REITs still investor workhorse.

At the start of 2005, analysts had REITs pegged for a major reversal of fortune from the previous years' stunning streak of big returns.

Choppy fundamentals in the office market, combined with uncertainty about the economy and the speed with which interest rates would Climb, seemed to cement the notion that REIT stock's dizzying ascension perhaps left it teetering and only poised for a fall.

Yet despite the negative predictions--and a poor first quarter that seemed to validate them--REITs again performed admirably in 2005 posting 12.1% average total returns, according to Morgan Stanley's REIT index, a yield that, while not enough to match the sector's recent +20% years, again handily trumped the major stock indexes.

In 2006, many of the concerns that didn't bode well for REIT yields in 2005 still remain. Interest rates may continue to increase, although the prevailing opinion is that they won't rise dramatically, the economy and job growth are still suspect and the pace with which the office market continues to strengthen on a national basis can be categorized as slow.

Yet perhaps due to the inaccuracy of last year's predictions, the prevailing sentiment for REIT performance in 2006 doesn't seem tainted by the same initial sense of doubt, but rather a renewed optimism that the sector could continue to post strong returns.

"There are a number of reasons to think that REIT performance can continue," said Bruce Schonbraun, a managing partner at national real estate financial consulting firm, the Schonbraun McCann Group.

One of them has been the amount of merger and acquisition activity in 2005 in which a number of REITs were purchased at premiums to their share price, a strong indication that REIT stock pricing has further room to grow. In one such deal, institutional investor DRA Advisors' purchased office REIT CRT Properties for $1.7 billion, a price that amounted to a $27.80 offering per share, a 15.4% premium on what CRT stock was trading for just before the deal.

Contrary to this evidence for future growth potential is the fact that REIT stock multiples have been steadily climbing, an ominous trend that would suggest pricing may have either reached or is close to reaching a peak. According to a third quarter report issued by REIT analysts Raymond James & Associates, average FFO multiples are on the verge of hitting 15x, well above the historical range of 7.5x to 12.5x. This would indicate that unless REITs manage impressive gains in earnings, the pace of stock appreciation may be curtailed. Valuations based on net asset value of the REIT's portfolio also in many cases seem to indicate that current REIT pricing is accurate but also could be near its peak.

"If you look at REITs broadly, they trade often at a six to six and a half cap rate when you compare the share price and calculate from that the value of the portfolio," Schonbraun said.

"And that's in line with what the private marketplace is paying."

Given that pricing for REIT shares translates into a cap rate that doesn't allow for significant further appreciation of the underlying real estate, a rise in REIT value fuelled solely by in increase in NAV--the phenomena heavily responsible for REIT stocks' major appreciation in recent years--seems like it can't be counted on to drive stocks in 2006.

"We've reached a pinnacle in real estate pricing levels," said Mitchell Hersh, president and CEO of REIT Mack-Cali. "I don't see pricing getting any higher."

Consequently, the focus for many investors in 2006 is on REITs that can increase their earnings growth, not an easy feat considering the nation's sluggishly improving office market.

Raymond James & Associates prescribes a focus on REITs with holdings in "markets with stronger-than-average fundamentals, such as Southern California, New York, and Washington D.C."

Cushman & Wakefield REIT analyst, Louis Wolfowitz, refined the criteria for investment even further by citing the importance of a REIT's management team.

"In the past few years, you could put money in office and industrial and retail and it wasn't that important to choose specific firms because the entire property class was doing well, just as long as you were in you would make money," Wolfowitz said. "Sector bets made more sense than on specific REITs.

"Now you really have to focus on the best leaders out there, the best management teams, because they're the ones that really know how to continue to grow and make money."

Firms like Vornado, SL Green, and Boston Properties, REITs that have property in strong markets and highly revered leadership, trade at very high multiples however.

But if the blue chips have the resourcefulness to increase dividends so that they remain above other fixed income investments like Treasurys--one of the big challenges for the REIT industry in 2006--investors will keep flocking and the share price should continue to rise.