Can the streak of positive returns continue?

When the equity market sank during the three years leading up to 2003, investors were able to find some measure of comfort by moving money into REITs and other real estate investments.

That wasn't so surprising since real estate has often been used, with varying degrees of success, as a hedge against fluctuations in the stock market.

What was surprising to many in the real estate sector, however, was what happened after equities bounced back last year: Investors stuck around.

Even with the robust rally in stocks-the S&P 500 rose 28% in 2003 and the Russell 2000 was up nearly 48%-investors didn't take their real estate investments and run, as some investment veterans quietly anticipated. Demand for real estate investments continued.

The result: The NAREIT Composite REIT Index rose 38.47%, which represents the index's highest growth rate in about a quarter century. Many in the real estate sector are taking these numbers as a message that real estate is no longer one of many alternatives that sit on the periphery of the investment portfolio universe. Investors, they say, seem to be finally embracing real estate as a core investment.

"I think investors, both institutions and individuals, are taking that whole concept to heart," says Michael Grupe, senior vice president for research and investment affairs for NAREIT, the National Association of Real Estate Investment Trusts. "It really underscores the importance of having a disciplined asset allocation approach. I think that's one of the reasons that real estate stocks performed as well as they did."

One of the trends giving rise to this attitude, those in the real estate sector say, is the growing amount of real estate properties moving from the private to public market. The securitization of real estate, they say, is mitigating the traditional fears about real estate being inherently risky.

"What I think people are starting to realize is that real estate is probably a less risky asset than it has been perceived to be," says John Kramer, president of Kensington Investment Group, a real estate investment advisory group in Orinda, Calif. "The risk premium assigned to real estate five years ago was too high. It's not as volatile a business as it was ten years ago."

Plus, with Treasuries providing yields in the area of 3%, real estate remained attractive to income investors, who could dip into REITs and enjoy average yields that were on average 200 basis points better than Treasuries. "I think the whole REIT industry has matured and gained greater acceptance," says Dan McNeela, a senior analyst with Morningstar.

Making the strong year in real estate even more surprising was the fact that it came after analysts were generally of the opinion that 2003 would represent a year of modest growth. It seemed like a rational view. At the conclusion of 2002, real estate had three straight years of positive returns under its belt. Stocks, meanwhile, were in a three-year rut.

"There was a general belief that the trend could not continue," McNeela says.

Economists were also lukewarm on their projections for the economy, with the prevailing view that the economic recovery would continue to progress slowly, putting another speed bump in the path of the real estate bandwagon.

As it turns out, the analysts were partly right. Although the economy in general performed better than anticipated, the fundamentals of the real estate sector were relatively weak, particularly in the apartment and office space sectors. That, however, didn't deter investors, who adopted a very forward-looking mentality when it came to real estate.

As it was in the equity market, the investment activity in real estate became a rising tide that lifted all boats. Even the moribund apartment real estate sector, where earnings continued to suffer in the face of low interest rates, investors saw an average return of about 25%. REITs specializing in office space, where vacancy rates are still high, saw an average gain of 34%. And even the lodging sector, in the doldrums since the September 11 terrorist attacks, saw a gain of nearly 32%.

Average dividend yields dropped from 7.32% to 5.75%, partly due to lowered earnings, but overall it was a year in which it was hard to go wrong in the real estate sector. In terms of total market capitalization, the Composite NAREIT Index increased to $224 billion at the end of 2004, up from $162 billion a year earlier.

Where does that leave the real estate landscape for 2004?

In some ways, pretty much where it was at the end of 2003-sort of waiting for the other shoe to drop. Grupe of NAREIT says the association's surveys indicate that analysts are generally predicting returns of between 0% and 12% for 2004. At least one, he says, is forecasting negative 5% for 2004. The general consensus seems to be that there was a gap between the fundamentals and the share prices in real estate last year. While no one is ready to utter the word "bubble," the general belief is that portions of the real estate sector are due for a landing.

"The outlook for this year seems to be pretty much the outlook we had last year," Grupe says. "The point being, it's very hard to be able to predict what these sectors are going to do."

But based on poor fundamentals in sectors such as apartments and offices, investors have very good reason to be cautious, says Samuel A. Lieber, founder and portfolio manager at Alpine Funds. Lieber feels that the main propellant fueling the real estate market the last few years has been low interest rates, both in terms of supply and demand, as many real estate companies have been able to restructure debt and expand. "It doesn't get better than this right now," he says.

Lieber sees real estate share prices peaking over the next six months, particularly if there is a rise in interest rates. That means, he says, that a blanket approach to real estate investing could be risky in 2004, as individual company performance will have more of an impact.

"Right now we need to see more of a separation between the better and less capable companies. The valuations are very rich right now," he says. "Investing across-the-board or in a (real estate) index fund is a big mistake right now ... You're better off, I think, buying into one of the better mutual funds with a track record and presumably people who can figure out how to handle all this."

On a sector-for-sector basis, fund managers say one of the better places to be in 2003 was retail, and that may again be the case this year. They note that the sector, in general, has benefited from consolidation and a continued spending by consumers.

"We have more people in this country in their sort of peak earning and spending years than at any other time history," says Grupe of NAREIT. "Those are slowly changing demographic trends and are not going to change any time soon."

The view on rental apartments is not as bright, as owners of existing properties are being squeezed by low interest rates from two directions. On the demand side, vacancy rates continue to increase as more consumers take advantage of low mortgage rates to buy homes. The jobless economic recovery has also hurt rental demand, analysts note. On the supply side, the cheap availability of financing has apartment owners confronting robust construction of new units-an infusion of new competition despite the low demand.

The environment has forced landlords to cut rents, as well as offer tenants numerous concessions and freebies on lease renewals, says Lieber. "Most of them don't expect an upside until 2005, and that's a hopeful outlook," he says.

By contrast, Lieber says, single-family homes have a brighter outlook. Demand for homes continues at a healthy pace, he says, and homebuilding stocks are trading at about eight times this year's earnings. Most companies, he adds, already have nine months of production in the pipeline.

The office sector is still weighed down by vacancy rates of 17% to 18%, with companies scrambling to reduce rents to retain tenants, says Lieber. That's a trend that's bound to continue, he adds. The term of leases in the sector average about seven years in length. As renewals continue in an environment of high vacancy rates, further earnings declines are likely.

"Tenants are going to be in the drivers seat for a couple of years," Lieber says. "That means a net operating income decline for many office companies for the next two if not three years. We don't think it's a terribly interesting place to be."

Kramer, of Kensington, agrees, saying, "I don't think you're going to see a lot of near-term improvement in office revenues."

Grupe feels the outlook for the industrial sector is a bit brighter because it stands to rebound faster as the economy picks up. Even with the low rate of job growth and the decline in manufacturing, warehousing and transportation stands to fill some of the gap, he says. "Sooner or later products need to be shipped over here, and it all has to be temporarily positioned someplace," he says.