Investors hunting for high yields or capital appreciation sell off.

The real estate market has been a bit of an enigma the past few years. One one hand, REITs have been on a four-year run that helped many investors weather the bear market and solidified the asset class as a staple in many portfolios. On the other, some observers have worried that real estate investors have become too speculative and, dare we say, exuberant, with too much fast money pouring into the market without regard for underlying fundamentals.

Now it seems those opposing viewpoints have come to a head.

What everyone said would happen sooner or later in real estate stocks has finally happened: The market fizzled. In the wake of a robust jobs report at the end of March, fears of interest hikes got the better of many real estate investors and sparked a selloff.

After starting the year strongly, the NAREIT Composite Price Index declined 15.26% in April, while the NAREIT Equity Price Index sank 14.58% over the same period. As of May 3, the composite index was down 3.19% for the year.

REIT funds, meanwhile, saw an exit of cash. Outflows of nearly $500 million were reported after the first three weeks of April. If the trend continues, it could mark the first quarter since the fourth quarter of 2001 that real estate funds have experienced net outflows.

The natural course of questions has since followed. Is the run over? Has the bubble burst? Was there a bubble in the first place? What do investors do with their real estate holdings now?

Not everyone is in panic mode. For advisors who utilize real estate first and foremost as a diversification tool, the events of April were par for the course-a healthy correction that could even be used as a buying opportunity.

"I don't think it's necessarily inaccurate to say that a little steam has been let out," says Michael Grupe, NAREIT's senior vice president for research and investment affairs. "I also think that from time to time that's probably a good thing. This may very well be one of those times."

The reason, Grupe says, lies in the strong, yet atypical, performance of real estate in recent years. In the four-year period covering 2000 through 2003, he says, NAREIT's total return index was up slightly more than 100% and the price index was up 50%.

Those were numbers that were viewed as a salvation by investors during the bear market. But they were also off the charts. Grupe points out that for the 30 years prior to this run, the NAREIT total return index had an average annual compound return of 14%.

With that history, he says, it's unreasonable to expect the real estate market to sustain the gains of the past four years.

"Those kinds of total returns just are sort of above the long-run expected return, and they run ahead of the kind of returns one would expect from real estate," he says.

That's why Grupe and others say the way an investor reacts to the April downturn probably will depend on what the investor was doing in the real estate sector in the first place.

If it was someone looking for yield or capital appreciation only, there's a good chance they'll be running scared. Asset allocators, meanwhile, are going to stay put.

Observers, in fact, feel it was the yield mongers who were largely responsible for the rash of selling. The reason: The sell-off didn't make a whole lot of sense.

While it is true that the strong jobs report of late March could foreshadow an increase in interest rates, it is also true that interest rates have historically had little impact on real estate performance over the long run. And the bull market in many types of real estate, most notably housing, isn't slowing down at all. If anything, it's getting just as frothy as REIT prices did.

The knee-jerk reaction was that higher interest rates would spell bad news for real estate companies leveraged with debt. Virtually ignored was the fact that the jobs report signaled a stronger economy, which would have a clearly positive ripple effect throughout the real estate industry. Also unrecognized was the boost higher interest rates would have on the residential apartment sector, whose high vacancy rates have been partly due to the availability of low-rate mortgages.

Debra Morrison, a principal with RegentAtlantic Capital in Chatham, N.J., feels the April selloff was precipitated by "amateurs" who invested in real estate solely in search of yields and with little understanding of the asset class. "REITs basically are a quality long-term diversifier," she says. "They're simply more than just yield machines."

With yields in 2000 to 2002 that averaged more than 7%, the real estate sector did attract many investors who were looking for alternatives to Treasuries. Yet what many investors may not have realized, says Morrison, is that the dividend tax cuts signed into law last year largely do not apply to REIT dividends. This is due to the fact that REITs generally do not pay corporate taxes.

