This year’s winner in the alternative investment space is—wait for it—real estate.

Among exchange traded funds (ETFs) that invest in real estate investment trusts (REITs), those employing leverage have zoomed to the upside; even non-leveraged funds, cranking out more pedestrian gains, have outgunned stocks and bonds. (See Table 1.)

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REITs have, in fact, been beating stocks and bonds over the past one-, three-, five- and 10-year periods, but generally with higher volatility. (See Chart 1.)

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Over those historic periods, REITs have behaved mostly like equities. That is, until now.

Take a look at Chart 2. Over the past five to 10 years, the Dow Jones U.S. Real Estate Index has been strongly correlated to the S&P 1500 Index, a proxy for the domestic equity market. Correlations to the Barclays Aggregate Credit Index, a broad-based bond benchmark, have been historically slight. Those relationships, however, have been twisted in the past year. In the past three months in particular, they’ve actually flipped. REITs are now acting more like bonds than stocks.

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The reason’s pretty simple: REITs, in this yield-hungry world, are seen as bond substitutes. Look at the dividend yields for REIT ETFs in Table 1. The current distribution yield on the Barclays Aggregate Credit Index is just 2.1 percent. Payouts for non-leveraged REIT funds are 60 percent higher.

There’s another reason. Investors believe REIT funds are immune from duration risk. They’re right, technically speaking, but there can still be exposure to rising interest rates. Duration risk represents a security’s sensitivity to changes in rates. Values for longer-dated paper—i.e., securities with greater duration—are prone to decrease more dramatically than short-term notes and bonds for a given hike in rates. REITs and REIT funds don’t have maturity dates, but some of their investments still have fuses that could be ignited by rising rates.

Overbought?

For now, consider this: On average, REIT ETFs are trading 10 percent above their 200-day moving averages. (See Table 1.)Does that mean these funds are too popular now? In other words, is it a crowded trade—perhaps even a bubble?

Steve Sachs, head of capital markets at ProShares, the sponsor of the ProShares Ultra Real Estate ETF (NYSE Arca: URE), suggests this may be the case. “Strict technicians,” he says, “would tell you that this is one sign that REITs may be a bit overbought.”

Still, Sachs, who admits he’s not a technical purist, is sanguine. “In the end, whenever you invest in a REIT you have to remember you’re buying an equity. There are times, however, when their inherent rate sensitivity makes them more bond-like. But that’s the short-term perspective. Fundamentals ultimately win out.”

On the other side is Paul Brigandi, head of trading at Direxion Shares, the issuer of the Direxion Daily Real Estate Bull 3X ETF (NYSE Arca: DRN). DRN was, at last look, 27 percent ahead of its 200-day moving average. “Keep in mind,” says Brigandi, “DRN is a leveraged fund, tracking daily returns. Given that, you have to look at moving averages a little bit differently. Prices trending above their 200-day average doesn’t necessarily mean the fund’s overbought. In fact, on an intermediate basis, it’s an indicator that the trend may continue.”

Financial advisors, not surprisingly, are a little cautious now. Rick Ferri, founder and CEO of Michigan-based Portfolio Solutions, thinks investors’ hunger for yield has inflated asset prices. “Everything with a decent yield has gotten a little pricey—high-dividend-paying stocks, MLPs, high-yield bonds, and REITs. It’s a component of persistently low interest rates coupled with relatively low volatility in yield spreads,” says Ferri.

The corollary? “These yields and spreads will likely regress to the mean when interest rates finally rise,” Ferri says.

Where’s the Risk?

REITs containing flat-rent, triple-net-leased commercial properties are most likely to suffer in a rising rate environment. A triple-net (“NNN”) lease earns its moniker because the lessee pays real estate taxes, building insurance and common area maintenance. Thus, the landlord receives rent “net” of all expenses. NNN leases generally run for long terms; 20 to 25 years is not unusual.

You can see where this is headed. An NNN lease, especially one written for flat rent, provides a very bond-like return. Real estate is priced using capitalization rates, representing net operating income divided by market value. In other words, a “cap rate” is the yield expected by an investor. When cap rates fall, property values rise to reflect the new yields sought by investors. The opposite holds true when cap rates rise; i.e., property values fall.

Generally speaking, cap rates track long-term interest rates. As Treasury yields go, so go cap rates. The implication? A hidden duration risk, at least for those ETFs with investments in NNN leases.

Not all REITs and REIT ETFs are loaded with NNN leases, however.

And studies have shown that REITs may not necessarily underperform when interest rates rise. In fact, a recent paper—“Rising Rates and REIT Returns,” by Arthur Hurley and Michael Orr of Columbia Management Investment Advisers—found that REITs, despite an initial knee-jerk reaction when interest rates first move up, often rebound to the upside. Hurley and Orr contend that an improving economy “has the potential to dampen the effects of duration risk and interest rate sensitivity, given the increased earnings and dividend growth REITs can produce.”

Short-Term Play or Portfolio Allocation?

Both ProShares’ Sachs and Direxion Shares’ Brigandi say that their leveraged products are best utilized tactically.

“DRN is geared for use by sophisticated investors with short-term objectives,” says Brigandi. “People with strong bullish outlooks for real estate can use the fund to magnify their opinions on the sector.”

Sachs is more explicit. “URE is a long-levered portfolio. An investor who wants to keep a real estate exposure can use URE to minimize his/her capital commitment to the sector. He/she gets $100 of exposure for just $50.”

Ferri has a more nuanced view. “I’d avoid using REITs as an income-producing investment today for taxable accounts. With yields below those of investment-grade corporate bonds, REITs don’t appear justified given their normal stock-like volatility and low growth. I still believe REITs are fine as a total return investment in a retirement fund, though.”