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.