With the annual NAREIT convention starting Wednesday in San Francisco, analysts and fund managers are once again questioning how much zoom is left among highflying real estate investment trust stocks.

Since the bull market for commercial real estate began about four years ago, REITs' net asset values have risen an average of 24% a year, according to Green Street Advisors, an independent REIT research shop. Year to date, most of the better real estate mutual funds are up over 25%, making them one of the best sector performers.

However, REITs have fallen 4% over the past week, the largest correction in months, again raising fears among some that the sector could post disappointing returns going forward.

A string of companies recently either missed quarterly earnings estimates, reduced guidance or provided lower-than-expected 2007 forecasts, spooking investors.

General Growth Properties ( GGP), the second largest mall owner in the country, reported funds from operations Tuesday that missed analyst estimates. The REIT also cut its guidance for the remainder of the year because of increased expenses and weak sales at its community development business.

Among those that also posted disappointing results in recent weeks are Mack-Cali ( CLI - Get Report), Liberty Property Trust ( LRY), Macerich ( MAC - Get Report), Post Properties ( PPS), Sunstone Hotel Investors ( SHO - Get Report) and Equity Residential ( EQR - Get Report).

While the causes of the shortfalls varied, the bad news overshadowed solid reports from mall owner Simon Property Group ( SPG - Get Report) and office landlord Equity Office two of the largest companies in the sector, according to Bank of America analyst Ross Nussbaum.

The U.S. MSCI REIT Index is down 4% since the beginning of November, after reaching an all-time high on Halloween.

Nussbaum says a correction was overdue because commercial real estate valuations have incorporated meaningful cash flow growth expectations over the next few years.

"With valuations at all-time highs, even the slightest 'scare' was likely to impact shares," he wrote in a report earlier this week. "While the stocks are not yet 'cheap' we do not think near-term downside risk is greater than about 5% at this stage (assuming this correction looks like the previous four). We suspect privatization activity may heat up again as a backstop."

Strong, but Expensive

Despite fears of overvaluation, fundamentals still look strong for REITs in the near term.

REITs across all sectors will grow funds from operations by a median of 7.4% this year and 8.4% in 2007, according to analyst estimates tracked by SNL Financial. That's down from the recent peak growth of 11.6% in 2005.

Funds from operations, a common REIT performance metric, adds back depreciation charges to net income.

However, you can always pay too much for a stock. To be fair, this question of whether REITs are too hot to touch has been brought up nearly every fourth quarter for the past few years.

One veteran hedge fund manager who invests in the sector asks if 2007 might be the reverse of 2001 and 2002.

In 2001 and 2002, when the sector first started handily outperforming the rest of the stock market, REITs had weak fundamentals, but the stock prices rose because the returns looked good on a relative basis (because of high dividend yields and future expected earnings growth coming off trough years).

The question now is whether fundamentals can be strong while the stock prices go down. "Prices got a year or two ahead of themselves," the fund manager says. The average REIT dividend yield is now 100 basis points below that of the 10-year Treasury note. This is unprecedented terrain.

Much of the gains in the stocks this year have been driven by multiple expansions, helped by a large wave of privatizations in the sector.

"Relative to bonds and stocks, REITs are as expensive as they've ever been," the manager says. "If the private market doesn't continue to push up valuations, will other things pull them back?"

If total expected returns in bonds and stocks continue to look attractive and outperform, then REITs could disappoint. Back in 2001 and 2002, it wasn't that REITs were extremely cheap; they simply looked better relative to alternative asset classes.

Lower Returns?

Last week, Mike Kirby, a well-respected analyst and long-time REIT watcher with Green Street Advisors, put out a note of caution on the sector.

He measured REITs on a price-to-AFFO measure. AFFO, or adjusted funds from operations, is a proxy for the cash flow REITs have available to pay out in dividends.

On a price-to-AFFO ratio, REIT multiples now stand at the same lofty level as the S&P 500 P/E multiple at the peak of the 1990's bull market for stocks, Kirby notes.

He grants that institutional capital continues to flood the REIT sector, but says it is hard to gauge if this is the type of return-chasing behavior seen with stocks in the late '90's.

Perhaps "it merely represents a smart diversification strategy pension funds should have employed years earlier," he says. "The fervor with which institutions are plowing money into real estate is unsettling, but it is not prima facie evidence that the market has become overheated."

Nonetheless, real estate investors should look for a drop in net returns to a range of 5% to 6% over the long haul, he says, with REITs on the top end of that range.

Kirby reasons that much of the total return enhancement of REITs over the recent bull run was caused by declining cap rates, or initial rates of return paid for direct real estate assets.

As cap rates drop, valuations increase. Cap rates today are lower than they have ever been. They are 180 basis points lower than the average of the last 25 years.

Over the past 25 years, the closely watched NCREIF Property Index posted average un-leveraged annual returns of 9%. Backing out the declining cap rates, total returns from un-leveraged real estate would have been about 7.9% annually over this time frame.

So long as cap rates don't decline, then history tells us that total returns have approximated initial yields, Kirby says.

The problem now, however, is that investors in real estate and REITs are paying 6% initial cap rates. If total return is supposed to equal beginning cap rates, as Kirby suggests, then realistic returns for REITs are now 6%, he says.

At today's prices, that means investors get the 4% initial dividend yield plus 2% long-term annual earnings growth.

"This does not mean that it is time for REIT/real estate investors to head for the exits," Kirby wrote. "Nevertheless, pricing is now elevated to the point that investors who move their target real estate/REIT allocations toward the lower end of their allocation ranges should be rewarded in the long run."