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Have REITs hit a ceiling?

Real estate mutual funds are ringing up impressive gains for the fifth year in a row, but some experts fear the sector's foundation soon will show some cracks.

These funds primarily invest in a portfolio of real estate investment trusts, or REITs, that own properties like hotels, apartments or office buildings and pass rental income on to shareholders. Real estate funds lost money during the tech mania of the late 1990s, but thanks to REITs' attractive yields and modest price tags, real estate funds _ typically pitched as humble portfolio-diversification tools _ averaged a whopping 17 percent annual gain over the past five years, compared with a nearly 2 percent annual loss for the Standard and Poor's 500 stock Index, according to Lipper Inc.

The funds have taken in more than $12.6-billion in new money since the end of 1999, when the category had less than $9-billion in assets, according to Boston fund consultant Financial Research Corp.

But REIT shares aren't nearly as cheap as they were a few years ago. That has some investors worried, particularly because the Federal Reserve Board has started raising its target short-term interest rate and, when rates tick up, some risk-averse investors switch to fixed-income securities. So far this year, real estate funds are up an average of more than 12 percent. But they seem vulnerable to bad news. Fears of rising interest rates knocked the funds down more than 13 percent in April, their worst one-month loss is more than two decades, according to Lipper.

"The double-digit losses in April showed investors they can suffer some serious losses in real estate stocks," says Dan McNeela, a senior fund analyst at Morningstar Inc.

While still cheaper than the overall stock market, REITs are trading at a higher multiple of the cash flows they churn out than usual. REITs now trade at about 13 times their cash flows, compared with 11.5 times cash flows over the past 15 years, says James Corl, co-manager of the $1.7-billion Cohen & Steers Realty Shares fund. At the end of 1999, when their current run began, they traded at just about eight times their cash flows.

These higher valuations worry some investors. In March, Litman/Gregory Asset Management, a fan of real estate funds for many years, moved most clients out of the funds. The reason: REITs no longer looked cheap compared with the broad stock market, after years of looking like "an awesome opportunity," says Josh Weiss, director of research for the Orinda, Calif., firm. The firm's No-Load Fund Analyst newsletter previously suggested investors put 5 percent of their assets in real estate funds.

Another concern stems from the popularity of the funds. Some worry that the gush of money into these funds could leave just as quickly if the sector falters, causing an even sharper decline in REIT shares.

Thanks to new investments and capital appreciation, real estate fund assets topped $33.2-billion at the end of July, up from less than $8.8-billion at the end of 1999, according to Financial Research Corp. In the first seven months of the year, assets of closed-end real estate funds, which are measured separately, also surged to more than $11.7-billion from $7.7-billion, according to Lipper. (Closed-end mutual funds issue a fixed number of shares that trade throughout the day on an exchange, often above or below the value of their portfolio holdings.)

Some experts aren't spooked. Cohen and Steers' Corl, for instance, thinks that interest rates, which his analysis indicates haven't historically had much correlation to REIT-share moves, will rise only if the economy is growing. And a growing economy would lead to lower vacancy rates and higher rents for hotel rooms, apartments and commercial space. This healthy supply-demand dynamic should lead to rising profits, he argues, thus leaving REIT stocks trading at a lower multiple of those higher earnings.

Don Cassidy, a senior analyst at Lipper, adds that demand for REITs and real estate funds should be strong as retiring baby boomers look for income from their portfolios. Today the average real estate fund has a 2.8 percent 12-month yield, according to Lipper, compared with about 1.8 percent for the S&P 500 and a little more than 3 percent for the average intermediate-term bond fund.

"REITs aren't quite stocks or bonds, and they don't really move in line with anything," he says. Thus their unique performance patterns, partly because of diversification among regions of the country, can cushion the blow of a tough time for stocks or bonds. Many real estate funds also can own shares of home builders, land developers and other real estate-related companies beyond REITS.

Since property prices typically rise with inflation, real estate funds can help protect an investor's purchasing power, says John Brynjolfsson, a managing director of Pacific Investment Management Co., or Pimco, and manager of the $336-million Pimco RealEstateRealReturn Strategy Fund.

With interest rates rising, "it's hard to see double-digit gains in real estate prices," he says. But over time, he says, property prices, and therefore real estate securities, should rise at least in line with overall inflation. His fund buys derivative contracts whose performances are tied to the Wilshire REIT Index, and the fund attempts to pick up additional return by investing in inflation-indexed bonds.

The once-sleepy sector is now more volatile. But Steve Buller, manager of the $3.5-billion Fidelity Real Estate Investment Portfolio, thinks real estate investments will continue to post competitive returns in coming years, if with a bit more volatility. Fidelity launched the new Fidelity International Real Estate Fund recently to bolster its REIT-fund offerings.

But even some advocates of real estate funds say investors should examine whether the sector's heady gains have resulted in their real estate holdings' growing into a much bigger portion of their portfolio than originally intended. If so, they say, it might be a good time to consider taking some profits and investing them in harder-hit sectors.