But its fundamentals still make the sector attractive.

How long will the string of positive returns last for real estate investment trusts?

REITs have grown at double-digit rates over the past three years. But some analysts say that real estate funds, at best, will perform in line with the market this year.

David Schulman, analyst with Lehman Brothers in New York, estimates REITs will return about 3% in 2003. The reason: The commercial real estate market is in a double bind. If the economy weakens, vacancy rates will rise from already high levels. Even if the economy improves, real estate still tends to lag the economy. Rising property taxes and soft demand for office and apartment rentals already are causing some REITs to cut dividends.

A Merrill Lynch report recently warned that dividend coverage ratios, on average, are starting to decline. Almost half of the 48 REITs followed by Merrill Lynch have coverage ratios that could be squeezed if economic growth is less than expected. The report says REIT earnings will decline this year. The office and apartment sectors have been hurt by high vacancies and declining rents. The hotel sector is volatile and vulnerable. Malls and shopping centers are the bright spots.

Industrywide, however, the National Association of Real Estate Investment Trusts reports that 89% of REITs have raised their dividend payouts since the third quarter of last year, and REITs still are yielding around 7%.

Meanwhile Milton Ezrati, senior economic strategist for Lord, Abbett & Co. in Jersey City, N.J., says REITs may have problems increasing their dividends unless the economy strengthens noticeably. Late last year, for example, Post Properties, a large apartment REIT, cut its dividend 50% to $1.80 due to problems in the rental market.

On the plus side, a survey by Pricewaterhouse-Coopers revealed that institutional investors favor high-quality properties with strong balance sheets and cash flow. They want to invest in office buildings located in the central business districts of New York, Chicago, Los Angeles, Philadelphia and Washington. The reason: Offices in these areas have diversified tenants. Rents and vacancies in these markets also are more stable than in other areas of the country.

The survey also revealed that real estate investors still are optimistic about regional malls and shopping centers. Last year, regional malls were top performers in the commercial real estate market. Mall REITs should perform well if the economy improves.

Leo Wells, president of the Wells Real Estate Funds in Atlanta, says some REITs have cut dividends, but he sees continued growth in most rental markets. The strongest REITs, for example, are not leveraged and have high-quality tenants that carry investment-grade ratings.

"All REITs are not created equal," Wells says. "You have to look inside the REITs. What is the quality of the tenants? How much leverage is being used? Are the properties diversified by tenants, industry and expiration? The key is to own properties that deal with investment-grade-rated tenants."

Richard Imperiale, manager of the Forward Uniplan Real Estate Investment Fund in Milwaukee, agrees there are more risks in the REIT sector compared with a couple of years ago. Price volatility has increased. Overall, earnings should grow at just 3% this year.

Nevertheless, he says the fundamentals still look good. The credit ratios of the large- and medium-cap REITs in his portfolio remain strong. Positive factors that support higher valuations include less severe real estate market cycles, better financial health, more competition for good properties among private buyers and low relative net-asset values.

Imperiale's mean reversion analysis shows that if over the next year REIT prices go back to their all-time low net-asset values, including the dividend, the total return would be -12.9%. The total return if prices move up to the average net-asset value would be 14.1%. This 1.1 to 1 risk-reward ratio makes the sector look attractive, he adds.

"Given the continued weakness of the economy and its impact on the cash flow of REITs, we believe investors should focus on credit quality and safety of dividends of REITs," he says. "You can buy strong REITs at reasonable prices and get paid to wait for the economy to recover."

Imperiale has made slight changes in his portfolio. He has moved some office, industrial and apartment assets out of the Southeast and into the Pacific and Mid-Atlantic states.

He is accumulating shares of attractive companies on market pullbacks. For example, he added to his stake of Hospitality Properties. The REIT buys hotels and leases them back to major operations. Recently, Candlewood Suites defaulted on its leases. However, the REIT has a $30 million security deposit to cover the loss. Imperiale expects the company to release the property to a stronger hotel company, such as a Host Marriott.

His largest holdings, which make up nearly 25% of the portfolio, include Chelsea Property Group, Simon Property Group, AMB Property, Duke-Weeks Realty, Home Properties of New York and Vornado Realty Trust.

Martin Cohen, manager of Cohen & Steers Realty Shares, sticks with the cream of the REIT crop because he expects the economy to improve. He believes the economy will grow 3% in the second half of 2003 and 3.5% in 2004. "We continue to invest in offices, industrial and regional malls because we anticipate a strengthening economy," he says. "Vacancy rates are peaking in important markets. New construction of offices has declined. That is a good sign occupancy rates and rents will grow. The mall sector will be the beneficiary of an improved economy."

The hotel sector has been showing recent strength, and he expects that to continue; he has 6% of the fund assets invested in Host Marriott, Starwood Hotels and Hilton Hotels, but is avoiding the apartment sector due to overbuilding and lack of demand.

Cohen says several favorable trends will sustain REIT prices. Big institutional money is flowing into REITs; the net demand by institutional investors over the past 18 months was $10.2 billion. Index funds are buying REITs because they've been added to several S&P indexes. More companies are repurchasing shares because their REITs are trading below net-asset value. And institutional investors are diversifying their portfolios with REITs.

The fly in the ointment remains the economy. "Although demand is strong, job growth will be required for REITs to improve in almost any type of property," Cohen says.

His ten largest holdings, which make up 50% of the portfolio, include big names such as Vornado Realty Trust, Boston Properties, Prologis, Simon Property Group, AvalonBay Communities and Rouse.

Other real estate stock fund managers are turning to Real Estate Operating Companies (REOC) for long-term growth instead of current income. REOCs are not required to distribute 95% of their income, as are REITs. They can pump the retained earnings back into new developments.

"There are pockets of opportunities in REITs," says Michael Winer, manager of the Third Avenue Real Estate Value Fund. "The key is to be very specific and invest in well-capitalized companies whose dividends are well covered and secure. These are companies that have tremendous staying power from strong balance sheets."

Winer focuses on long-term capital appreciation rather than income. He's buying REOCs when he thinks the price represents a significant discount to its true value. The fund owns just 30 stocks, 60% of which are real estate operating companies as opposed to REITs. And 70% of the fund's top ten holdings are real estate operating companies.

"Real estate operating companies are a vehicle for growth," he says. "Real estate is a capital intensive business. Companies that retain cash flow have a significant advantage over REITs, which pay out all their cash to shareholders."

Winer says that as cash comes into the fund, he is primarily accumulating more shares in the following companies due to their long-term growth opportunities:

St. Joe Co. Winer sees the company unlocking hidden value in millions of acres of land in northwest Florida, which is being developed for residential resorts, single-family homes, as well as condominium and mall, office and industrial space. The company will create residential properties and resorts on valuable costal land, with $500,000 condominiums along the beach. It also owns valuable land adjacent to the proposed Palm City International Airport.

Forest City Enterprises. A commercial real estate operating company that develops projects in urban areas. It is developing an infill area in New York City and is redeveloping the old Denver airport. Its company has properties in 24 states and is well-diversified in office, retail, residential and hotel properties.

Tejon Ranch Co. This company owns 270,000 acres of land 60 miles north of Los Angeles in Kerin County, California. Much of the land is adjacent to Interstate 5, the busiest freeway in the nation. It is considered the next and perhaps last great frontier in land development in California.