If you don’t already have a significant chunk of your net worth invested in rental property, it’s time to think about buying stock in real estate companies. But in our first Real Estate Stock Talk, Alexander Goldfarb, a seasoned stock analyst, and Peter Slatin, a veteran journalist and industry observer, suggest you go slow.

Forbes. Welcome, gentlemen, to our first Talk.

Let’s talk broadly about investing in real estate. Ibbotson Associates and other research firms say we all ought to have a big chunk of our net worth in investment property. Just owning a house doesn’t count. Something like 10% to 20% of our net worth should be in rental property–offices, warehouses shopping malls, hotels, apartment buildings, college dorms, prisons, self-storage or whatever else we can think of.

But how? Should a reader, wealthy or not, buy a property himself or herself? Invest through private partnerships? Or should he or she prefer realty stocks, and in particular, REITs? These are large enterprises that own many, many buildings, whose shares trade on stock exchanges in New York or overseas and pay out rental income in the form of dividends.

Peter Slatin, Real Capital Analytics. It’s an important question. Once you’ve accepted the diversification argument, there’s another strong argument for investing in real estate: income. The nasty lesson of the past few years is that growth is part of the story, but it should never be the whole story.

So why REITs? Well, there is a lot to be said for professional, experienced management that understands its industry. Why do lay people feel they can invest directly in real estate? It looks simple. Buy it, fix it up, rent it, re-sell it. Yes, but … Real estate investor Sam Zell thought he could do that with the Tribune Co. but he didn’t know beans about the media (other than how to give interviews).

But Zell and other REIT managements have come out looking pretty darn good against all those private fund-runners. The REITs were big sellers rather than buyers during the peak, according to our numbers at Real Capital. And this year they’ve raised a lot of capital, more than anybody else, as the possibility of distressed sales looms ever larger.

Forbes. I understand that REITs have issued $16 billion in new equity so far this year and nearly $3 billion in new debt. So apparently lots of people agree REITs are winners.

Slatin. Some, though not all, REIT managements have also made a successful transition from the days of entrepreneurial ownership to corporate leadership. Those are the companies that will endure.

Alexander Goldfarb, Sandler O’Neill. While REITs were sellers at the peak, they were also buyers. They did indulge in the bull market credit that was available. Instead of issuing 3% converts [convertible bonds], they should have issued equity at 5% cap rates to de-lever. Just shows that even experienced teams do not get it right all the time.

Given that the commercial mortgage-backed securities machine has essentially shut down and major players like Lehman Brothers and Bear Stearns are gone, refinancing debt is going to require some conversion to equity. The beauty of the REITs, which is why we entitled our April initiation (of coverage report) “REITs are Part of the Solution,” is that the equity markets never shut down through this crisis. Further, the tightening of the unsecured credit markets shows the advantage (both size and cost) that the investment-grade REITs have, in general, over non-investment grade REITs and privates. Clearly, low leverage is key, whether investment grade or not, and whether private or public.

Forbes. OK, so should investors prefer public REITs over private investment in real estate?

Goldfarb. REITs were originally billed as income plays (growing cash dividend) with low volatility that would increase the return profile of a portfolio. Clearly, those are out the door with the increased volatility and dividend cuts. The challenge is for REITs to regain their ground as a place for cash income and stability. Given that direct real estate is not marked to market daily, assuming positive leverage and comfort with the rent roll, one could argue that direct investing is preferable over REITs, if one has the resources.

Forbes. Surprise! A REIT analyst says that sometimes a simple property purchase is a more appealing move. Boy, that’s not what I expected you to say.

Goldfarb. Don’t get me wrong, REITs are a great place to invest. But folks need to be careful and not bank too much that every REIT will be a successful “distress investor” or “grave dancer.”

Slatin. Direct investing can work for well-heeled individuals who have the time and energy–and assistance from professionals–to do it right. But since your own forecast calls for poor rent growth in the near to medium-term for apartments, which is the likeliest choice for real estate do-it-yourselfers, there’s a tough road ahead. Even the wealthy Kuwaitis turned to an apartment REIT based in Highlands Ranch, Colo. called UDR for help in that sphere with their $450 million joint venture .

Goldfarb. Agreed that direct investing is not easy but, like anything, prudence and careful analysis is best.

Forbes. Peter, what about Alex’s point, that REITs did indulge in some unwise purchases a couple of years ago, when the market was frothy?

Slatin. He’s absolutely right. But it looks as though those errors will be easier to recover from, due to greater liquidity, than the trading-card games of the private-equity players. On the other hand, I believe we are due for another correction in REIT shares this fall as anxiety grows over CRE debt and problems. As you know, Real Capital is following about $130 billion of troubled assets in its database.

Forbes. So even the smartest REIT managers had a hard time staying out of the market when their best instincts suggest they should? Cohen & Steers analyst Jon Y. Cheigh noted in an interview with me this summer that Hamid Moghadam, the respected chief at San Francisco-based industrial property owner AMB Property. sold a lot of property in 2005 and complained the market was overpriced. Alas, Moghadam seemed to reverse himself somewhat and did some purchasing the following year.

Slatin. Stephane, we studied this at Real Capital. During the bubble years from 2005 to 2009, REITs accounted for 13% of all commercial real estate purchases and 18.6% of sales. So generally, they were sober.

And some were especially shrewd during the bubble’s peak year, 2007. Apartment REITs were responsible for just 5.2% rental-apartment purchases but accounted for 30.6% of sales. Office REITs, too, accounted for less than one-tenth of all the office-building purchases in 2007 but nearly one-third of sales.

