Itís eased the three-year pain from stocks, but can its run continue in 2003?

Beset with meteoric declines in the equity markets, advisors committed to asset allocation are no doubt thankful for real estate. For three years in a row, the stock market has declined and, in a textbook example of diversification principles in action, real estate has yielded positive returns.

Although real estate typically only makes up about 15% of the portfolios of even the most faithful followers of asset allocation, that's still a nice dose of relief-for advisors and their clients. "It's just one of the best real world examples of why everyone should have real estate as a core asset class in their portfolio," says Jack McAllister, vice president of investment affairs of the National Association of Real Estate Investment Trusts (NAREIT).

But if equities continue to sink in 2003, can investors count on real estate to relieve some of the pain again? Analysts say there are no guarantees. Much will depend on whether the economy picks up, not to mention the wild card that a U.S. war in Iraq would represent.

They also note that there's another reason to be cautious: The sagging economy seemed to finally catch up to the real estate investment market in 2002. Although the market gained, real estate had its worst year since 1999. The NAREIT Composite index finished up 5.22%, compared with gains of 15.50% in 2001 and 25.89% in 2000. In a sign that real estate may be running out of steam, the market achieved most of its gains in the first half of the year. The market actually lost ground in the third quarter-its first quarterly loss since 1999.

Healthy dividend yields were among the key reasons the market stayed afloat last year, observers say, but that helped cover up the fact that vacancy rates were up, particularly in the residential sector. In fact, if you break down the REIT industry for 2002, there were wide gaps in performance from sector to sector, making it a challenge to predict how the field will change this year, observers say.

"There was huge variation in return based on property type," says Kenneth D. Statz, managing director of Security Capital Research and Management Inc. in Chicago. "It hasn't been this varied in five years."

Take, for example, the residential and retail sectors. The residential sector, comprised largely of apartment buildings, was in the doldrums last year as low interest rates, increased housing sales and job deterioration drove up vacancy rates. The residential component of the NAREIT Composite was down 5.97% last year. Retail, by comparison, benefited from stable levels of consumer spending and relatively healthy vacancy rates, finishing with a gain of 21.07%.

Although much will depend on the course of the economy, Statz says, he expects more of the same in 2003-an overall up real estate market with large disparities in performance from sector to sector. "We think we'll have the exact same story in 2003, but just a rotation in players," he says. "Some of the companies that got beat up in 2002 might be the most interesting in 2003."

Statz, for example, is keeping a watchful eye on the residential sector, where he says there's a value disparity between residential real estate companies and the real estate itself. He notes that $28 billion worth of multifamily apartment buildings changed hands in 2002, particularly in high-priced housing markets such as the Boston area and California.

The flurry of activity, driven by professional investors with a ten-year time horizon, drove up residential real estate prices at the same time REIT values, shaped by investors with a shorter horizon, were dropping. "What it leaves us with, as professional investors, is that real estate is a lot cheaper on Wall Street than it is on Main Street," he says.

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