Their resilience reveals investors'
broadening view of the asset class.

    REITs are turning into the 21st century's Teflon investment. The asset class is in its seventh consecutive year of strong performance-a period of time when there have been legitimate reasons to worry about the ability of real estate to sustain its momentum.
There's been rampant speculation, house flipping, fears of a valuation bubble and, most recently, rising interest rates. But none of the potential setbacks ever seem to stick.
    In early April, REITs-with total year-to-date returns of about 12%-were outperforming every Russell index except for the Russell 2000 small-cap family. REITs, meanwhile, continue to enjoy inflows of money both domestically and internationally-while attaining a stronger presence in 401(k) plans, IRAs and other retirement investment plans.
    Publicly traded REITs now consist of 195 companies with assets totaling $379.8 billion, according to the National Association of Real Estate Investment Trusts (NAREIT). What's behind the resilience of real estate investments?

Among the theories is that investors have gone beyond viewing REITs as just a fixed-income vehicle, and are recognizing the asset class's capital appreciation benefits. Also, with investors placing more focus on asset allocation and diversification, real estate's noncorrelation with the stock market has become an attractive selling point.
    The quest for diversification, in fact, is cited as one of the reasons there's been an uptick in demand for global real estate investments, particularly in Europe, Asia and Australia, as well as interest in U.S. real estate from foreign investors. "We really feel strongly that investors are attracted to real estate because of the diversification benefits," says Abby McCarthy, NAREIT's senior director of industry information statistics. "The bigger story here is that people are focused again on investing for the long term."
    The performance of real estate in recent years has certainly built the case for long-term plays in the sector. The NAREIT Composite Index was up nearly 12% in total returns-capital appreciation and dividends-at the end of March, according to NAREIT. The index has a 10-year annual compound return of 14.50%, compared with 9.02% for the S&P 500 and 9.85% for the Russell 2000. The MSCI US REIT Index was up 12.38% in total returns, year to date, as of April 6.
    Share prices have held up despite the fact that rising long-term interest rates have brought the yield on ten-year Treasury notes to their highest point in two years, nearly 5%. The NAREIT Composite average dividend, meanwhile, slightly tops 4%. Historically, the contrast in yields would indicate a cooling in real estate investors, as yield-focused investors put their assets to work in bond vehicles.
    The real estate market, however, has yet to see investors take flight. "If you look at real estate's typical correlation with interest rates, it's a little surprising," says Jay Rosenberg, equity portfolio manager of the First American Real Estate Securities Fund. "But I think what we have here is that there is a tremendous amount of money on the sidelines trying to get into real estate."
    Much of that money is starting to come from foreign and institutional investors who see real estate as a solution for diversification, income and capital appreciation. "As an income alternative, real estate offers corporate bond-like yield with good growth on top of that," Rosenberg says. "That growth really offers an inflation hedge."
    The new focus on international real estate investments was partly illustrated recently by the recent launch of the Dow Jones Wilshire Global RESI/REIT indexes. Nancy Holland, portfolio manager of ABN Amro Real Estate Fund, sees the broadening of the real estate market as a move by investors to add another layer of diversification to their holdings. "They are realizing that while property itself has attractive returns, and positive results in a diversified portfolio because of low correlation, there is also low correlation within different regions of the world," Holland says.
    Jason Mattox, executive vice president of Behringer Harvard's REIT I and Opportunity REIT I, publicly registered nontraded REITs specializing in commercial real estate, sees a deep-seated change in the way investors view real estate investments. "Having gone through the technology bust, I think people in this case have a long memory," he says. "I don't think they want to be overweight in one sector like technology ever again."

Mattox says he also sees a good supply of quality real estate. The Behringer Harvard REITs focuses on properties in the top 20 metropolitan markets in the nation. "If you really continue to apply good, sound underwriting and don't try to kid yourself that you are going to rent $25 in an $18 market, you can buy property and be successful," he says.

Even with the influx of money, whether real estate can support a 12% return rate through the year remains to be seen. Rosenberg, for instance, feels a return to the mean is inevitable-what is questionable is when that reversion will happen.
    Holland is predicting returns of 8% to 10% this year, which would mean a pullback sometime before December 31. "I don't think that's a sustainable level," Holland says of the 12% real estate return. "I think the volatility over the last 24 months to 36 months is going to continue, and may be exacerbated by this run-up in the first few months of the year."

Real estate market watchers, however, say that even if there is a cooling off in 2006, fundamentals across real estate sectors remain healthy and in some cases are improving. In a continuation of a trend developed last year, residential properties-particularly rental units-are leading the sector, along with the retail sector.

Real estate on a broad level has benefited from a general pickup in the economy, they say. While interest rates do have an adverse impact on real estate investments on one end, market watchers note, higher interest rates also are indicative of a growing economy-which translates into lower vacancy rates and higher rents.

Also, unlike other periods during real estate's seven-year run, valuations are starting to become more aligned with fundamentals, market watchers say. "While valuations are fuller than a year or two ago, they are at least being supported by improving fundamentals," Holland says.
    REIT investors, meanwhile, are becoming more discriminating and are less tolerant of REITs with poor business practices and fundamentals,     Rosenberg says. "Companies that are messing up are really getting hammered," he says.
Rosenberg says his fund is finding investment opportunities in virtually all real estate sectors, and that the sector is entering a period where "leverage is moving to the landlord from the tenant." In many cases it's a matter of demand catching up to supply, such as in the hotel, industrial and apartment sectors, he says. Tighter supply is also leading to higher rents and revenues in certain office sectors, notably New York City, Washington, D.C., Los Angeles and other urban coastal markets.

For suburban markets, office space is still suffering from oversupply, with some landlords having to roll down rents upwards of 10% on long-term lease renewals. "We haven't entered a phase of pricing power across all sectors," he says. "But as a generalization, we are moving there."

The ABN Amro Real Estate Fund is overweight in apartment, industrial and retail mall properties, says Joe Pavnica, the fund's North America portfolio manager. The fund, however, is a bit wary of valuations in the apartment sector, which is still enjoying the momentum from a strong fourth quarter 2005. "Valuations are a little bit ahead of themselves," Pavnica says.
    Retail malls, which have enjoyed a rise in consumer spending, are considered a safe play if there is a spending slowdown because their retail tenants typically are locked into eight- to ten-year leases, he adds.
    The industrial sector, he says, is less dependent on job growth than other sectors. Occupancy rates are rising in this sector, Pavnica says, and rental rates are starting to increase. He notes that this sector can be an indirect international play in cases where industrial space is tied to a global business.

Rosenberg, whose fund has about 10% to 15% of its holdings devoted to retail mall companies, says that unlike other real estate sectors, retail malls have not had to contend with an oversupply of space. "Of all the sectors, this is the most consolidated," Rosenberg says. "There is not a lot of new malls being built and we don't have the supply issues that have dogged other sectors."
    Apartments and offices are the sectors most represented in the fund, he says. Offices remain a tenants' market, Rosenberg says, but the fund has targeted niche markets such as New York City, where there have been reports of 40% hikes in rent because of high demand and low supply.