Surely by now you've heard the hype: The real estate sector is the only way to make money in this market.

This recession has been kind to real estate. Unlike past recessions, which were largely due to heavy borrowing and overspending in real estate, this recession has roots in the technology sector. "This time, the banks lent too much money to telecommunications companies, not real estate," says Sam Lieber, manager of Alpine's three real estate funds,

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U.S. Real Estate Equity,

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International Real Estate Equity and the

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Realty Income and Growth fund. "Real estate isn't the black hole of the economy this time around."

Indeed, real estate funds have crushed U.S. diversified funds of late, returning 9.6% this year, compared with a 3.4% loss.

But for those investors used to thinking that diversification means dividing a portfolio between large-cap growth and large-cap value stocks, choosing a real estate fund is new territory.

Perhaps the most important distinction investors need to make is between real estate funds and REIT funds.

Real estate investment trusts, or REITs, are companies that purchase, own and operate income-producing properties. They're structured so that they must pay out 90% of their taxable income as a dividend -- this makes them great income-producing stocks. The average REIT dividend last year was 8.4%

Real estate funds can own REITs (indeed, virtually all do), but if a fund calls itself a REIT fund, it must have at least 80% of its assets invested in REITs, and that may be more than you want.

REITs have had a phenomenal run of late, having shot up more than 13.3% in the past 12 months, while the

S&P 500

fell 15%. In the past two years, REITs are up 23.3%, while the S&P is down 24%.

But if the past two years have taught investors anything, it's to be wary of bubbles.

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Indeed, real estate fund managers have begun a slow shift away from REITs and more toward other real estate investments, such as commercial developers, homebuilders and other property-operating companies that are not structured as REITs. "REITS aren't the cheapest place to be, but they are still attractive," Lieber says "But there are other places that have better value." Lieber particularly likes the homebuilding sector, which has been on the rise and shows no sign of slowing down.

Other managers are even more wary of REITs. Michael Winer, manager of

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Third Avenue Real Estate Value fund, for instance, has just 14% of his fund in REITs. Winer looks for companies that have a strong financial position and are trading at a discount to their

net asset value. (Because REITs are representative of many properties and ventures, the valuation terminology is similar to that of mutual funds.)

For instance, Winer likes Forest City Enterprise, a $5 billion Cleveland-based developer operating in 22 states. "It has geographic diversity and diversity among property types," he says. "Plus, it has $150 million in cash flow. If it were structured as a REIT, it would have to pay out some $100 million of that."

Finding a Way to Play

But for investors looking for income-producing investments, a real estate fund heavy on the REITs could warrant greater consideration. Diversification within a REIT fund is still important and easier to achieve than in a stock fund. Because there are only roughly 180 REITs, Morningstar analyst Alan Papier says, a fund needs to own only 50 to 60 REITs to be properly diversified.

Plus, industrial, office and retail leases make up 50% of the REIT subsector, according to NAREIT, an industry trade group for REITs. Consequently, REIT funds that have a heavy concentration in those areas can still offer reasonable diversification. Funds that focus more specifically in REITs than own only, say, health care properties, will be much more volatile.

There are a few REIT indices, such as NAREIT's, Morgan Stanley's and Wilshire's, but few REIT index funds. (Vanguard's, which tracks the Morgan Stanley REIT index, is the most prominent.) There's good reason for not investing in a REIT index fund, though: This is one area where an actively managed fund can routinely beat the index.)

The REIT indices essentially track the whole universe of REITs, Papier says. Therefore, simply by

not

owning a few of the smaller, poorly performing REITs, a manager can beat the index.

In general, the best way to think about real estate funds is as you would any other sector fund: as a supporting player. Just as you wouldn't want 50% of your assets in a technology fund, you shouldn't overweight real estate. This sector, though, has a high negative correlation to the S&P 500, which means it merits a place in many portfolios.

Investors looking to hedge their blue-chip equity portfolios should consider allocating some 5% to 10% to real estate, Papier says.

And when evaluating a real estate fund, look at its R-squared, a measurement of how closely a fund correlates with a specific benchmark index. The range is either 0 to 1, or 0 to 100: A zero indicates no correlation, whereas a 1 (or 100) equals perfect correlation. As of April 30, the average real estate fund had an R-squared of 0.04 (or, on a scale to 100, an R-squared of 4) to the S&P. That's exceptionally low, but you might want to pay particular attention to that metric if you're looking to hedge a portfolio heavy on companies in the S&P.

These days, it's no wonder real estate looks so good.