Would-be real estate investors must find it hard not to feel like the last guest at a party. Some have left already, others are putting on their coats, and those who remain are chatting wistfully about the fantastic returns of the last few years.

But it is not yet time to give up on the sector. While real estate investment trusts (Reits) – companies that manage a portfolio of real estate holdings, essentially letting you be a landlord without the hassles – may be a tad richly valued at the moment, their long-term prospects are still attractive. And it may be only a matter of another 5 per cent dip before bargains start reappearing.

“We don’t think there are a lot of opportunities right now,” says Ryan Dobratz, a Reit analyst at Chicago-based research group Morningstar, who considers the group of 65 Reit stocks he covers to be 11 per cent overvalued. “I would wait for a better entry point. But fundamentally it is still a strong investment.”

In fact, a correction may have already begun. From the sector’s frothy March highs down to recent lows, the drop has been a full 10 per cent. Money flows into the sector have gone negative. The sectoral sag is no surprise to Mark Arbeter, chief technical strategist at Standard & Poor’s, whose number-crunching led him to call for a 15 per cent pullback. “We’ve seen a decent part of that already, and I still see a chance for another 5 per cent downside,” Mr Arbeter says. “That would take us back to long-term trendlines.”

Reits have a number of factors to thank for their powerhouse returns. Long-term bond yields have, until just recently, been supremely uninspiring as an alternative investment. Reits pay out 90 per cent of earnings as dividends, which has proved a big lure in a market of limited returns. Institutional investors such as pension funds have been increasing the real estate portion of their portfolios in an attempt to improve their diversification across asset classes. Real estate is a traditional hedge against inflation, the prospect of which still haunts the US economy and its markets. And a number of Reits have been taken private in the last year, at premium prices, as hedge funds searched for suitable places to stake their bets.

Add it all up and it explains why Reits have performed so well even in an environment of rising interest rates, which should theoretically spell trouble for real estate investments. During this year’s first quarter, as the Federal Reserve continued to raise interest rates, the sector leaped 15 per cent. Some experts say the interest rate obsession is wrongheaded in any case. “The market continually makes the error that if rates go up, it’s always bad news for Reits,” says Andrew Clark, a senior analyst at Lipper, the research group, “but that’s not necessarily the case. Many of these companies locked in long-term funding a while ago, so you can’t make that blanket statement.”

But Reits are facing a number of additional headwinds. Long-term bond yields are now more than 5 per cent, which could lure away income-hungry investors who are looking for less risk. Countries such as the UK have been approving Reit structures, which means international investors – who have helped fuel the US real estate gains – might now redirect their resources abroad. And the longtime outperformance of the S&P means many Reit stocks have simply become pricier than their underlying fundamentals warrant.

So now that the sector has bumped up against long-term trendlines and is considered “overbought” by analysts such as Mr Arbeter, are there still decent values to be found? Not all Reits are alike and many are highly specialised: there are Reits to invest solely in shopping malls, in hospitals, hotels, or offices and apartments.

Lipper’s Mr Clark likes hotel Reits, which have been relatively battered in recent years and have entered the territory where they interest value investors. His top picks include Winston Hotels (WXH), Equity Inns (ENN), Host Hotels and Resorts (HST), and Innkeepers USA Trust (KPA). One area to be cautious of is residential Reits, many of which have been bid up by earnings expectations that are “unreasonable,” Mr Clark warns. “

Deutsche Bank Reit analyst Louis Taylor is also hard-pressed to find bargains. He suggests names that have been unfairly knocked around: Highwoods Properties (HIW), which has been working through some accounting issues; or General Growth Properties (GGP), whose stock price has been held back by sniping about its business plan.

The concerns are “overdone,” Mr Taylor says. For its part, ratings company Morningstar has identified two five-star opportunities in the sector: Nationwide Health Properties (NHP), which invests in assisted-living facilities for the elderly, and The Mills Corp. (MLS), which has been buffeted but whose business value and strong properties remain intact.

Among the expensive stocks that should inspire wariness, according to Morningstar’s Mr Dobratz: Kilroy Realty (KRC), a company focused on the white-hot southern California market, which has been bid up beyond what its cash flow would suggest. Deutsche Bank’s Mr Taylor adds SL Green Realty (SLG), which deals in Manhattan office buildings, whose “phenomenal run” means the company’s successes have been priced into the stock.

When it comes to real estate funds – mutual funds that invest largely in Reits but also occasionally related businesses such as real estate operating companies – Morningstar fund analyst John Coumarianos likes T. Rowe Price Real Estate (TRREX), JP Morgan US Real Estate (SUSIX), and Morgan Stanley’s Institutional US Real Estate (MSUSX). But he warns of a potential reckoning for the sector, given the gains made for so many years.

Investors who are still looking to get in on the party would be wise to pick their spots, he says. “I would urge investors to approach Reits gingerly and wait for more of a pullback,” he says. “This category is up 20 per cent a year for the last five years, which is even better than the performance of natural resource funds. It has been staggering.”

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