I should note that the pattern breaks down for retail REITs. Their purchases made up 30.1% of all shopping mall and strip-center buys in 2007, but of the sales that year, REITs were responsible for just 23.7%.

Forbes. So, on balance, REITs didn’t act like drunken sailors during the bubble years. Marty Cohen and Bob Steers say REITs will be big buyers in the years ahead, though. Do you agree?

Slatin. Yes, though it isn’t happening yet, and that’s key. Even now with all that distress on tap it isn’t flowing into the market. When it does become available, there will be bidding wars. Investors are balking at 50% discounts today. They want more. Are they right?

Forbes. Alex, what do you think?

Goldfarb. Right now no seller will sell if they think the buyer is going to make 30%-plus returns. And lenders seemingly are not forcing the issue. I’m of the camp that says while there may be distress, it will likely be some time in coming and likely not on the scale that most [potential buyers] are hoping for. That’s why I think UDR’s Kuwaiti deal is interesting, because it reflects the reality that if you want to buy, the pricing is up from the peak (cap rate-wise ) but not at the distressed prices many were hoping for.

There are two upcoming credit issues. For REITs there are the 2010-12 lines of credit, which need to be refinanced. And there’s $23 billion of converts (many of which are put-able come back).

And then in 2015-17, there’s the commercial mortgage-backed securities market. Extending loans is likely preferable for lenders, as owners may not have any equity in the deal or not enough to refinance. The government is not encouraging anyone to take losses and lenders are not forcing the issue.

With all the talk of trying to avoid a Japanese-style lost decade, we seem to be setting ourselves up to repeat it.

Forbes. We’ll have to wait and see about the fire-sale purchases, hopefully for less than a decade. Onward. So what about buying these stocks today? Are they cheap or expensive or what?

No doubt they were cheaper a few months ago. First, REIT stocks have doubled from the all-time lows they set in the spring. Now the stocks are trading at something like 15 times an earnings measure we call “adjusted funds from operations”–that’s net income with one-time gains or losses from property sales and with depreciation added back but minus whatever is necessary to cover routine property-level maintenance.

But is 15 times AFFO too high for REITs? They used to trade at 25 times AFFO, which was clearly too high. Right now, stocks in the Standard & Poor’s 500 are trading at an average of 15 times earnings per share. So no huge premium there. Many REITs are still trading at slight discounts to net asset value–that is, their shares are priced at less than the underlying equity in their assets if those were sold at fair market value.

So are they cheap or pricey?

Goldfarb. When you see REITs’ implied capitalization rates suggesting minimal, or even negative leverage, price/AFFO multiples higher than the S&P 500′s price/earnings ratio (I think AFFO is akin to EPS), and dividend yields near 5% that are being cut or paid in stock, it looks like REITs are fully priced. How much of a sell-off will we get? Tough to say as the bias of this market is clearly up.

Longer term, there are certainly some REITs that belong in any REIT portfolio. For example, I’ll mention apartment REIT AvalonBay Communities. shopping mall REIT Simon Property Group. office REIT Boston Properties and strip center owner Federal Realty Investment Trust. There are also some interesting growth stories, like college-dorm owner American Campus Communities and even some that can materially benefit from distress, like Los Angeles office landlord Douglas Emmett.

The question is price. Right now, I’m not an incremental buyer but I would not be a seller at the moment of these names either.

Forbes. OK, so it’s time for restraint. If readers already own some of these names, hold them. But if they want to invest, maybe it’s better to wait. Or just buy a little and plan to hold a long time.

Slatin. All this underscores the need for caution and selectivity at this stage of the real estate cycle. It’s very volatile and uncertain, which is evident in daily trading data.

I agree there are some great niche plays like American Campus. Medical office or life-science real estate is also interesting to me, so Alexandria Real Estate Equities is a great buy-and-hold right now. Brookfield Asset Management, though not a REIT, is a diversified real estate, energy and timber play with top-quality management and a good balance sheet.

Goldfarb. I would also throw in an apartment owner, Essex Property Trust. of Palo Alto, Calif. if you want a geographically targeted REIT with a skilled management team that has delivered. You get a lot of steak with minimal sizzle.

Slatin. Agreed. I also believe now is a time to restrain buying. Hotels have already had their run-up for the most part, although as I note in my column they may get a bump when the Hyatt IPO comes off. Fundamentals overall, in every property type, are just too uncertain while prices are now too rich.

Goldfarb. Yes, that’s right. Essex also falls into that “hold” camp, but I would not be an incremental buyer at current prices.

Forbes. Peter, in your column in Forbes magazine last month, you said it’s time to consider being more careful. The group looks expensive to you. You make an interesting suggestion: Buy the laggards. You suggest Associated Estates in Cleveland. They own apartment properties and have a dividend yield near 10%. They’ll never win the award for best REIT management but it’s OK to say yes to double-digit dividend yields.

If you’re right that it’s too pricey to get really excited this week, when should the patient investor jump in? What’s a good rule of thumb for when an investor should buy or sell? Should they be looking at price/affo multiples? Price/NAV? Dividend yields? And what’s the right number?

Slatin. For individual investors, these are always personal questions relating to issues like return threshold (or pain threshold), income needs, and of course when you bought into the stock. Everyone has a story about selling after a 100% gain, only to see a stock double or triple again. No need to beat yourself up over that.

Forbes. Maybe I’ll try harder to pin down Alex and you on this next time we talk.

That’s it for this week, gentlemen. The Real Estate Stock Talk will be back every other week or so. Readers who would like to pose questions to our panel for the next time we get together are invited to e-mail them to me at sfitch@forbes.com .