Housing markets remain depressed, but the picture is very different for commercial real estate, a category that includes offices, malls, and hotels. As the economy slowly grows, commercial real estate is recovering smartly. Hotel occupancy is improving, and office rents are climbing in strong markets such as New York and Washington, D.C. The office vacancy rate in central business districts dropped from 14.6% in the first quarter of 2011 to 13.9% in the second quarter, according to Cushman & Wakefield. During the past year, real estate mutual funds—which invest in commercial real estate—have returned 17%, outpacing the S&P 500 by a wide margin, according to Morningstar.

Commercial real estate is recovering

Simple supply and demand is driving the revival. Although demand for hotel rooms and office space is increasing, developers are not building many new properties. “It is hard to get financing to build new hotels or offices,” says Jon Cheigh, portfolio manager of Cohen & Steers Realty Shares, a mutual fund. 

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Problems with financing began to appear in 2005. At the time, developers were racing to build single-family houses and condos. The fevered activity pushed up prices for land and construction materials. The higher prices did not slow down the hordes who wanted to buy houses, but developers of commercial properties found that it was uneconomical to proceed with new projects. As the financial crisis unfolded, construction of all kinds of real estate stopped dead in its tracks.

When will supplies of new commercial properties begin to surge? Not for at least several years. It can take five years for a developer to design an office building and complete the project. Since few projects started in 2007 and 2008, there can be no spike in new properties until sometime after 2013.

To participate in strengthening markets, consider investing in Real Estate Investment Trusts (REITs), companies that own portfolios of properties. Over long periods, REITs have delivered strong returns. While the S&P 500 returned 2.6% annually during the past decade, REITs delivered 10.3% annually, according to the National Association of Real Estate Investment Trusts.

Real estate dividends pay out richly

Under the rules, REITs must pay out most of their income to shareholders as dividends. As a result, REITs tend to provide rich sources of income. The average REIT currently yields 4.9%. Besides providing income, REITs can help to diversify portfolios, sometimes rising when most other stocks are falling. REITs often outdo stocks during inflationary periods. This occurs because landlords can raise their rents when other prices are climbing.

Many REITs specialize in specific sectors, such as apartments or industrial properties. A solid office REIT is Boston Properties, says Steve Shigekawa, portfolio manager of Neuberger Berman Real Estate Fund. The REIT owns high-quality offices in Boston and New York. “We are seeing good demand for offices in coastal cities,” says Shigekawa. “In New York, the vacancy rate has dropped below 10%, which is an indication that the market is improving.”

Shigekawa also likes upscale mall REITs. While customers of mid-price stores are still watching their wallets, high-end consumers are shopping for their favorite luxury brands. “In the better malls we have seen double-digit sales growth in the last several quarters,” Shigekawa says.

As sales rise, mall owners can increase their rents. Among the strongest mall REITs is Taubman Centers, which owns 23 upscale malls.

Hotel business is picking up

Hotel REITs have been among the top performers. With business and leisure travel increasing in the past year, hotel occupancy rates have improved sharply. Room rates are climbing. In the troubled Phoenix market, the average room rate climbed 13% in the past year to $82, according to Smith Travel Research. In San Francisco, the rate jumped 17% to $171. A solid hotel REIT is Host Hotels and Resorts, which owns 110 luxury properties that are located in prime urban locations or in resorts. The hotels operate under a variety of brands, including Hilton and Starwood.

Occupancy rates of apartment complexes are also improving. Unable to afford buying houses, many people are shifting to renting apartments. The outlook for apartments is likely to improve in coming years, says Jon Cheigh, of Cohen & Steers. The demand for apartments is connected to the number of people aged 18 to 30, he says. When more young people finish school and begin searching for housing, demand for apartments increases. That will happen during the next 10 years as the Echo Boomers—children of Baby Boomers—graduate high school. Cheigh recommends UDR, a REIT that owns mid-priced apartments. Many of the REIT’s properties are aimed at young professionals and blue-collar families.

An improving economy could provide a special boost to warehouse REITs. Many of these own warehouses near ports and airports that are used by retailers and other businesses that need to ship goods. The boom in shipments from Asia and other overseas markets is providing a boost to demand for warehouses. Leading REITs have been gaining sales by building larger facilities that can handle deliveries more efficiently. A top warehouse REIT is ProLogis. Besides expanding in the United States, ProLogis is also growing rapidly in Asia.

To hold a diversified collection of REITs, consider a real estate fund. A strong choice is Neuberger Berman Real Estate. The fund typically holds 40 REITs. The portfolio recently had 17% of assets in malls, 14% in apartments, and 13% in warehouses. During the past five years, Neuberger Berman has returned 5.3% annually, outdoing 95% of its competitors, according to Morningstar. By buying a solid fund like Neuberger Berman, you may be able to diversify your portfolio and obtain steadier results in difficult markets.