As the subprime meltdown continues and credit markets swoon, exchange-traded funds (ETFs) focusing on real estate are showing signs of life.

In the past month, real estate's the best-performing category among open-end mutual funds in the U.S., according to Morningstar data. The average real estate specialty fund had returned -0.30% in the past month through Monday. That compares to small value's 7.48% fall and large-cap value's 7.24% slip. (Blend and growth categories in all market-cap sizes are down even more in the past 30 days.)

Funds investing in real estate, typically through real estate investment trusts (REITs), are largely considered value-styled stocks. And most fall on the smaller end of the cap spectrum. So are they simply catching an improving wave from value as a whole?

Step back to the past three months, and REIT funds score only slightly better than most small-cap value funds. But trailing 12-month returns show real estate falling more than seven percentage points behind their more diversified small-cap value rivals.

One month certainly doesn't make for a new trend. What's positive for REIT investors, however, is that valuations are down from much higher levels even a year ago.

"They're not at the lowest they've ever been, but REITs are at a point now in terms of valuations where they can be considered attractive investments," said Anthony Welch, a money manager at Sarasota Capital Strategies.

Last week, the advisor started buying iShares Dow Jones U.S. Real Estate ETF (NYSE: IYR) and iShares Cohen & Steers Realty Majors ETF (NYSE: ICF).

"We're not going in heavily," Welch said. "But we still like REITs as good diversifiers for the rest of our equity ETF portfolios."

Looking Closer At Valuations

Many investors consider price-to-book as a key ratio when comparing REITs. But the industry places emphasis on so-called funds-from-operations, or FFO. It's a valuation measure similar for REITs as earnings per share calculations are for common stocks.

The problem with book valuations is that REITs use a lot of different accounting standards that are unique to their tax structure. One issue with normal calculations is the importance of depreciation on a REIT's books.

Funds-from-operations represent profits excluding gains from sales of property and depreciation. It's viewed as a better measure of ongoing income being generated.

In that regard, Welch says the average REIT price is trading at a multiple of around 17 times its FFO value. "In the last few years, the FFO was above 20," he said. "After the big sell-off in REITs that started in February 2007, that's come down a good deal. Now, they're trading right around their longer-term FFO averages."

The National Association of Real Estate Investment Trusts reported in its latest survey that leading office REIT names are averaging a better-than 8% growth rate in FFO levels in the past 12 months. Industrial REIT companies are up around 7% in that same time frame, while mixed office/industrial firms have seen their FFO rates drop slightly.

With 30-year Treasury yields paying about 4.35% and the average REIT yielding around 5.5% now, he says real estate remains an attractive diversifying tool for long-term investors.

"REITs have been beaten down so much over the past 12 months that their dividend yields have increased to attractive levels," Welch said, pointing out that price and yield move in opposite directions in most cases.

"If you've owned a REIT fund for a long time and stuck with it, now's not the time to be panic selling," he added. "It's too late for that. If anything, people should be considering whether to add to their holdings."

J.D. Steinhilber, a Nashville, Tenn.-based adviser, agrees that REITs should be back on investors' radar screens. He notes that REIT indexes troughed in January 2007 with a yield of 3.8%.

"Relative to 10-year Treasury yields, REITs are trading at a positive yield spread of 150 basis points, the most attractive level in over three years," Steinhilber said. "As a result, the asset class had returned to more reasonable relative valuations."

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