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After racing up 8.5% in January (versus 1.4% for the S&P 500), the Morgan Stanley REIT index has fallen 14% from what we're affectionately calling the "Sam Zell Peak" on Feb. 7. After this week's 5.2% decline, the group is now in the red year-to-date (with a decline of 3.1% versus an S&P 500 gain of 6.7%). We believe a combination of factors have contributed to the latest bout of weakness: Better-than-expected earnings growth and increasing profit margins for many S&P 500 companies has caused non-dedicated investors to continue to rotate out of the REIT group, and increasing fears of negative changes in private market values have added to the downward pressure.With the group now trading at a 7% discount to our forward net-asset-value estimates (which generally take into account a 25 basis-points increase in cap rates from the current level), the market appears to be pricing in fears of a decline in commercial real-estate values over the next 12-months caused by rising interest rates and/or wider debt spreads (and thus, higher cap rates), and slowing property level cash flow growth.But for now, the bark appears to be worse than the bite. According to the latest National Council of Real Estate Investment Fiduciaries (NCREIF) data, cap rates actually declined 7 basis points quarter-over-quarter and 40 basis points year-over-year in the first quarter of 2007 to 5.61%. While the data suggests that cap rate compression halts in periods of rising interest rates, the plethora of capital waiting on the wings in the commercial real-estate market appears to be keeping rates at historically low levels. While we are not suggesting that cap rates will remain this low forever, we don't foresee a decline in commercial real-estate prices on the horizon. Rather, we expect a more normalized inflation-like level of appreciation in property values over the next few years, as healthy (albeit slowing) low-to-mid single-digit property level cash-flow growth will likely offset a rise in cap rates helping keep property values flat to modestly higher.In this environment, we recommend that investors place a greater emphasis on stock-picking. We favor companies with high-quality management teams, clean balance sheets, and strong low-risk growth profiles derived through a geographic focus on coastal/infill coastal markets and/or development opportunities. We believe these companies are more immune to valuation concerns given the greater stability of property level cash-flow growth- Banc of America Securities

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