With the stock market potentially retreating and interest rates inching upward, real estate investment trusts--pooled funds that invest in income-producing residential and commercial properties--could be a welcome alternative. Since these securities do not move in sync with equities, brokers stress the diversification appeal of Real Estate Investment Trusts (REITs). The sales pitch is seductive: In 1996, the index of 198 publicly traded real estate investment trusts tracked monthly by the National Association of Real Estate Investment Trusts (NAREIT) returned 35.8%, including dividends, compared with 20% for the Standard & Poor's 500-stock index. Not only did REITs outpace most stocks, but they also offered better yields--some of them as high as 10%--than a lot of bonds.

PO DELUGE. You may not want to write out that check just yet, though. The REIT index is up a paltry 1.2% through the first two months of 1997, compared with 6.76% for the Standard & Poor's index. Still, a flood of REIT initial public offerings will probably hit the market during the next decade. And as large blocks of U.S. real estate become ''equitized,'' investment opportunities will dramatically expand, says Steven C. Leuthold, chairman of The Leuthold Group, an institutional research firm in Minneapolis.

To find the best plays among the current crop of REITs, investors need to know where to look. First, check the prospectus or annual report for REITs with established track records. Although there are quality managers who have been in business less than a decade, Michael Evans, national director of E&Y Kenneth Leventhal Group, real estate consultants in San Francisco, suggests targeting those that have weathered several real estate cycles, including the REIT debacle of the early 1970s.

Next, focus on high levels of institutional and insider ownership, says Andrew Davis, portfolio manager of Davis Real Estate Fund, in Santa Fe, N.M. If management is selling, why should you be buying? The proxy will tell you how much of the common stock is owned by REIT insiders. A minimum of 10% of outstanding shares is recommended. Inside ownership averages 18% for the REITs tracked by New York-based Cohen & Steers Capital Management.

Another sign of a high-quality REIT may be found with-in the proxy: executive compensation. If the pay of the firm's top brass is tied to appreciation in the stock price, it is likely that management and shareholders are on the same team.

WIDE RANGE. It's also important to make sure that the individual REITs are diversified by property type and geographic location. ''You can own the best-managed REIT available, but if it is a property type or region that isn't doing well, you won't make money,'' warns Robert H. Steers of Cohen & Steers, whose REITs typically own more than 30 properties ranging from shopping malls to office buildings. You can call major real estate firms such as Cushman & Wakefield for national or regional reports on the office, industrial, retail, and apartment markets.

Only now are you ready to focus on financial performance. Don't be lured by high yields alone. Too often, REITs with the heftiest dividends are also the ones that carry the most risk. For example, the average factory-outlet REIT pays a generous 8% dividend. But because regional markets can only support a limited number of outlets, future earnings growth may be modest. Conversely, many low-yielding REITs shouldn't be overlooked. Office REITs, with modest yields of around 5.5% on average, now are the most expensive sector of the market, since their cash flow is expected to grow some 30% in 1997. Since REITs must pay out 95% of their income in dividends to shareholders, investors in the office sector can expect sizable dividend increases in 1998.

Then, check the annual report to determine the amount and type--variable and fixed rate--of debt that the REIT has on its balance sheets. Institutional investors suggest debt levels no higher than 35% of total capitalization. And remember: REITs with lots of variable-rate debt will be hurt if rates keep rising.

Lastly, you'll need to get a sense of whether the REIT is reasonably priced. Ask your broker about adjusted funds from operations, which is how analysts measure cash flow. Current cash flow multiples range from 8 to 15, depending on the properties.

Buying wisely in this market requires extensive analysis. So if your broker cannot explain these basic fundamentals, you shouldn't be buying at all.

By Evan Simonoff
EDITED BY EDWARD C. BAIG