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Real estate funds will be going for a three-peat in 2005, but investors expecting another year of overall market leadership will probably be disappointed.

REIT funds trumped all other Morningstar fund categories in 2004, returning a gaudy 30%. And that was coming off an even stronger 2003 when they were up 37%.

Back-to-back 30%-plus gains may not be unprecedented, but they don't come around too often, especially in an asset class like REITs, which are more income- than growth-based. Despite the past two profitable years, most analysts and fund managers expect the era of outsized gains to end in 2005 with REIT returns finishing in the 9% to 11% range. They also say results could be far worse if interest rates spike for the wrong reasons, like a crippled U.S. currency as opposed to steady economic growth.

"REIT performance depends on the economy now," says Samuel Lieber, portfolio manager for the $250 million


Alpine U.S. Real Estate Equity fund. "We've gone beyond balancing out the inefficiencies of the late 1990s."

REIT shares were ignored during the tech bubble as investors chased after growth-oriented companies more interested in reinvesting their cash than paying out dividends. Following the bubble's collapse, however, investors about-faced and poured their investment dollars into steady, income-producing assets like REITs.

That cash spigot has yet to be turned off despite the run-up in prices, says Lieber, who expects REITs to return 10% in the coming year, half of that coming from dividends. According to Lieber, huge institutional dollars have been committed and not deployed into REITs and the "weight of that money should sustain prices and valuations in the coming year."

Furthermore, that stream of institutional money is bearing down on a relatively narrow group of stocks, which only serves to support REIT share prices. According to the National Association of Real Estate Investment Trusts, or NAREIT, the entire market cap for the roughly 150 publicly traded equity REITs is around $260 billion, or, in other words, 10% less than the market cap for




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Like most other REIT fund managers, Lieber says the major caveat to his forecast is a spike in interest rates. When rates shot up nearly a full percentage point last spring, REITs sank 18% in a span of only a few weeks.

Many fund managers blamed that swoon on institutional investors unwinding the so-called carry trade, a bet that involves borrowing short-term money at low interest rates and using it to purchase longer-term securities like REITs. Still, the incident attuned many investors to the dangers of rates rising too quickly.

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"Generally rising rates are priced into the marketplace, but significant short-term moves can disrupt prices," says Michael Torres, portfolio manager for the $45 million

( LLUKX)Adelante U.S. Real Estate fund. "People panicked unnecessarily last April."

As long as the


continues with its "measured" rate hike strategy and the move up is orderly, fund managers say REITs should not be hurt by rising rates. In fact, most real estate fund managers would welcome higher rates provided they are a function of an expanding economy that will allow landlords to raise rents. Higher lending costs also makes renting preferable to home-buying for many people, thus increasing the value of rental properties owned by REITs.

Of course, all this focus on rates should not supercede the three primary rules of real estate investing: location, location, location.

Fund managers are especially bullish on REITs holding properties in New York and Washington, a pair of cities with growing economies and high barriers to entry.

Joe Rodriguez, portfolio manager of the $1 billion

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AIM Real Estate fund, chooses New York-based

S.L. Green

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as his top pick due to its plethora of well-situated, second-tier buildings. And Adelante's Torres names

Boston Properties

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as his favorite choice due to the company's significant stakes in both the Big Apple and capital.

Meanwhile, Alpine's Lieber says a new signature building on Manhattan's Lexington Avenue will help spur earnings for bankrupt retailer-turned-REIT


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, as well as

Vornado Realty Trust

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, which controls about one-third of Alexander's shares.

On the earnings front, AIM's Rodriguez says that for all the attention being paid to REITs over the past five years, earnings growth has actually been "anemic" over the period. He expects that to change this year now that the industry's fundamentals have caught up with the rapid price appreciation.

"Real estate is a lagging industry," says Rodriguez. "Multiple expansion has been driving prices higher, but when earnings start increasing investors might see those multiples contract."

Rodriguez is predicting high-single-digit returns for REITs in 2005 and warns investors that they best be prepared for a scenario where the best they can do is clip coupons. Speaking of those all-important coupon payments, the average dividend yield on an equity REIT is 4.6%, according to NAREIT, while Morningstar says the average yield from a REIT fund is around 2.9%. The approximate difference between the two is the average 1.6% in fund expenses, according to Morningstar REIT fund analyst Dan McNeela.

Like the fund managers themselves, McNeela does not see REIT funds stretching their 30%-per-year winning streak through 2005. He expects most fund managers would be satisfied with returns in the 7% range this year, but readily admits that he shortchanged the group last year at this time and was proven wrong.

"My expectations were for modest returns in 2004 and we were proved wrong, so you never know," says McNeela. "But the source driving these returns is more demand for the stocks than fundamentals, which makes me even more suspicious."