NAREIT estimates that only about a third of REIT dividends qualify for the 15% dividend-tax rate. The rest are usually subject to ordinary income tax. "The trouble is that unsuspecting investors I think have been lured in by the headlines, but once you look at the tax effect it may be disappointing," Morrison says.

The exuberance of yield investors was probably one major influence behind the run-up in real estate and particularly REIT values during the previous four years, says Nancy Holland, manager of the ABM-AMRO Real Estate Fund. "I think that people didn't understand necessarily why they were investing," she says. "It's not a fixed-income alternative. And it's not just equity. It's a nice combination of both that has diversifying aspects to it in a portfolio. I don't think they understood that."

The overzealousness of real estate investors became apparent in 2003, says Holland, when weak sectors such as residential apartments and office space were going up as strongly as sectors such as retail. There was little correlation between fundamentals and value. Being anywhere in real estate was leading to healthy returns. "We saw less differentiation between the sectors than any prior year," Holland says.

Holland now feels another 5% needs to be eroded to get back to fair value. If the investment community overreacts, as it often does, the drop may be as much as 10%.

She foresees real estate performing from zero to 10% this year, but has a positive outlook on the retail sector, which continues to benefit from healthy consumer spending and may be nearing a shortage in floor space. A rebound in the residential sector may take longer, given the continued affordability of home ownership, she says. Holland says her fund is also underweight in the office sector, which continues to be hobbled by an oversupply of space and a weak job market. "What's healthy is that the market hasn't completely fallen away. We haven't seen a tremendous overreaction," she says. "Fundamentals are getting better."

Another positive sign, albeit an anecdotal one, is that institutional investors are reportedly increasing their real estate holdings, says Grupe of NAREIT. Such investors, particularly plan sponsors and international investors, reportedly have significant sums ready to be allocated to real estate, he says. "What that tells me is, at least on the institutional side, a lot of these institutions, after getting hit pretty hard in the bear market, did their homework and decided they need a real estate allocation," Grupe says.

Advisors who decided long ago that REITs belong in their clients' portfolios for diversification alone also say they see no reason to let up on that thinking. "We use them as a strategic component and as one of three or four market diversifiers," says Tom Davison, a senior advisor with Summit Financial in Columbus, Ohio. A typical client portfolio, he says, will have between 2% and 4% in a REIT fund. REITs are placed in a group with the Merger Fund, the MLM Index Fund and international bonds not hedged to the U.S. dollar as portfolio diversifiers. "The driving thing is the low correlation with the other asset classes and decent returns on their own," he says.

Thomas Grzymala of Principal Alexandria Financial Associates in Alexandria, Va., says that although several of the firm's REIT funds were sold after hitting stop-loss limits in April, these securities continues to have a permanent place in client portfolios. "I think they're back into the fair value range now," he says.

Raymond Nasser, of Financial Planning and Consulting in Midlothian, Va., recommends a 5% to 10% exposure to real estate, through an indexed real estate fund. Investing directly in REITs, and trying to make judgments regarding individual real estate sectors, is something he leaves to the experts. "Far be it from me to tell which segment will perform the best or which individual REIT will perform the best," he says.

Some advisors, however, feel investing directly in REITs can bring special advantages. Michael Helffrich, owner of PFP Advisors in Minneapolis, invests in natural resource REITs, particularly REITs that own timberland, including the Plum Creek Timber REIT.

One of the advantages to such REITs, he says, is that they are not correlated to the broader real estate market and their dividends are tax advantaged because they primarily are treated as capital gains distributions and a return of capital. "They're just a great stable source of income," he says.

Joel Ticknor of Ticknor Financial Inc. in Reston, Va., devotes anywhere from 4% to 10% of his clients' assets to real estate, depending on their risk tolerance. "The main point is that when you put these in a portfolio it is an allocation decision you stay with," he says.

Agreeing with that statement is Michael Dubis, president of Touchstone Financial in Madison, Wis. "We had a pretty good correction there, but it's totally irrelevant" in terms of the long-term picture, he says. "Timing the real estate market is crazy."