After soaring 21% from late March through early August, the Dow Jones REIT Index got clobbered last week as 10-year Treasury yields rose dramatically. Following a bearish cover story about the sector in

Barron's

over the weekend, the index fell another 3% Monday and it seemed as if no one wanted to touch real estate investment trusts.

But the sector has made a bit of a comeback since, and industry observers say the same conditions that originally attracted investors toward high-yielding investments such as REITs remain in place. Notably, REITs rose while the rest of the market fell on Wednesday, and the Dow Jones REIT Index was recently up 1.7% Thursday, outperforming major averages.

"We believe that capital looking for property investment will prove to be quite sticky and will not disappear in a higher-yield environment," says Dave Harris, REIT analyst at Lehman Brothers.

With the

Federal Reserve

seemingly intent on continuing its tightening campaign, few -- Harris included -- deny there are risks associated with rate-sensitive stocks, including REITs. Undeniably, the same phenomenon that led to the residential housing boom -- historically low interest rates -- has led those searching for higher returns into high-yielding assets, such as REITs. The frenzy to own tangible assets such as real estate has also, by extension, boosted the price of REIT stocks.

But with short-term interest rates poised to continue rising, and with 10-year Treasury yields now seemingly following suit, the appeal of REITs should wane. Furthermore, the once generous dividend yields of 8.75% offered by the sector in 1999 have dwindled to roughly 4.5%.

A short-term correction may indeed be in the works, says Harris. "By historic standards, the stocks are not cheap. Even after last week's fall, they're still very expensive," he says.

But what happened last week was likely just "a pricking out of the exuberance" in the stocks rather than the end of the bull market, Harris says.

REIT stocks had been trading in a "detached manner" from the fundamentals that normally affect them, such as the direction of long bond yields, he says. Yields started rising in late June, but REITs kept on rising amid high expectations for second-quarter earnings.

But when earnings such as

Vornado Realty Trust's

(VNO) - Get Report

only came in line with expectations, the stage was set for some profit-taking and a return to something closer to normalcy. Vornado also issued new equity last week, which raised concerns that other REITs would do the same, the Lehman analyst says.

In addition, hedge funds have been active and heavy players in REITs, and they had taken short positions ahead of earnings.

"The combination

of all these factors created a downdraft" for REIT shares last week," Harris says. "But there's been somewhat of a recovery. There is still plenty of forces who want to invest capital" in REITs.

Indeed, it would take a 150-basis-point move higher on the yield of the 10-year bond -- to about 6% -- to really start negatively impacting REITs, according to Jeffrey Kleintop, chief investment strategist at PNC Advisors.

The same is true for residential housing, he says, as the spread of new exotic forms of loans such as adjustable-rate mortgages (ARMs) and interest-only loans keeps homes affordable for many, even if that's only in the short term.

If and when house prices do start to fall, there might be an added bonus for some REITs, according to Kleintop. Apartment REITs, such as

Equity Residential Properties Trust

(EQR) - Get Report

and

AIMCO

(AIV) - Get Report

, have been struggling lately as speculation in housing has boosted the supply and brought down the price of residential rentals, which compete with apartment REITs.

So when housing prices eventually come down, apartment prices should rise, which would benefit these REITs. On the other hand, they may very well get burned if the condo market eventually cools off. In REITs, as everywhere else, "it's a stock picker's market," says PNC's Kleintop, who would avoid mall REITs, which have benefited from strong retail sales but are increasingly challenged by the expansion of independently located retailers such as

Target

(TGT) - Get Report

and the consolidation of department stores, such as the merger of

Federated Department Stores

( FD) and

May Department Stores

( MAY).

Notably, some stock pickers who should have the best handle on the outlook for the sector -- REIT executives -- have been in a buying mood.

Last week,

Public Storage

(PSA) - Get Report

made an unsolicited $2.5 billion bid for

Shurgard Storage Centers

( SHU). Separately,

Equity One

(EQY)

made a $379 million unsolicited bid for

Cedar Shopping Centers

(CDR) - Get Report

.

"An unsolicited bid in the REIT sector is a rare event," Harris says. "Two in a week suggests unusual times."

It's unusual, and a sign the ground is not about to fall out from under the feet of REIT investors -- at least not just yet.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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