Doubters fear a bubble that is ready to burst.

    The real estate sector entered the year with a remarkable five-year performance run that was partly spurred by the "" bust of the late 1990s and the resulting quest for income and reasonable valuations.
    Now, as real estate performance has sputtered thus far in 2005, the comparisons to the high-tech boom continue to linger-and possibly haunt-the normally quiet real estate sector. The questions being whispered on Wall Street ask if real estate values have gone too far out of sight after five years of serving as a "safe" refuge for investors battered by the volatile equity market.
    Namely, have the values of real estate investments been pumped up too far by speculators and quick-money seekers? Is real estate due for a correction, a return to the mean or, in a worst-case scenario, a collapse?
    Another danger sign reminiscent of the go-go 1990s, some advisors say, is that many clients are calling with get-rich-quick schemes that center around real estate holdings. These plans often involve purchasing homes for speculation purchases and then "flipping" them for a profit.
Real estate, some advisors say, has become the investment that everyone and their neighbor wants to get involved in. The last time that happened, they note, it was a foreshadowing of the stock market, led by high-tech issues, falling off a cliff.
    "It's just so similar to the tech boom of five or six years ago," says Steven Podros, a CFP who owns and operates Wealth Care LLC in Merritt Island, Fla., where the real estate market has been especially hot. Podros says he's had to talk many of his clients out of buying homes for speculation purposes, usually after pointing out to them that the costs of ownership will outweigh any benefits they can accrue from leasing. "You can go into any condo development these days and find 30 units where the owners are trying to rent or sell or flip," he says.
    Perhaps even more important to the real estate sector is the question of whether or not the wide investor acceptance of real estate is a permanent change in attitude, or a short-lived trend. These are not concerns arising just from a feeling of paranoia. Real estate investments, particularly publicly traded REITs, have benefited from surge in popularity since 2000. Last year, the Morgan Stanley REIT Index gained more than 31%, which marked the fifth consecutive year in which it outperformed the S&P 500 index. The Composite REIT Index has a five-year annualized return of 20.08% as of March 31.
    That amounts to stellar performance for a sector that previously was a fringe component of many portfolios, when it was included in portfolios at all. But, coming so soon after a stock market collapse that gave birth to a three-year bear market, concerns of overvaluation have naturally been nagging the sector.
    Real estate investors have already taken note of hedge funds starting to rotate out of the real estate sector. Even advisors who shun tactical allocation, and stick to strategic long-term models, are getting uncomfortable. They are, in many cases, lightening up in real estate through portfolio rebalancing.
    Some market watchers suggest that such fears may be healthy for the market. By throwing some cold water on the heated pace of investments, they say, it will help avoid the type of "irrational exuberance" that gripped the market in 1998 and 1999.
That's why some in the real estate investment industry are not disappointed by the recent slowdown of capital flows into the asset class. About $800 million flowed into real estate funds in the first quarter, compared with a record $3.2 billion in the first quarter of 2004.
    "My sense is, that's just fine," says Michael Grupe, senior vice president of research and investment affairs at the National Association of Real Estate Investment Trusts (NAREIT). "I would become more unsettled if there wasn't some variation in this data to indicate some moderation of behavior by investors."
    Indeed, few in the real estate investment industry expect a continued run of performance of the likes seen from 2000 to 2004. Helped along by low interest rates, a low-return equity market and a renewed investor appreciation of dividend yields, REITs hit a high of 38.47% in total returns in 2003. Last year, which also began with fears that the market had become overextended, the Composite REIT Index finished with a gain of 30.4%. Also like last year, real estate has started the year with a stumble, although the same could be said for the rest of the investment market.
    Through March 31, the Composite NAREIT Index showed a loss of 7.50%, with all real estate categories sharing in the losses. Retail malls, the best performing real estate category over the past few years, was down 4.73% as of February 28. The residential sector, where some analysts feel there is the most danger of values reaching "bubble" proportions, has been among the worst performers. Home financing, for example, was the single worst category as of February 28, down 10.75%.
    Residential apartments, which have brought investors good returns in recent years despite high vacancy rates and a supply that still far exceeds demand, were down 7.64%.
    It's still too early to determine if any trends are underlying the numbers, observers say. Grupe notes that the entire investment market has been suffering for a number of reasons, including mixed economic indicators, the continued cost of the war in Iraq and the huge federal budget deficit. Interest rates are starting.
