At the annual National Association of Real Estate Investment Trusts convention in Chicago, it's easy to find people bullish on REITs for the long haul. But a growing number of pundits are turning bearish for the short term, as the biggest scares for the sector continue to be rising interest rates and high valuations .

It's the "most uncertain time for REITs in five years," said Ken Rosen, chairman of real estate hedge fund Rosen Real Estate Securities, in a morning session Thursday. He said it is likely REIT stocks will decline 20% on average in 2006, hurt by rising long-term interest rates.

Rosen projects the yield on the 10-year Treasury could hit 5.5% or 6% by the end of next year. He recommends investors start hedging their real estate positions by either selling short or selling off some holdings. His hedge fund is currently 20% short residential mortgage REITs and homebuilders (which are not REITs) and 80% long apartment and office REITs.

Rosen admits he likes many REITs' fundamentals, but he expects rising interest rates to significantly dampen the sector's attractiveness as a yield investment. He also said that even though most REITs aren't directly tied to the single-family housing industry, REITs across all property types will suffer if the national housing bubble deflates because of investors' psychological association between REITs and anything that is tied to real estate.

Citigroup analyst Jonathan Litt said he expects REITs to finish 2005 either flat or down, and suggested investors should consider investing in cash in the short term as an alternative. He doesn't think a 20% drop in REITs is likely unless "cap rates," the yields that investors pay for commercial properties, increase significantly and thus prices drop.

One way for such a cap rate boost to occur, Litt said, is if borrowers start defaulting at a high rate on risky mezzanine loans. One of the reasons commercial real estate properties have shot up in price over the past few years is the tremendous amount of mezzanine debt being written on deals, he said, which is making borrowers highly leveraged.

Mike Kirby, an analyst with Green Street Advisers, laid out a positive scenario for REITs next year in which the Federal Reserve pushes too hard in its rate-hike campaign, the economy slows mid-year, and the 10-year Treasury hits 3.5% by the end of 2006. Under such a scenario, REITs would perform fine next year, given that they'll look particularly attractive on a yield basis, he said.

"A low return world is a great backdrop for real estate," Kirby said.

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