The old aphorism holds that a key to real estate is "location, location, location." But in the world of real estate securities the past few years, the mantra may as well be, "diversification, diversification, diversification." That's because in recent years, REITs and other real estate investments did exactly what their proponents say they're supposed to do-they acted independently of the broad market.

Real estate has beaten the returns of the S&P 500 each of the past two years and, as an added bonus, has provided shareholders with dividend yields that have dwarfed much of the bond market. In a market that's in desperate search of solid returns, that type of performance is going to attract attention.

Standard & Poor's, for example, last year included Real Estate Investment Trusts in the S&P 500, MidCap 400 and SmallCap 600 indexes for the first time. Mutual fund companies also are starting to roll out real estate products, including New York-based Neuberger Berman, which in January recruited two managers from Cohen & Steers Capital Management to head its new real estate securities effort.

Fortune 500 companies, meanwhile, are adding real estate options to employee 401(k) plans, and smaller companies are following suit. As a result, some advisors express the hope that more colleagues finally will stop viewing real estate as an "alternative" or even boring investment and recognize it as a staple of portfolio diversification.

"That's their primary purpose," says Barbara Lynn Steinmetz, an advisor in Burlingame, Calif., who typically puts up to 5% to 7% of clients' portfolios into REITs. "This gives you the opportunity to add another dimension to a portfolio, with more liquidity than if you bought real estate the old-fashioned way."

At the same time, some warn against getting too exuberant about the potential of real estate. It's easy to get excited about the performance of real estate the past two years, considering the performance of the stock market in general. Indeed, some note, many flocked to real estate because there were few other alternatives for deriving growth and income.

Some analysts also feel that if the economy continues to drudge along in a slow recession, the impact eventually will be felt in real estate, where the ability to fill commercial properties with rent-paying corporate tenants is crucial. That's something investors should keep in mind if they go into real estate thinking it's a "sure thing" when it comes to both diversification and a high-dividend yield, says Morningstar analyst Alan Papier.

"The dividends do kind of insulate it from volatility. You can count on that income every year to offset losses if things go bad," Papier says. "That being said, you're talking about equity offerings. Their prices can move substantially day to day and week to week."

It was the movement of real estate prices in 2000 and 2001 that caught investors' fancy. The NAREIT Composite Index of publicly traded REITs, for example, had REITs showing a return of 25.89% in 2000 and 15.5% in 2001-compared with declines of 9.1% and 11.89% for the S&P 500.

Through January, the NAREIT index was up 0.38%, while the S&P 500 was down 1.46%. REITs, which by law have to pass on at least 90% of income to shareholders, also have surpassed bonds as income generators in recent years. Over the past two years, REITs have had an average dividend yield of about 7%, compared with a 5% yield for 10-year U.S. Treasury notes during that time.

It is this comparative yield performance that has some feeling REITs are suitable not just for portfolio diversification, but also as an alternative fixed-income investment. That view, of course, is not universal, as some consider REITs too volatile over the long-term compared with bonds.

But Leo Wells III, founder and president of Wells Real Estate Funds in Atlanta, feels the volatility factor is overplayed. Look beyond the price component of your average REIT, he maintains, and what you find is a robust annual dividend yield. Since 1960, he says, REIT dividends have averaged more than 9%.

"That's what the beauty of REITs is-the dividend," Wells says. The stability, he says, comes from the fact that REITs derive their income from rents, which in many cases are locked up in long-term leases.

Wells Real Estate Funds hones in on this aspect of REITs by focusing on properties that have been preleased for terms of 10 to 15 years to single-occupant Fortune 500 tenants. One benefit of this arrangement is leases typically have inflationary increases built into them, he says. Another advantage, he says, is that lease obligations legally take precedence over bond and dividend obligations. "When you get into surety, you want to be as high up on the food chain as you can get," he says. "To me, that's why rent is so important and such a big issue compared to corporate bonds."

He notes that for investors focused on share price, growth and the chance at hitting a 20% home run, this is an aspect to REITs that often gets overlooked. "The investors I'm looking for are the people who say, 'I want that dividend every single month, and I don't want to take the chance on a tech fund that has never made a dime in their life,'" Wells says.

Likewise, the CPA:15 real estate fund created by W.P Carey & Co. LLC in November centers on single-occupant tenants with 15- to 20-year leases, says Anne R. Coolidge, the fund's president and portfolio manager. "It's designed for long-term cash flow," she says. "We have 65,000 investors in all our funds, and a lot of them are elderly and living off the dividends."

Underscoring the contrast between real estate and the rest of the financial markets, an Ibbotson Associates study released last spring concluded that the correlation of REIT stock returns and other common stocks and bonds has been declining for the past 30 years.

The study cited a 65% drop in correlation between REITs and small stocks, a 61% drop between REITs and large stocks and a 41% drop between REITs and long-term bonds. "Ibbotson found that the behavior of REITs makes a strong case for their inclusion in portfolios as a hedge against the volatility and underperformance of other securities," says Steven A. Wechsler, president and CEO of the National Association of Real Estate Investment Trusts (NAREIT), which commissioned the study.

Those characteristics have put REITs in the limelight at a time when most equities are not inspiring great confidence-and that is why analysts expect an increase in the number of retail REIT mutual funds this year. Neuberger Berman has begun offering real estate products to institutional and high-net-worth clients, says Peter E. Sundman, executive vice president and head of the firm's mutual fund and institutional business.

"It's a perfect time for this now with the market volatility, and bond yields as low as they are," Sundman says. "If you can marry the dividend yield of REITs with just a little bit of capital gain, you're into the double digits."

Analysts, of course, do interject with the sobering reminder that low market correlation works both ways. In 1998 and 1999, for instance, the NAREIT Composite Index was down 18.82% and 6.48%, respectively, while the S&P 500 was returning a bullish 28.58% and 21.04%.

REITs were doing what they were expected to do, but that didn't stop some advisors from being pummeled by their clients when, for the sake of diversity, they left money in REITs during those years. In other words, if investors get into REITs thinking they've hit on a new "can't miss" investment, they're going to be disappointed, says Ted Roman, owner of Roman Financial Advisors in San Diego.

"Even though I think REITs are a little high, it doesn't matter," Roman says. "Because, again, we're buying it to diversify. If the market's going up or the market's going down, I don't really care."

Although he feels real estate should be part of every portfolio, Roman doesn't put his money into individual REITs. He considers that too risky. Instead, he relies on REIT mutual funds offered by Vanguard and Fidelity. For the average client, he says, this is the most sensible way to include REITs as a portfolio diversifier. "Buying an individual REIT is just too narrow and just too much risk," he says.

There appears to be at least increased recognition of the role REITs play in diversifying a portfolio. Some companies that recently have added REIT options to their employee 401(k) plans include Dow Chemical, Eastman Kodak, General Motors and Verizon, says Jack McAllister, NAREIT's vice president of institutional affairs.

"The question we ask is, 'Why aren't more doing it?' What we think is important is that real estate, like other types of investments, should be a part of an investor's portfolio all the time," he says.

At the same time, investors need to be aware of some of the risks. In 2001, for instance, REIT funds that specialized in the lodging industry were hurt by the recession and then clobbered by September 11 and the subsequent concerns about air safety, Morningstar's Papier notes.

If corporate earnings don't pick up, he says, the trickle-down effect eventually will be felt across the real estate industry. A hint of such an impact was seen in the latter part of 2001, when there was a slight decline in demand for B- and C-type office properties, he says. "If corporate America continues to miss earnings and lay people off, that could slacken demand for offices," Papier says.