BusinessReport.com

Lance Paddock does not have much hope for big returns in commercial real estate.

Paddock, the chief executive officer of Thompson Creek Wealth Advisors, did not advise clients to put their money into real estate investment trusts, or REITs, because the prices were too high to make an adequate return on their investment before last year.

Then the recession hit. REITs tumbled to a low point in March, valued at 77% less than at their peak in January 2007. Since then, REITs have recovered slowly, sparking an interest in commercial real estate as a long-term investment.

“Relative to most other instruments, REITs are relatively attractive right now,” Paddock says. “I’m not suggesting the returns for the next two to three years would be very good.”

Why have REITs become good-looking prospects in the current economic climate? Because the rents or loans that keep them running are contracts, and short of a default, there’s a good chance investors will receive at least a small return on their investment.

Mike Patton, president of Integrity Wealth Management, says REITs also have tax benefits. For example, if an investor makes $1,000 in income from a REIT, they would be able to write off $400 of that income as a phantom deduction on their tax return because of depreciation.

Patton pulled out of real estate mid-2008, but he says REITs have become a better investment now that prices are lower.

“It’s a hard thing to know for sure,” he says. “I’m on the sidelines right now, but I’m in a mind-set to put money back into REITs. That said, I still wouldn’t jump in with both feet because commercial defaults are on the rise.”

The risk in REITs stems from the commercial market. High unemployment means less demand for commercial services, which leads to cuts in costs that impact commercial locations. That impacts rents or interest on loans in a commercial location in the form of nonrenewal or default, lessening the basis of income for a REIT.

At the same time, shrinking credit markets have left little room for refinancing. REITs use leverage, or debt, in order to acquire additional property in order to multiply returns, paying off the loans with generated income. If the income of those properties declines, a REIT’s debt obligation remains the same, forcing the trust to refinance or sell off assets to raise cash, which dilutes property values in the market.

“REITs are lower risk most of the time and higher risk some of the time,” Paddock says. “You’d better have some other things that are lower risk in your portfolio that have even higher returns to make up for the potential of that risk.”

When you add an uncertain economic recovery, the deck might be stacked against commercial real estate, says Kelley Pace, professor of finance and director of LSU’s Real Estate Research Institute.

“It’s literally a roll of the dice,” he says. “Some investors lose and others that allocate their money to the right investments at the right time win. It’s the way the market works.”

Pace says REITs are a good diversifier in any portfolio because there is no direct correlation with the stock market. REITs might follow the trends of stocks, but might also gain even if stocks lose based on trends in the commercial market.

“A portfolio should never be 100% REITs and nothing else,” he says. “In the past, generally there was not much risk in REITs. Now, because of current economic conditions, that’s not necessarily true.”

Paddock says a balanced portfolio puts between 5% and 15% of its risk portion into real estate. Patton is more cautious with real estate between 3% and 7%.

“REITs have a valuable place in any portfolio,” he says, “but as with any investment, you shouldn’t put all of your eggs in one basket.”

While there might be good long-term value in REITs, Paddock does not expect them to pay off in the short term.

“Just because something’s a good long-term value, that doesn’t necessarily mean it will go up,” he says. “What if the long term to make a decent return is five or 10 years? When I say something is a reasonable long-term value, and I think REITs are now, it does not mean over the next five years I think they’ll even be positive.”

Pace says private REITs have displayed less volatility in the market, and most investors are less interested in private REITs than in publicly traded ones. Paddock believes the losses in private REITs are yet to come because it has not yet been marked down.

“Private investments generally show up on your statement as very steady because they’re not traded every day,” he says. “They seem not as volatile, but if you try to go sell it, you might find it has been much more volatile than it is listed because the price isn’t being reflected in its value.”

Any portfolio should be customized to the needs and goals of the investor, including their risk tolerance and how much risk they can actually afford to take. Though REITs look like an attractive prospect compared to other parts of the market, any long-term gains depend on the strength of economic recovery.

“REITs actually are subject to unique negative factors people need to take into account,” Paddock says. “REITs are one of the more reasonable valued parts of the market longer term, but it is also one of the parts of the market that has more potential shoes to drop as far as the risk than others.”