After fits of fever and delirium, and even near-death experiences, the REIT sector finally seems to be reviving.

It's still a fragile market, says Barry Vinocur, editor of the Realty Stock Review, and high returns may be years away. But careful stockpickers can find solid trusts that pay 4% annual dividends for domestic real estate investment trusts and 7.5% in some of the more promising foreign markets. "What you see is not necessarily that the patient is ready to go home, but the patient is off the ventilator," Vinocur says. "Still in intensive care, but there is no one waiting for the patient to expire now."

With high vacancy rates in most property groups, not to mention a precarious economy, there's little room for error. Moreover, after two rocky years in which the sector took a beating, most investors remain risk averse.

One of the big concerns is leverage. Debt levels that looked sustainable when REIT stocks were high suddenly seem crippling when stock prices fell.

"In the REIT industry, we've always had kind of a love/hate relationship with REITs pursuing aggressive business strategies," says Ralph Block, portfolio manager for Phocas Financial. "At times we cheer it and say, 'Great, you're creating value.' And then when things don't go well, we tend to say, 'Geez, you ought to stick to your knitting-we bought you because you're a piece of real estate'"

Investor distaste for leverage is so strong, Block says, that Simon Property Group and other REITs that have issued secondary stock to clean up their balance sheets actually saw their stock price rise despite the dilution. At the moment, Block says, investors looking for best results are not measuring debt-to-asset value, but rather debt-to-EBITDA, a more conservative measure that better shows whether the company's cash flows can withstand a major downdraft.

REIT executives seem to have heard investors' message and are taking on less debt. "If there is one lesson that hopefully has been learned, it's the pitfalls of leverage," Vinocur says.

Buying American

Although the second quarter ended with a loss for the sector, Vinocur remains positive about the long-term prospects of U.S. REITs. The quarter ended with MSCI's U.S. REIT index total year-to-date return down by 4%, But over the past 12 months, REITs are up 48.6%.

The overall REIT sector can be segmented into four main parts: office space, residential, retail and hotel/healthcare. Each has its own set of cues and indicators:

• Office space: Improved slightly in the second quarter, but the office sector still has not quite turned around, according to CBRE Econometric Advisors data. Vacancy rates were up again in the second quarter, to 16.7%, the 11th consecutive quarter of vacancy growth, but CBRE economists noted that the increase was "the smallest incremental change in two and a half years."
• Residential: Despite a sell-off in June, residential REITs are still a little overpriced, Vinocur says. Apartment vacancies stood at a 30-year high of 8% at the beginning of the year, but are now down to 7.8%, according to REIS, a New York-based property research firm. If job growth expands, the apartment market should improve.
• Retail: A wait-and-see game, but the environment seems to be improving slightly. "What we've seen there is that until the last three or four months, investors have been very worried about large tenant bankruptcies and leases expiring without filling the space," says Block of Phocas. But, retailers are, in fact, renewing leases, albeit at lower rents, he adds. The overall climate is still fairly bleak, with vacancies at 10.9%, just short of the 11% the country last hit in 1991, REIS says.
• Hotels and healthcare: For bulls, hotels may be the area to watch. Vinocur says it is the sector that will first pick up when business turns around. Bears, on the other hand, may want to look at healthcare. Block says healthcare is one sector that has proven to be a good defensive play in the past few years. It's not recession-proof, but it is recession-resistant, he notes.

But, Block says that even if real estate does continue to improve, most REITs won't show the effects right away. Lease terms often lag behind the economy. "If you have long-term leases and the economy is doing well, it may be years before you can reap the benefits of higher rents," he says.

In the end, analysts say, how U.S. REITs perform will depend on a sustained economic recovery. If the economy "kind of groans along," Block expects solid single-digit returns. "If you want 10%, I don't think you're going to get it with REITs, but then again I'm not sure you're going to get it anywhere in this kind of environment," he says.