Some investors are throwing common sense to the wind in hopes of offsetting sluggish stock returns. The property market's strength in the face of the stock market's tepid recovery from deep losses in the early years of the decade is prompting many wealthy investors to view real estate as the alternative investment of choice. But advisors with experience in the field say it's anything but a panacea in its own right. They warn that investors should take the time and trouble to understand some basic "rules of the road" for investing in real estate before making it part of a carefully balanced portfolio.

"Real estate is an important part of a long-term financial plan, but it is not the silver bullet that some people think it is," says Steven Lugar, managing director of BHCO Capital Management, an investment advisory in Dallas. In fact, he adds, those who view it that way are apt to be "flailing around without an effective asset-allocation strategy" against which to weigh their assumptions about real estate. But "investors with [long-term strategies] will understand that the real estate market is a portion of their portfolio, not an alternative to it," says Lugar.

That said, the attractions of a booming real estate market - before, during and now long after the 2001 recession - are hard to deny. Real estate investment trusts, or REITs, in the National Association of Real Estate Investment Trusts's (nareit.com) NAREIT Composite Index returned 22.5% through the past five years, putting them ahead of every major U.S. equity guage. Similar to closed-end mutual funds, REITs invest in real estate or loans secured by real estate and issue shares in those investments.

And while experts say those numbers are turning heads, it isn't the comparatively transparent and liquid REIT that's catching high-net-worth eyes so much as direct investment: in vacation homes, farmland, rental apartments, even airport hangars. Some wealthy investors are liquidating out-sized portions of their investment portfolios to channel money directly into real estate, according to the Zero Alpha Group (ZAG), a network of eight independent investment advisories, including BHCO.

That kind of whole-hog approach to real estate investing makes little sense to J.E. Wilson Advisors' president and ZAG member James Wilson. "People who are smarting from investment losses or just generally disappointed by relatively low returns are the first to fail to appreciate the importance of liquidity," he says. Rebalancing a portfolio to take into account changing circumstances or to respond to immediate needs isn't "so easy when you have most of your money tied up in real estate and the bubble bursts - or at least deflates a bit," he says. Investment advisory J.E. Wilson is based in Columbia, S.C.

In a paper available on its website, ZAG cautions against betting the farm, so to speak, on real estate. View it as "an integral part of a globally diversified financial portfolio," by all means, but not as a cure-all "for investors frustrated with sluggish stock market returns."

ZAG also points out that tax-aware strategies are important when it comes to real estate investing. Because it's so tax inefficient, it should be held tax deferred accounts. But figuring out how to do that "as the foundation for avoiding the tax bite when you purchase real estate, mortgage notes, tax lien certificates, leases and other related income streams" calls for expert advice, says ZAG.

To avoid the dangers of regional or local market downturns, ZAG suggests geographically diversified vehicles like REITs and managed real estate pools. Though both bare watching from a tax perspective, REITs are liquid enough to come in handy as rebalancing tools, and directly-owned managed real estate pools take no leverage and so have a standard deviation comparable to one-year Treasury bills. ZAG says managed pools also give financial professionals a higher comfort level because they can get a clear sense of the credit and administrative processes behind the investment - something that can be be especially desireable in a "down" real estate market.

Phil Kruzan, financial planning director with the Foster Group, an investment advisory in West Des Moines, Iowa, sums up ZAG's overall point. "It's no longer the case that you necessarily have to hold title to, maintain and insure multiple properties in order to 'own real estate' for investment purposes," he says. And, that, he adds, is good news for "people who want to focus on real estate as part of their investment portfolios." -FWR