If everything is virtual, what will happen to what's real?

That question came to mind recently as I sat with two investors and listened to them talk about looking for places to invest money. We're not talking about small investors, here. These are fellows who manage family money, money in amounts with lots of zeroes after it. It's also money that can afford to be patient, money that likes to get an actual income return while waiting for capital gains.

One, a Dallas real estate developer, explained that there was little point to having all the overhead and risk of being a developer when you could go out and buy properties at a discount to book value. He was speaking, of course, about the bear market in the shares of Real Estate Investment Trusts.

I think he's right.

Things are so bad--- and the sector is so depressed--- that Realty Stock Review editor Barry Vinocur titled an October essay "Hang Crepe." Even though the Morgan Stanley REIT index is a total return index, meaning that it includes dividends, he noted, the index was near its low from last year. In addition, the spread between net asset values and market prices was at its highest level in eight years--- all the way back to the banking crisis. While the real estate market itself is hot all around the country, the market for real estate shares is stone cold.

Nor was there much hope that things were going to get better. Mr. Vinocur wrote that he thought things would probably get worse before they got better, largely because no one--- absolutely no one--- wanted to invest in REITs. He was expecting a slide of another 10 to 15 percent.

As he said, "Hang Crepe."

You can get some idea of how depressed the sector is by comparing REITs with junk bond funds.

Junk Bonds. At the end of September, the average yield on 316 junk bond funds in the Morningstar database was 7.87 percent. The average coupon on bonds in fund portfolios was 8.56 percent. While either figure is enough to get your attention in a world of 5 and 6 percent CD and Treasury yields, you have to remember that the default rate is going up and that junk bonds got their name for a reason--- there was significant doubt about the ability of the borrower to repay the borrowed money. More important, junk bond holders are at the end of the creditor line when it comes to their claims on collateral, if any, when things go awry.

In spite of that, yields on REIT shares are higher than yields on junk bonds.

REITs. In mid October, a list of 18 major REITs that specialize in owning and managing apartments was providing an average yield of 8.6 percent while selling at an average discount of 11.7 percent from asset value. United Dominion Realty Trust (UDR), the 31 largest REIT of any type with a market capitalization of $1,164 million and a portfolio of 62,800 apartments in 225 communities was yielding 9.9 percent and selling at a 15.6 percent discount from asset value. Even upscale Avalon Bay Communities (AVB), a REIT specializing in luxury apartments in California, was yielding 6.7 percent and selling at a 15.5 percent discount from asset value.

The situation was worse with REITs in other sectors. The average Shopping Center REIT was yielding 9.9 percent; Regional malls, 9.7 percent; Offices, 7.3 percent; Healthcare, 14.1 percent; and Lodging, 11.1 percent. All were selling at significant discounts to asset value.

To be sure, there are things to worry about. The ongoing upheaval in medical care delivery may culminate in hospital closings.   The development of e-commerce may make some shopping centers and malls a bit redundant. The development of serious broadband communication and on-line TV may substitute virtual meetings for the meetings that need hotel rooms. The rising tide of telecommuters may crimp the need for office buildings.

But apartments?

Let's get real. You can't live in a virtual apartment. You need the real thing. No matter how virtual some of the future is, we're all going to need a place to hang our hats, stow our stuff, and crash at the end of yet another day of unlimited connectivity. We'll also need a place to keep our computer or we won't be able to live our virtual lives.

Tuesday: A Room of Your Own, But No View.