As the U.S. economy continued its sluggish recovery last year and markets continued to improve, one of the brightest spots was the sector that triggered the financial collapse—real estate. Real estate investment trusts have displayed a strong performance in the last couple of years, and professional investors expect that to continue in 2013. The reasons are simple: gradually improving demand combined with little growth in supply.

The FTSE EPRA/NAREIT Equity Index gained 19.7% last year, outpacing the 13% gains notched by the S&P 500. Worldwide, REITs did even better, with the FTSE EPRA/NAREIT Global Total Return Index climbing 25%. With REITs worldwide increasing dividends last year to 3.5% to 4%, they were a no-brainer for income-hungry investors. Last year U.S.-based REITs grew dividends at a double-digit pace.

In the next 12 to 24 months, fund managers expect REITs to post annual earnings growth of 7% to 10%. Much of that could yield dividends, says Rick Romano, co-portfolio manager of Prudential Global Real Estate Fund. Romano says REITs are attractive compared with the 10-year Treasury bond or corporate bonds. "On a relative return basis, if this slow growth environment continues, you should be able to get an income premium over bonds and some growth attached to that," Romano says.

This has not gone unnoticed. REITs in the S&P 500 are now trading around three times book value, while the overall market is trading at 2.2. By comparison, many other financial companies like banks are trading at less than book value. David Darst, chief investment strategist at Morgan Stanley, says REITs are closer to fair value, "maybe bordering on expensive."

Paying for Certainty

Many pros say REITs are worth it for the cash flow. Romano reckons that investors bid up the price on REITs because they are willing to pay upwards for identified earnings streams. REITs already had annual income identified on Jan. 1, he notes, while the typical S&P 500 company started the year with zero revenues. "People don't want to pay for uncertainty in today's environment," Romano says.

Others observers are even more upbeat. Ritson Ferguson, portfolio manager of the ING Global Real Estate Fund, says his research shows that the U.S. REITs are actually trading at a discount when compared to privately held property. (Listed companies hold just 10% of the world's property; the other 90% is in private hands.) Ferguson is CEO and co-CIO of CBRE Clarion Securities, a real estate services specialist, and through his firm's market intelligence, he calculates that listed REITs are trading at a 5% discount to their net asset value.

"Valuations are not stretched," Ferguson says. Retail, office buildings, apartments, industrial properties, and hotels are all trading at discounts, according to his calculations. Health care, storage, and the tiny net lease sector, comprised of companies that own big box stores with a single tenant, are all trading at premiums to their net asset values.

Rising Rents, Falling Rates

REITs have performed well over the last three years, but share prices have not been driven up purely because investors are hungry for yield. In the United States, the underlying value as an investment is improving, with occupancy rates growing close to the last peaks of 2007. Rents are rising as well—but not at a rate that justifies new construction, except for apartments. Supply is still well below the long-term average, near a 30-year low. Thanks to low interest rates, U.S. REIT balance sheets are in much better shape than any time in the last five years.

Low rates have done more than prompt investors to seek yield. They have also stoked fears of inflation, which caused a search for hard assets to protect investors, says Bob Zenouzi, chief investment officer for the Real Estate Securities and Income Solutions Groups at Delaware Investments. This combination of safety and yield has boosted REITs over the past three years. While U.S. REITs have reaped much of the benefit, global REITs joined in last year.

Over the last three years, the U.S. REIT market has outperformed while companies availed themselves of increasingly cheaper credit. Now the easy money—plus rising prices on domestic properties—is encouraging investors to go abroad to shop for bargains. "Real estate is no longer a local game. It's a global game affected by global macro events," Zenouzi says.

Witness Australian REITs, which had a very low cost of capital from 2001 to 2007. Today, they're selling because their currency is more expensive. Now the biggest U.S. REITs, including Simon Properties and Boston Properties, are buying real estate in England, China and India, as well as taking positions in other real estate investment companies, such as Klepierre, a French retail specialist. If money gets cheaper and lending conditions ease even more, Zenouzi expects to see the next tier of U.S. REITs going abroad.

Trips Around the World

Zenouzi warns investors looking globally not to be seduced by red-hot growth figures, like China's 7.5% annual clip. "Don't be fooled by [the idea that] higher GDP means higher total return. That's completely untrue," Zenouzi says. He notes that from 2010 to 2011, Singapore and China had higher GDP growth than the United States, but much tighter credit conditions. While the United States was stumbling through an anemic recovery, U.S. REITs still outperformed their Asian brethren handily in those years because the Fed had turned on the liquidity spout. Now, as credit conditions are easier in China, the tables are turning and those real estate companies are doing well.

Still, Zenouzi is cautious on the region. He notes that Hong Kong residential prices have passed their 1997 peak, and local authorities are starting to manage the market in Hong Kong and Singapore by adding inventory to slow price inflation and placing restrictions on the market. He holds no pure residential developers in the region and has cut back his portfolio's exposure to more diversified real estate developers such as Keppel Land and CapitaLand.

Zenouzi says Japan is at a crossroads, with a new government coming to power, and expected quantitative easing raising the possibility that policy changes could spur the market. Although investors have been calling a bottom to Japan's slide for 20 years, there are some facts in its favor. Land prices are finally back to where they were in 1981, 60% off the peak in 1990. With inflation rates now above zero, investors are starting to believe that the end of deflation is at hand, which is a good setting for hard assets like property. The markets have responded, with the Japanese real estate sector climbing about 35% for the year in U.S. dollar terms by mid-December, compared with 4% for the broader market.

