After four years of outsized returns and star status in a down market, experts don't think real estate funds will be raising the roof much longer.

Though they are outpacing stocks, bonds and just about everything but the long-short daily double at the dog track, prospective investors should heed the experts, who think real estate investment trusts, or REITs, can't sustain their recent rates of return.

High rates of home buying and a general building boom helped push the indices that track REITs -- the securitized versions of real estate portfolios -- to record levels, especially in the past 15 months. But with interest rates about as low as they can go, the entire real estate sector is due to cool, and that calls for caution, even in the face of attractive numbers from REIT mutual funds.

With year-to-date total returns of the approximately 65 open-end REIT mutual funds at 7.01%, according to fund tracker Lipper, they look like a great way to avoid some of the risk of an equity market correction and still register bang-up returns. With a whopping 2003 average total return of 48.73% and a five-year average total return of 16.23%, the REIT-powered bounty of real estate funds looks all the more seductive, but look at them with a wary eye. By comparison, the S&P 500's total return for the year to date is 3.25% and its 12-month return is 38.52%, but the index's five-year return is still a loss of 0.12%.

Real estate should be a constant component of a diversified investment portfolio, but the recent outsized returns are prompting investment professionals to downsize their clients' allocations. Although REIT funds aren't tied to the performance of the equity or fixed income markets, they can still be volatile, warns Don Cassidy, an analyst with Lipper.

"You can still make a case for REIT funds because they tend not to correlate with other asset classes," he says. "But I have some concern that people are following the easy path to yield and ignoring the risk."

Lipper data shows the average expense ratio on a closed-end REIT fund is about 0.77%, excluding any leverage costs. (When a fund borrows to increase its holdings in a particular REIT, it must pay interest on the money it uses.) The use of leverage in closed-end funds can amplify returns, but also increase both risk and expense, Cassidy says. Open-ended funds have an average expense ratio of 1.66%, according to Lipper.

Cassidy and others caution that while the secret to real estate success is location, location and location, the key to real estate investment fund success is timing.

Other investors may have already beaten you to the punch. Analysts and financial advisers believe many of these funds are now overpriced, and some worry that new real estate enthusiasts are overlooking the volatility and pricing of the investment trusts that make up the funds' underlying investments.

"Right now the real estate market is -- I would say fairly valued is an understatement -- I would say it's fairly high," says Judith Lau, a financial planner in Wilmington, Del.

The real estate investment trusts themselves have also lost a bit of their appeal because recent tax cuts have reduced the tax advantages of investing in them, says Dan McNeela, a mutual fund analyst at Morningstar. When a portfolio of real estate holdings is set up as a REIT, the corporate structure requires it to pass 90% of its earnings on to investors, which generally prevents it being hit with the same tax rate as other corporations.

There are different types of REITs -- equity REITs that take equity positions in real estate and then pass along rental income and gains from the sale of property; mortgage REITs, which specialize in lending money to developers and get their income from the interest payments; and hybrid REITs, which mix equity and debt investments.

The mutual funds that invest in REITs, from the Vanguard REIT Index Investor (VGSIX) fund to the family of funds run by Cohen & Steers, including the Cohen & Steers Realty Shares fund (CSRSX), distinguish themselves by the types of real estate trust in which they invest. Some will focus on commercial real estate, others on residential developments, while other portfolios may load up on REITs that own nursing homes or shopping malls.

A look at different sectors should guide any considerations about investing.

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."

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