The domestic real estate investment trust (REIT) sector roared into 2007 on a seven-year winning streak during which it smoked the Dow Jones Industrial, S&P 500, Russell 2000, Nasdaq Composite and 10-year U.S. Treasury benchmarks. But following the subprime mortgage crisis and ensuing credit crunch, the collective group exited the year with its tail between its legs.

The FTSE NAREIT All REIT index lost nearly 18% last year, which underperformed the other major market metrics by a mile. REITs are companies that own and often manage income-producing real estate, and they have nothing to do with the residential home market (with the exception of the small mortgage REIT subsector that makes or owns loans secured by real estate collateral). But the subprime mess gave investors an excuse to book profits in a sector many thought was overextended after a long bull run.

The carnage was severe, with big losers ranging from apartments (-25.4%) and self-storage (-24.8%) to lodging/resorts (-22.4%) and office (-19%).

Some people think the REIT sell-off was overdone and that the sector is primed to rebound. U.S. REITs on average traded at a 13% premium to their underlying net asset value at year-end 2006, far above the typical 4% premium. By year-end 2007, REITs traded at an 18% discount to net asset value. It reached 20% earlier this year before the group rallied in March to cut the discount to about 9% by the end of the first quarter, according to Green Street Advisors, a REIT investing and consulting firm in Newport Beach, Calif. But some analysts believe the discount is actually higher. Richard Moore, a REIT analyst at RBC Capital Markets, pegged the discount somewhere in the mid-teens.

Either way, REITs have been through the wringer, and some recently traded at very hefty discounts in the 20% to 30% range. That's bargain-bin territory. "When you buy REITs at a discount, you tend to get extraordinary returns," says Brad Case, research chief at the National Association of Real Estate Investment Trusts (NAREIT).

Investors already seemed clued into that. Two of last year's big losers zoomed in this year's first quarter, with the self-storage sector up 20.23% and apartments up 11.20%. And the group as a whole held steady during the tumultuous quarter, with the NAREIT All REIT index down a hair at 0.42%. That handily beat the other major market benchmarks thanks to the index's nearly 4% rise in March. Excluding hotels, all sectors gained in March.

Have We Hit Bottom Yet?

REITs were created by Congress in 1960 (as part of a tobacco bill, no less) as a way for the public to invest in income-producing real estate. Before the recent slump, there were three significant downturns in that brief history, including one in the early 1970s that offers little guidance because the REIT universe was so small then.

According to NAREIT, REITs tumbled 23.9% during a 14-month peak-to-trough downturn that began in August 1989, a setback blamed on a real estate depression caused by oversupply. During that period, the average annual return for individual REITs sank 20.9%. But after REITs hit their nadir, the group enjoyed an 89-month rally.

Then came a 23-month peak-to-trough downturn that began in December 1997 and lasted through November 1999 when the group plunged 23.7% and companies suffered annual declines of 13.2%. "There wasn't anything wrong with real estate fundamentals," Case says. "It was that nobody wanted to invest in real estate when they could invest in tech stocks." Afterward, REITs rallied for the next 86 months.

The current downturn began after the REIT market peaked in January 2007 and eventually nose-dived 27% by the end of this past February, with the average annual decline for REITs at 25.2%. But they recovered from that collective freefall a bit, and were at negative 24.1% by the end of March.  "The severity of this downturn is worse than the prior two," Case says.

Yielding Results

REITs are required to pay out at least 90% of their taxable income to shareholders. In return, they can deduct the dividends paid from their corporate tax bill. The combination of steady dividend income and potential stock price appreciation are big selling points for REITs, and dividend yields have held steady during the downturn. In fact, yields rose last year as prices fell-the average yield was 5.29% at year-end 2007 versus 4.06% at year-end 2006, and they averaged 5.57% as of the end of the first quarter.

"Dividend yields are pretty secure for the most part," says Tom Bohjalian, a portfolio manager at the REIT investing firm Cohen & Steers. "There are isolated cases every year where one or two companies cut their dividend because they sold a big portfolio and no longer have enough cash flow to sustain a dividend."

Bohjalian believes that commercial real estate fundamentals in the U.S. point to moderate growth rather than a major downturn. For starters, there isn't a major oversupply problem with commercial real estate because soaring building supply costs helped limit new construction in recent years. And if the rash of federal stimulus programs perk up the economy in the second half and beyond, as expected, he says that should create enough jobs to support demand in the office, apartment and hotel sectors, among others.

But the sputtering economy will impact REIT cash flow growth, which Bohjalian expects will be in the 5% to 7% range both this year and next, down from 10% in 2007. He adds that all bets are off if there's a deep recession, but his firm doesn't anticipate one. For now, he sees a number of REITs trading at discounts and sporting safe, attractive yields.

Bohjalian points to a couple of storage companies-Extra Space Storage and Sovran Self Storage-that recently traded at roughly 15% discounts, had stable cash flow projections and had yields of about 6%.  On the office side, Bohjalian likes Mack-Cali Realty Corp., which is concentrated in the Northeast, and Liberty Property Trust, which has a strong East Coast presence. Both had recent yields of about 7% and strong balance sheets. He also likes companies with established beachheads in key markets where it's difficult to add new office supply such as New York, Boston, Washington, D.C., and Los Angeles. Among them are Boston Properties, Vornado Realty Trust, SL Green Realty Corp. and Kilory Realty Corp.

