Itís eased the three-year pain from stocks, but can its run continue in 2003?

Beset with meteoric declines in the equity markets, advisors committed to asset allocation are no doubt thankful for real estate. For three years in a row, the stock market has declined and, in a textbook example of diversification principles in action, real estate has yielded positive returns.

Although real estate typically only makes up about 15% of the portfolios of even the most faithful followers of asset allocation, that's still a nice dose of relief-for advisors and their clients. "It's just one of the best real world examples of why everyone should have real estate as a core asset class in their portfolio," says Jack McAllister, vice president of investment affairs of the National Association of Real Estate Investment Trusts (NAREIT).

But if equities continue to sink in 2003, can investors count on real estate to relieve some of the pain again? Analysts say there are no guarantees. Much will depend on whether the economy picks up, not to mention the wild card that a U.S. war in Iraq would represent.

They also note that there's another reason to be cautious: The sagging economy seemed to finally catch up to the real estate investment market in 2002. Although the market gained, real estate had its worst year since 1999. The NAREIT Composite index finished up 5.22%, compared with gains of 15.50% in 2001 and 25.89% in 2000. In a sign that real estate may be running out of steam, the market achieved most of its gains in the first half of the year. The market actually lost ground in the third quarter-its first quarterly loss since 1999.

Healthy dividend yields were among the key reasons the market stayed afloat last year, observers say, but that helped cover up the fact that vacancy rates were up, particularly in the residential sector. In fact, if you break down the REIT industry for 2002, there were wide gaps in performance from sector to sector, making it a challenge to predict how the field will change this year, observers say.

"There was huge variation in return based on property type," says Kenneth D. Statz, managing director of Security Capital Research and Management Inc. in Chicago. "It hasn't been this varied in five years."

Take, for example, the residential and retail sectors. The residential sector, comprised largely of apartment buildings, was in the doldrums last year as low interest rates, increased housing sales and job deterioration drove up vacancy rates. The residential component of the NAREIT Composite was down 5.97% last year. Retail, by comparison, benefited from stable levels of consumer spending and relatively healthy vacancy rates, finishing with a gain of 21.07%.

Although much will depend on the course of the economy, Statz says, he expects more of the same in 2003-an overall up real estate market with large disparities in performance from sector to sector. "We think we'll have the exact same story in 2003, but just a rotation in players," he says. "Some of the companies that got beat up in 2002 might be the most interesting in 2003."

Statz, for example, is keeping a watchful eye on the residential sector, where he says there's a value disparity between residential real estate companies and the real estate itself. He notes that $28 billion worth of multifamily apartment buildings changed hands in 2002, particularly in high-priced housing markets such as the Boston area and California.

The flurry of activity, driven by professional investors with a ten-year time horizon, drove up residential real estate prices at the same time REIT values, shaped by investors with a shorter horizon, were dropping. "What it leaves us with, as professional investors, is that real estate is a lot cheaper on Wall Street than it is on Main Street," he says.

He likes multifamily housing companies that are operating in high-cost housing markets. "It's very difficult to buy a home in those markets and difficult to get the zoning to build more," he says. "That is a type of property that institutional investors continue to buy very aggressively." Statz, meanwhile, is less sure that the retail sector-where he feels activity has pushed prices too high-will have as strong a year in 2003.

Other sectors could also teeter either way in 2003, analysts say. The lodging industry, they note, is still trying to recover from September 11, and hasn't been helped by waning consumer confidence and the threat of war and continued terrorism.

Likewise, the office space sector-which has been weighed down by an overabundance of supply ever since the dotcom industry became the dot-bomb business-is in need of a prolonged stretch of job growth, analysts say. "Job growth is what will drive real estate fundamentals in a large way," says NAREIT's McAllister.

Beyond the cyclical changes in the market, however, some note that real estate investments seem to be more highly regarded by investors as a portfolio diversifier. A recent study by the Profit Sharing 401(k ) Council of America showed that 8.6% of 401(k) plans had a real estate option in 2002, which was up from 6.3% in 2001, McAllister notes. Among the companies that have added real estate to their 401(k) plans since 1999, he says, are Dow Chemical, Eastman Kodak, General Motors and Verizon.

There has also been a steady rise in the number of domestic real estate funds, with the number increasing to 154 in 2002 from 106 in 1999, according to Lipper, the research and analysis arm of Reuters. A recent development was TIAA-CREF's announcement that it would create a real estate securities fund based on the Wilshire Real Estate Securities Index.

The steady income stream that real estate can provide also has been seen as a boon in the current market, says Stephen Hamrick, managing director at W.P. Carey & Co. LLC in New York City. Since it was founded in the early 1970s, the firm has formed 14 real estate funds, all utilizing the same strategy: purchasing single-tenant corporate properties and leasing them back to the original owners in 15- to 20-year contracts. The funds have given investors annual dividend yields ranging from 5.22% to 19.86%.

"Independent advisors like this product because it's a means for their clients to derive income and good returns without being dependent on the traded markets," says Hamrick. "They use it as a stabilizer-a fixed-income alternative."

Neuberger Berman launched its real estate fund May 1 of last year. It started with $5 million in assets and grew to $25 million by the end of 2002, says fund manager Steve Brown. The fund, which finished the year down 0.46%, beat the performance of the NAREIT Composite index by 445 basis points during its eight months of operation last year, he says.

He attributes the fund's success to having been overweight in REITs that owned regional shopping malls and underweight in those that owned apartments. Brown says he's closely watching the warehousing sector in anticipation of an uptick in corporate earnings the last half of 2003.

All signs indicate the growth of the real estate securities market will continue, says Donald L. Cassidy, senior research analyst at Lipper. "I think investors will continue to view it as a safe haven, unless we have a really bad economy and start having stories about serious real estate vacancy problems and defaults on loans," he says.

Statz agrees, saying that as investors become more familiar with real estate securities, they are more likely to stay. "Five years ago, these stocks were used as a refuge by advisors. When they didn't like anything else, they might buy a REIT," he says. "Now we're seeing a whole different mindset, where it's viewed as first and foremost an asset allocation tool."