By Ralph Block

Politics may make strange bedfellows, but the equities markets may do so as well. Many investors have become conservative in recent years and are very comfortable in the low-tech world of real estate. In this domain, cash flows are stable and predictable, and current yields are high. Thus investment capital has been flowing into real estate, directly and through REIT share accumulation.

But conservative investors are not the only REIT share buyers. REITs' investment appeal, along with higher underlying net asset values (NAVs), have generated price movements resembling a tech stock on steroids, e.g., 37.1 percent and 31.6 percent total returns in 2003 and 2004, respectively. And this hasn't gone unnoticed by the hedge fund industry. Whatever we think of hedge funds, we must acknowledge that their time horizons are generally shorter than those of traditional REIT investors. And these funds have lots of money to invest. A recent study estimated the assets of the hedge fund industry at $934 billion, up 17 percent in 2004.

Economist John Maynard Keynes admonished market speculators to ignore the prettiest girl in the beauty contest and to focus instead on whom the judges will choose as the prettiest girl. Just as hedge funds and traders will sell if they think other investors will soon do so. And some hedge funds have, for better or worse, been playing in the REIT sandbox. They tend to be secretive, so it's hard to know the numbers, but the greater liquidity of REIT stocks today and the advent of exchange-traded funds (ETFs) that can be traded quickly and in large quantities facilitate such speculation.

Another good news–bad news story is the inclusion of REITs in the S&P indices. This has goaded performance-minded equity investors to dabble in REIT stocks if they expect them to outperform their benchmarks. But these investors don't have to own REITs, and will be quick to exit if they think they can find better opportunities elsewhere.

This recent entry of hedge funds and equity mutual funds into our industry, along with greater liquidity, has created a more fluid REIT investor base and has made the stocks more volatile. During the fortnight beginning March 31, 2004 and ending April 14, 2004, the NAREIT Equity REIT Index fell 14.2 percent; and, from Dec. 31, 2004 through Jan. 27, 2005, perhaps assisted by portfolio rebalancing, the decline was 8.6 percent. So the good news is that REIT stocks are now playing in the big leagues, and competing alongside other large and mid-cap equities (and bonds) for investor attention. The bad news is that this has made them more volatile. So how should we view this volatility? Is it an unalloyed curse?

Volatility can certainly impact valuation. Investors will tend to trim the prices of stocks that act like drunken revelers; furthermore, many financial advisors may compare the volatility of REIT stocks to that of bonds, and advise their clients to avoid REITs altogether. After all, if it's volatility the investor wants, plenty of it can be found in techs.

And yet we must cheerfully acknowledge that REITs, while all about real estate, are also equities and, as JP Morgan once said, "stocks will fluctuate." So common sense dictates that we take REIT stocks as we find them, and accept their higher volatility as the flip side of REITs' growing popularity. Furthermore, as we saw last spring, such volatility may create better bargains more frequently, allowing us to take advantage of others' shortsightedness.

Investing, it's been said, is a marathon, not a sprint. We may not enjoy the bumps in the road arising from greater volatility, but successful long-term investors will simply learn to ride them out.