REITs' Rally Could Be Grounded

With interest rates at historic lows, McNeela says REIT funds that have large apartment holdings will fare worse, while those that support new housing developments have benefited from higher sales rates. Low rates make home ownership more affordable and mean fewer people are likely to rent apartments, crimping returns from residential property REITs. REITs that back new developments have done well, but with interest rates having nowhere to go but up, that looks less sustainable, he warns.

"You have some fund managers who put a fairly broad definition on what real estate is, and those will include real estate operating companies as well," he says.

The CGM Realty fund (CGMRX) and the Alpine US Real Estate Equity fund (EUEYX) both had returns of more than 100% in 2003, which is exactly why McNeela says not to chase their performance.

"I would be very hesitant to invest in some of the funds that have done the best recently because of their narrow focus and the gains they've already posted," he says. "Diversification is the best reason for investing in REIT funds right now, and it should be a long-term move."

Mike Nozzarella, a financial planner in Newport Beach, Calif., says in the case of REIT funds, potential investors should be at least a little wary of success.

"Many experts are kind of puzzled about why they have held up so well," he says. "For any of our clients who has a nice substantial return on a REIT, or a REIT fund, we are paring it back across the board. We think valuations are stretched. But we think we'll get an opportunity in the next year or so to buy in cheaper."