    "We are leading the parade, but it is a parade," he says. "I think the market pretty much across the board has entered the year with a heightened awareness and concern about the risks that are out there."
        Nancy Holland, portfolio manager of the ABN Amro Real Estate Fund, says she is looking for REITs to turn in a total return of 5% to 8% this year. Like Grupe, she attributes the slow start partly to lingering questions about the economy and the slow pace of the economic expansion.
    "The economic news has been so inconsistent," she says. "We get strong employment one month and then the next month retail sales are weakening."
    Holland feels the talk of a bubble and the comparisons to the high-tech boom are unfounded. Fundamentally speaking, she says, the real estate sector is a far healthier place than the sector was in the 1990's. She notes that, aside from the office and apartment markets, demand is catching up to supply for all real estate markets.
    Economic expansion, she says, will continue to make the fundamentals better. "What may seem negative in the short term is really positive as the economic expansion fills the vacant space and gives the landlords pricing power," she says.
    In regards to her fund's portfolio, Holland says she is overweight in the industrial and retail REIT sectors. "Retail remains positive and the companies have a lot of built in earnings growth from lease renewals and replacements," she says.
    Industrial properties will be among the first beneficiaries of the economic expansion, she says, benefiting from more inventory and the movement of more goods. "Industrials have had a great run but we think there is still room in pricing there," she says.
    Holland is underweight on the net lease and healthcare categories, primarily because they are so dependent on new acquisitions to maintain earnings growth. She's sitting on the fence when it comes to office space, and slightly underweight in residential apartments. Both categories, she notes, have been dealing with excess supply in recent years, particularly apartments. While she feels increased interest rates will be a boon to apartment properties, she doesn't see an immediate improvement in these categories. "We don't expect to see an uptick until 2006, based on the growth rate of the expansion and the typical lag between employment growth and decreasing vacancy."
    The exceptions, she says, are niche companies that focus on particular regions or markets. The fund, for example, has invested in office properties focusing on the Washington, D.C., and New York City markets.
    For the advisors who are watching what the managers are doing, the real estate market has in many cases forced some adjustments in strategy. But most seem to feel that real estate holdings are a valuable portfolio diversifier, as well as a source of income, that deserves a permanent place in most portfolios.
    At the Abacus Planning Group in Columbia, S.C., it's been a matter of aggressive rebalancing to get previous year's real estate gains into other areas of the portfolio, says financial analyst George Flowers. The typical client portfolio has about 3% to 5% devoted to REITs, he adds. "We're seeing a lot of similarities to 1999, so we have been aggressively scaling," he says. "But we always feel there's a place for REITs and we're not going to get rid of them. They're a natural inflation hedge that produces income."
    RegentAtlantic Capital LLC in Chatham, N.J., also uses a strategic asset allocation approach and has been using REIT investments for 20 years, says Edward Stuart, a vice president and wealth manager at the firm. But the firm did decide to address what it perceived to be "generous" values in the REIT market compared to historical norms through the utilization of offshore REIT investments.
    The firm this year decided to devote a little less than half of its REIT allocations to foreign holdings, which it sees as a diversifier since foreign REITs are not correlated to domestic REITs, Stuart says. The firm also views the move as a hedge against the dollar.
    The move wasn't easy, Stuart adds, since there are few fund vehicles available for foreign REIT investments. The firm decided to go with the Morgan
Stanley European Real Estate Fund after it was indicated the fund might expand its holdings to regions outside Europe, he says. Dimensional Fund Advisor funds is also working on an international REIT fund, he adds.
    "There's not a lot of international REIT mutual funds out there at the moment," Stuart says.
    The availability of REITs in employee-sponsored 401(k) plans, another indicator of acceptance of real estate by investors, is growing-but slowly. In the late 1990's, about 5% of all plans offered a real estate fund, according to NAREIT. That has since grown to 12%, according to the association.
    One notable addition to the list within the past year was IBM, which sponsors one of the nation's largest employee 401(k) plans, according to Grupe of NAREIT. There are also proposals in Congress to add a REIT fund option to the Federal Thrift Savings Plan, the retirement savings program for civil service, postal and military personnel.
    Another reason Grupe feels that REITs are in portfolios to stay, unlike the dot.coms of the 1990s, is that the sector's earnings and performance are not a matter of speculation. "We are talking about hard assets," he says. "They are not disappearing. They are going to be there, occupied by tenants, with rents paid. I think that's a world of difference from what you've had in the technology sector."