Positions Of Strength

Moore from RBC is bullish on retail REITs despite the current turmoil surrounding consumers and retailers alike. "Retail is the most oft-missed sector by real estate investors because they incorrectly associate the fortunes of retailers or consumers with what's happening at the real estate level," he says.

Moore says retailer expansion plans look beyond the current slowdown and that the companies want to be in the best shopping centers, the majority of which are owned by REITs. "Every time we have any kind of pullback, people say it's the end of the retail guys," says Moore. "And every time we pull out of it, they see that earnings are stronger than anticipated. Retailers still have to pay the landlord."

His top retail pick is Simon Property Group. "It's the big dog in the regional mall space and is one of the best companies out there, period," says Moore, who adds that its strengths include a strong balance sheet, great management and an international presence. "They can position themselves for the next 15 years with a bigger international push and by taking advantage of others' weaker balance sheets," he says.

Elsewhere in REIT-land, Moore likes the earnings outlook in the industrial warehouse sector, along with specialty office properties that aren't tied to the vagaries of the economy. In the industrial area, he likes ProLogis, the world's largest owner and manager of warehouses. He says its presence in port cities puts it on the front lines of global trade.

Moore favors two companies in the specialty office space. Digital Realty Trust provides data center space that's in big demand from tech companies and financial institutions. "Digital Realty is the dominant player in this space, and they have little competition," he says. The other, Corporate Office Properties Trust, focuses on government, defense and intelligence contractors.

Homes Out, Apartments In

Home ownership rates dipped to 67.8% at the end of last year from a peak of 69.2% in 2004, while apartment occupancy rates have hovered in the mid-90% area. It seems logical that rentals would benefit in a tough single-family home environment marked by tighter credit and rising foreclosures, which helps explain the comeback of the apartment REIT sector in the first quarter.

Another thing in their corner is that residential rental REITs qualify for cheap and readily available financing from Fannie Mae and Freddie Mac, in effect giving them a subsidy from the two government-sponsored mortgage agencies that helps lower their costs, support asset values and boost the return on their investments versus other REITs. "Apartment REITs have a cost-of-debt advantage of about 50 to 150 basis points," says Haendel St. Juste, an analyst with Green Street Advisors.

But apartment REITs face some pressures, too. For starters, they might suffer in a recession when job growth stalls because there's a strong correlation between apartment demand and job growth. In addition, there's growing competition from the so-called shadow market of unsold single-family houses and condos being turned into rental units in overbuilt areas such as Miami, Las Vegas and Phoenix.

"There's a fundamental tug-of-war going on in the sector," says St. Juste, "but we feel there will be sufficient demand to generate low- to mid-3% revenue growth in apartment REITs in 2008." His top picks include AvalonBay Communities, which he says has the highest-quality and best-located apartment portfolio in the space in such markets as Seattle, northern California, New York City, Boston and Washington, D.C.

St. Juste also likes UDR Inc., which recently sold 86 of its lower-growth, lower-quality apartment properties for $1.7 billion. He says the result is a better-positioned portfolio with improved growth prospects and money in hand to buy back stock, reduce leverage and make strategic acquisitions.

To Buy Or Not To Buy

Joseph Janiczek, a wealth manager in Greenwood Village, Colo., played the REIT market like a fiddle. He says he bought positions for clients during 1999 and 2000 (with some additional purchases afterward) when they traded at double-digit discounts and offered double-digit yields, and then sold off his entire position piecemeal in 2006 through early 2007 because he thought the sector was overvalued.

Janiczek wants to get back into REITs and says he's monitoring them closely, but he's not ready to take the plunge. "If the underlying real estate drops in valuation, that's more risk than we want," he says.

For some investors, the recent commercial real estate headlines--from pullbacks in new construction and falloffs in business office rentals to predictions that commercial real estate prices could fall--are yellow flags for REITs. There are differences between the public- and private-market values of real estate; conventional wisdom holds that REIT prices are leading indicators of where prices are going on the private side. Given the recent downturn in publicly traded REITs, some expect the other shoe to drop on the private side.

That remains to be seen. At the same time, some people argue that declines in REITs--and the mutual funds and exchange-traded funds that focus on that space--have already priced in the bad news and are looking ahead toward an economic recovery.

"If you know the REIT market and can use it effectively in a portfolio, it can be an attractive investment opportunity," says Kevin Mahn, chief investment officer at Hennion & Walsh, a broker-dealer in Parsippany, N.J.

One of his favorite REIT sectors is health care because of its long-term staying power. "It's a service sector that will never be outsourced and there will always be a need for it," he says. His top pick is Health Care REIT, whose portfolio includes senior housing, nursing homes, hospitals and other health-care facilities in 38 states. It produces steady cash flow, has a safe dividend north of 5% and generated total returns of 9% last year.

"We don't recommend that clients put a significant portion of their allocation in REITs," Mahn says, "but we like to see some exposure because they're negatively correlated to the general equity market and can outperform in certain periods."