitalized economic activity and greater demand."

INVESTING IN REITs
Investors who seek exposure to this important segment of the domestic and global economy may find it challenging to invest directly in commercial and residential real estate companies. Changes in tax or zoning laws, overbuilding, environmental issues, as well as changes in interest rates, the quality of property management, and other factors could hurt investments in real estate. Investments in foreign securities will also be subject to the risks inherent in non-U.S. issues. However, mutual fund managers can draw upon deep experience and institutional resources to help navigate this complex asset class. "We seek flexibility with a mix of holdings that potentially can participate in a recovery or prosper in uncertain times," Lee says. "The adage that what matters most in real estate is location, location, location plays an important role in our investment selection."

Evaluate your portfolio to determine if your current exposure to this asset class makes sense. As with all sector products, we advise not concentrating your assets in one asset class. Be sure to devise a well-diversified portfolio that meets your long-term goals.

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