By Ralph Block

We real estate investors are cycle-sensitive veterans and know that no trend is forever. Perhaps, for this reason alone, we can be excused for expecting the real estate asset class (including REITs) to follow that hoary but reliable investment maxim, “Reversion to the Mean.” REIT stocks have kicked sand in the faces of virtually all other asset classes over the past five years; aren't they “entitled” to stumble in '05?

Although investments do tend to revert to the mean, it is also true that, as suggested by elementary physics, “an object in motion tends to stay in motion.” So let's examine some of the key reasons for real estate's (and REITs') outperformance and consider whether they are likely to self-destruct over the next 12 months.

Real estate is under-owned. Real estate investing has delivered solid and relatively predictable returns over many years, but real estate (including REIT stocks) has not been a substantial part of institutional or individual investors' portfolios relative to other asset classes. This is changing, and increasing allocations to real estate have been a key driver of lower cap rates and higher REIT stock valuations. This trend could reverse; however, nobody is yet choking on too much real estate, either direct or securitized.

Yield is king. The growing appreciation of a substantial dividend yield has been another trend that has favored real estate and REIT investing in recent years. There are lots of valid reasons justifying this trend, including a greater sensitivity toward risk in the equities market, the desire for predictable—and spendable—investment returns on the part of aging “boomers and institutions” and the need to fund increased near-term pension obligations. Bonds also provide strong current yields, but offer no protection against inflation. The high esteem in which investors hold income remains intact.

Prospective relative returns. Today, capital chases the highest risk-adjusted returns as zealously as my dog Sammy chases squirrels. Many sophisticated investors are convinced that, due to current valuations and companies' lack of pricing power, average annual returns from equities won't top 8 percent during the next few years. Meanwhile, yields on investment grade bonds barely exceed 6 percent. REIT stocks, bearing dividend yields of about 5 percent and providing prospects of 3 percent to 5 percent annual capital appreciation driven by rebounding cash flows, remain attractive even after their impressive five-year performance—especially when risk is considered.

Ah, but what about the valuation issue? Some claim that REIT stocks are substantially overvalued. But REIT stocks now appear to be priced on the basis of an average annual total return expectation of 8 percent to 9 percent. Though down from 11 percent to 12 percent in prior years, this seems rational in a low inflationary environment.

Of course, there is no guarantee that fickle investors won't suddenly turn against REITs and channel their investment dollars elsewhere; an unexpected rise in long-term interest rates could cause substantial pain for REIT investors (though owners of other assets wouldn't fare well either). But aside from oil and gas prices, the inflation ogre still snoozes under his bridge; interest rates are apt to remain benign. If so, REITs should deliver total returns in the high single-digit range in 2005.