As an asset class, real estate is growing in importance to professional advisors and their clients. Not only did the asset class provide high returns in the past few years, but managers kept improving the opportunities for investments. Enthusiasm seems to be growing for the class in general, and for new offerings in particular.The run-up in prices over the last few years grabbed headlines. But from the 30 percent average pace of recent times, advisors expect that performance will drop into a more reasonable range, perhaps in the high single digits.

"We've been very fortunate with the run-up in real estate in the last number of years," said Glenn Frank, CPA, PFS, of Wachovia Wealth Management in Waltham, Mass. "Now, we're naturally moving assets into other classes to keep portfolios diversified."

The benefits of real estate investing, however, do spawn some negative characteristics. Real estate investment trusts command a large percentage of real estate assets due to their liquidity. Rebalancing is made possible because REITs are traded on exchanges. The relatively high yields and low correlations with other assets also serve to attract investors. The tax inefficiency of REITs is the downside. "We're careful to manage clients' tax liabilities," Frank said. "REITs are the first asset that goes into any tax-favored account."

The liquidity and popularity of REITs provide other benefits. Transparency is increasing, along with all publicly traded assets. And while return expectations have slowed, so has the risk.

"We expect REITs' decline in standard deviation to continue," said Kacy Gott, CPA, CFP, of Kochis, Fitz, Tracy, Fitzhugh & Gott Inc., in San Francisco.

The importance of real estate as a portfolio diversifier may be growing. Kochis Fitz is abandoning absolute return strategies. "Given the growth in hedge fund assets, we believe that managers will need to take on excessive risk to provide past returns," said Gott. "Over the next year, we'll move the 5 to 15 percent allocation from hedge funds into fixed income, real estate or commodities."

Expectations for lower future returns impact investors' portfolios in broader ways. If prices on residential real estate decline, consumers may feel less wealthy and cut back spending. Sectors of the economy that depend on active consumers would then suffer.

The most direct factor driving real estate values lower is the trend to higher interest rates. Higher rates lead to increased return expectations for fixed income. "We've adjusted our capital market expectations," explained Gott. "Our fixed income expectations are now at 6 percent from the previous 4.5 percent."

Higher rates mean lower valuations on fixed income in the near term. But those that anticipated the shift are less affected. "It didn't take a rocket scientist to know where interest rates were headed," said Roger Ochs, JD, MBA and president of broker/dealer H.D. Vest Inc. "We shortened durations a few years ago because we anticipated this move."

Advisors who offer mortgage products experience the increase in interest rates in another way. Ochs reported that H.D. Vest's mortgage refinancing business in 2005 dropped to half the level of that in 2004. "Homeowners are still moving around, so the business hasn't completely dried up, but the market is pretty much re-fied [refinanced] away."

Advisors still focus investors' attention on home equity loan originations and Section 1031 like-kind exchanges. Clients have significant equity in residential real estate that can be tapped for home improvements or other major expenditures, like college. Clients with significant appreciation in single properties might seek diversification or different income streams. The exchange allows the property owner to avoid current taxes on the gain.

Also, intermediaries such as Dividend Capital offer opportunities to diversify through shared ownership in tenant-in-common transactions. "We've got $15 million to $20 million of these exchanges in the pipeline," said Ochs. "That's a significant increase from basically no activity just 18 months ago."

New flavors of REITs also expand the usefulness of the asset class. More offerings in more groups like property managers, hotels and offshore holdings mean investors get greater diversification. Evidence of the growing interest in offshore comes from many corners. REIT index providers like the FTSE Group (best known for the U.K. stock index sporting the group's name) now calculate global indexes as well as country-specific rankings. Several U.S. REITs, such as Capital Automotive REIT, Entertainment Properties Trust, General Growth Properties Inc. and Highland Hospitality Corp., shopped the world for expansion and now own offshore properties, in addition to those in the U.S.

"While our real estate allocations may have dropped from 10 percent down to 7, the difference was often made up by increasing offshore real estate holdings," said Frank. "Of course, that only makes sense for the most wealthy clients, because for smaller ones it's not worthwhile to split assets into 2 percent and 3 percent allocations."

Investors' plans include direct ownership of real estate. Owners of rental real estate control the ultimate disposition of the asset, and want to maximize gains by selling into a hot market. But most advisors tell clients to ignore their primary residence when making investment decisions. "They need to live someplace, and their current home has a one-to-one correlation with all other local real estate," Frank said.

Advisors would need to work with clients to separate investing in real estate as a class in general from fears over the recent bubble in home prices. "It could be that the last thing worried clients want to do is invest in REITs," said Gott. "But the reality is that the asset class is now more important than ever."

Greater transparency, more products and ever-diversified markets mean more opportunities for investors and more education for advisors. "This is a maturing, but not yet fully mature, asset class," said Gott. "One implication of that is that the past information about the class may not provide much of a guide for the future."

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