The iShares Dow Jones U.S. Real Estate Index Fund (IYR) is an exchange-traded fund (ETF) that invests wholly in real estate investment trusts (REITs). REITs are companies that invest in either property or mortgages. Essentially, they provide investors with liquid ways to invest in the real estate market. REITs typically pay high dividends, which they fund from rents or mortgages. Some REITs hold both mortgages and actual property.

The value of an equity REIT--a REIT that invests in property rather than in mortgages--is based on the underlying value of the firm's property portfolio as well as the rental income it receives from that portfolio. Many REITs invest in things like shopping malls or hotels. These properties are highly correlated to the economy, as leisure and shopping prices tend to fluctuate along with our nation's economic health.

Mortgage-based REITs will also move along with the economy because the ability of the owners to service their mortgage payments will depend on the economic viability of the project. More important though is the direction of interest rates, which has a direct impact on the value of these fund. Higher interest rates lead to lower prices--just like any bond.

The iShares Real Estate Fund (IYR) invests primarily in equity REITs. Because of this, the fund isn't as closely tied to interest rates. This is borne out by the fund's correlation to the iShares 20+ Year U.S. Government Bond Fund (TLT), which is under 15%. However, recent price action has seen a tighter correlation, as higher rates have started to slow real estate gains in 2004.

HOW TO MAKE MONEY IN IYR THIS YEAR
Anybody who assumes that REIT-based indices are totally safe obviously never went through something like April 2004. During that one month alone IYR tumbled about -20%. It has since recovered more than half its losses. However, with interest rates still likely to continue higher over the next year, to be followed by a slower economy in the latter part of 2005, IYR is unlikely to exceed the $110.90 high it set in early April anytime soon.

Will the fund collapse? That is not all that likely either, as the market has already priced in the impact of an large number of future interest rate hikes. In addition, the fund's approximate +5% dividend certainly will smooth things for those willing to hold this fund over the long haul.

If I were to make a recommendation solely on the price chart, then I would suggest shorting the fund with stop losses near $105. However, due to the very high dividend payout, short sales in this fund are problematic. Why? Well, when you short a fund with a fat dividend like this, you'll need to pay out all dividends to those who lend you the shares. If I thought IYR was due for another -20% drop, I would suggest such sales. However, that now appears unlikely. Therefore, the best thing to do with IYR now is stand aside and only look to buy the fund near its May 2004 low of $87.50.

This fund is an excellent defensive play, and if and when the economy starts to ease, as long as the REITs it holds remain solvent, the index should outperform the stock market overall. In addition, the fund will pay you a considerable amount of income while you wait for economic conditions to improve.

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