Bottom-Feeding REITs

Yes, it's true that the commercial real estate industry is suffering from increasing vacancies, decreasing rents and declining property values. Call it a trifecta of bad news. Yet, for bottom-feeders — er, contrarians — this might be a good time to start considering investing in real estate — especially publicly registered, non-traded REITs.

Because prices for commercial property have dropped 25 percent to 30 percent on average, pushing commercial real estate yields up as much as 2 percent, investors who plow money into non-traded REITs could achieve better total returns than investors have in the past. (And those returns, until recently, had been stellar.)

“This is the greatest buying opportunity in our lifetime, and because non-traded REITs have access to capital, they'll be able to take advantage of it,” says Martel Day, executive vice president of Inland Securities Corp., and president of the Investment Program Association, a national organization that advocates investment in direct participation programs.

Not only will non-traded REITs be able to provide fatter dividends if they get their assets at a bargain, investors could see juicier returns at the liquidation event. “Investor returns are going to be enhanced by the REIT's ability to buy low and sell high,” Day adds.

Avoiding Volatility

Keep in mind that non-traded REITs are not appropriate investments for everyone. Not only do they have minimum income requirements — investors need to have a liquid net worth of $250,000 (exclusive of their homes), or income of $70,000 per year and $70,000 in assets — they are illiquid investments because they don't trade on any stock exchange. Most have an investment horizon of three to seven years before they are liquidated, either through an IPO or by selling off the property portfolio.

With property values falling, none of the non-traded REITs enjoyed a liquidity event in 2008. In fact, sponsors can choose not to liquidate if the time isn't right. While this protects investors against losses, it also makes non-traded REITs that much more illiquid.

Of course, that illiquidity isn't necessarily a bad thing because non-traded REITs are able to avoid the volatility of the stock market, preserving the initial investment while hedging against inflation, says Carrie Coghill Kuntz, president of DB Root & Company, a Pittsburgh, Pa.-based wealth management firm. Moreover, they have a low correlation with other asset classes.

A recent survey of financial advisors who routinely recommend non-traded REITs found that 63 percent of advisors expect to increase their use of non-traded REITs in light of the volatile markets. The survey, conducted by GDC Research and Practical Perspectives on behalf of the IPA, also discovered that 64 percent of participating financial advisors expect to increase their usage of non-traded REITs in 2009.

Reliable Dividends

Non-traded REITs pay monthly or quarterly dividends in cash, with dividends typically starting in the mid-5 percent range. As the REITs acquire properties and establish their operating platforms, dividends can get up to 6 or 7 percent.

Strategic Storage Trust, for example, is targeting dividends of 7 percent and a holding period of roughly five to seven years, according to Michael Schwartz, CEO of Strategic Storage Trust, a non-traded REIT that specializes in self-storage facilities. Based in Ladera Beach, Calif., the non-traded REIT began raising money in early 2008, and has raised $20 million to date. It expects to raise a total of $1 billion over the next four years to invest in self-storage facilities across the U.S.

While most non-traded REITs have been able to maintain their dividends during the recession, they are not immune from the challenges facing the entire commercial property industry. That means their dividends could come under pressure if rents continue to fall and vacancies continue to increase.

However, non-traded REITs that buy at the bottom of the market (or closer to it) will have greater financial flexibility to sustain their dividends, Day notes. And, when the commercial property values rebound, these non-traded REITs will be able to sell their properties for much more than they paid.

The number of non-traded REITs available for investment is growing every year, and over 15 sponsors are actively raising money to acquire commercial property. Another six are in the midst of filing with the SEC.

Unlike publicly traded REITs, non-traded REITs — such as Inland Real Estate Investment Corp., Behringer Harvard Funds and Wells Capital — are not dependent on the capital markets to raise money, because they can sell directly to individual investors. In 2008, investment in non-traded REITs exceeded $9.1 billion, according to Robert A. Stanger & Co., a Shrewsbury N.J.-based investment banking firm that specializes in the direct investment securities markets.

Over the past couple of years, non-traded REIT sponsors have diversified into more property types, giving investors many more options. Just a few years ago, investors were limited to the four traditional property types: office, retail, apartment and industrial. If investors wanted exposure in specialty real estate, they were forced to invest either in publicly traded REITs or real estate mutual funds.

Now, there are non-traded REITs that specialize in non-traditional sectors such as health care, self-storage, entertainment and timberland. Many of these sectors have outperformed during this recession.

Foreign Soil

Non-traded REIT sponsors are even diversifying into real estate, giving Americans an opportunity to invest in foreign real estate markets. Non-traded REITs are just about the only investment vehicle that allows U.S. investors to gain exposure to emerging markets while avoiding the volatility of the various foreign stock exchanges. (The alternative is to acquire real estate directly, but it's illegal in many countries for a foreigner to own property.)

For example, CB Richard Ellis REIT expects to invest up to 30 percent of its portfolio in Western Europe, China and Japan. Similarly, New York City-based W.P. Carey & Co.'s non-traded REIT, with the rather unusual name, “CPA:17-Global,” will invest in international real estate, primarily sale-leasebacks with credit-worthy corporations. And, just last month (January 2009), well-known non-traded REIT sponsor CNL Financial Group partnered with Australia-based Macquarie Group Limited to launch the CNL Macquarie Global Growth Trust, a new non-traded REIT that will invest in office, retail, industrial, multifamily and health care properties around the globe.

Many foreign real estate markets have weathered this global economic downturn better than the U.S., so investing in non-traded REITs with a global platform can help investors reduce risk and generate better returns, according to Joe Zarlenga, a senior financial advisor with Ameriprise Financial in Naperville, Ill.

“When my clients see negative returns on all other investments — even bonds — and 6 percent to 7 percent returns on non-traded REITs, they want to add more of them to their portfolios,” Zarlenga says. “They just can't get enough of non-traded REITs.”

2008'S TOP FIVE NON-TRADED REIT FUNDRAISERS*

All five are actively looking for properties to acquire. This is a list of non-traded REITs that operate in non-traditional real estate sectors. They are all raising money and looking for opportunities to deploy it.