Reforms to the Japanese REIT market are on the table, which would allow the companies to enter into overseas transactions. "It could be the best thing in 20 years," says Zenouzi, who notes that despite its slump of more than a decade, Japan is still the world's second-biggest economy. Ferguson is also enthusiastic, particularly about seeing improvement in Tokyo's central business district. His picks include Mitsui Fudosan and Mitsubishi Estate.

Both Zenouzi and Ferguson are cautious on Europe, citing the region's weak financial state. Zenouzi says the quality of the companies is also worrying.

"You only want to own core properties in Europe [London, Paris, Berlin], not secondary and tertiary cities, because the quality of companies' balance sheet growth is not as good as the United States or companies in Asia," Zenouzi says. Unibail-Rodamco, the French firm, gets his nod of approval as the owner of some of the best retail properties in Europe.

What's more, prices for properties in secondary and tertiary cities could be hurt as banks in Spain and elsewhere are forced to sell off their foreclosed assets—most likely to private equity and hedge fund investors. Zenouzi notes that European banks hold about $2 trillion worth of real estate loans, most of which have not yet been marked down to their market value.

In the United States, Zenouzi admits that much good news has been reflected in the share prices. He reckons valuations are at 8% to 9% premiums to net asset value. "Fundamentals need to catch up to valuations," he says. As long as credit stays healthy, Zenouzi says, the stocks can continue to post "decent returns."

Sector Prospects

On a sector level, some of the best performers have been self-storage REITs. They have prospered on demand growth, and the bigger public companies are taking market share from smaller privately held companies through sophisticated marketing and online platforms. They are winning customers with clever ad searches on Google, says Jason Yablon, a portfolio manager at real estate specialist Cohen & Steers.

Self-storage leaders like Extra Space, with stock that rose around 45% last year, have capitalized on technology to gain occupancy and push rental rates higher on existing tenants, scoring healthy same-store revenue with little expense growth. The company has done so well it's been able to buy out some of its joint venture partners and buy new properties. Its secret is being more aggressive on pricing than smaller privately held competitors.

"The company is trying to market to people who'll stay longer and can handle the price increases," Yablon says. "Do you give the discount to the college kid or the homebuilder who needs to store his drywall? The construction guy will be there for the next five years, so I can raise his rent in the next three months by a bit."

The improving economy and residential market has also helped the self-storage firms. Rather than new single-family homes spelling the end of apartment renters storing their extra furniture, "It's more about churn," Yablon says. "When there's no churn, people who graduate are living with their parents, and people in homes are staying in their homes...[Now] people are moving around the country taking new jobs."

The industrial sector has the strongest prospects for growth next year, Yablon says. The group has been prospering as large distribution centers have been in demand, thanks to the growth from online retailers like The larger spaces in the healthier markets like West Los Angeles and parts of Texas have filled up. Companies like Prologis, the largest in the sector, were the big winners last year and are still well positioned. Yablon thinks the next wave will happen this year as spaces catering to smaller retailers start to get filled.

A related trend that helps industrials is the recovery in housing. Regional builders and contractors will need to store their supplies as demand picks up for renovations and new home construction. The large REITs, which own a lot of land, should see more development opportunities in the United States in the next year. Yablon reckons that will translate into a decent return on those land investments. A favorite is DCT Industrial.

Loosening Up at Home

Investors believe corporate decision-makers will finally be able to move forward with spending decisions as fears of the fiscal cliff fade. That should help REITs that own office space. Yablon's picks among REITs serving businesses include DuPont Fabrose Technology, which provides data storage.

Several investors also expect hotels to improve as corporate travel picks up again. Rates that companies negotiate for their travelers will climb 5% this year, Romano estimates, while group bookings for conferences at hotels are picking up. Hotel REITs that Yablon expects to benefit include Pebblebrook, which specializes in higher end business hotels, as well as Hersha Hospitality.

In retail, several investors favor the highest quality regional malls, like those owned by Simon Properties. Sales per square foot at top properties, like the Short Hills Mall in New Jersey, have hit record levels of $500 per square foot, passing their 2007 peaks. That means landlords have pricing power to increase rents. One of Darst's favorite REITs is regional mall owner Macerich, with 96 properties in 19 states.

Apartments have been the laggards in the United States recently, as they have seen earnings decelerate as the market for single-family homes has recovered. However, all is not gloom and doom for apartment REITs. Yablon thinks the group was oversold, and likes Apartment Investment and Management Co. because it's cheap.

Ferguson likes the entire group. He notes that home ownership rates, which peaked in 2007 at 69%, are now down to 64%, and many observers think they could sink as low as 63%. With 150 million households in the United States, another 1% decline translates to 1.5 million households of new renters. Even with subpar job growth, apartments have seen strong rental and occupancy growth because of the migration from excessive home ownership back to a long-term norm.

But even with improvements in job growth, household formation gets a boost, and typically a third of those are renters. That translates into good pricing power for apartment owners. A favorite of both Ferguson and Darst is AvalonBay Communities.