Double-digit returns and high yields, coupled with a gradually improving economy, are driving investment demand in commercial real estate investment trusts (REITs). And the attractive performance should continue, suggests Philip Martin, an analyst for Morningstar Inc. in Chicago.

“Healthy balance sheets and dividend payout ratios should allow equity REITs to maintain, and in many cases increase, dividends,” Martin predicts. A healthy supply of commercial real estate and an improving economy, he says, should boost REIT operating fundamentals, cash flow and underlying portfolio valuations.

Almost all sectors of the REIT market produced double-digit total returns in the first nine months of 2012, according to the National Association of Real Estate Investment Trusts (NAREIT) in Washington, D.C. Commercial financing REITs gained 35.13%, industrial REITs gained 25.46%, shopping centers gained 24.65%, office REITs gained 14.08% and health-care REITs gained 13.67%. By contrast, the S&P 500 gained just 16.44%.

NAREIT says the 4% dividends paid out—nearly double the S&P 500’s 2.2% dividend yield over the same period—were a major contributor to those total returns. Many analysts and fund managers agree on the industry’s gradually improving fundamentals. REITs took on less debt than other real estate. They acquired solid properties and sold some at the top of the market.

But an October 2012 survey by New York-based PricewaterhouseCoopers and the Urban Land Institute, Washington, D.C., suggests that investors should temper their expectations about commercial real estate performance and look forward to only modest gains in leasing, rents and pricing for all property sectors nationwide in 2013.

“The industry is moving forward bit by bit,” says Stephen Blank, senior resident fellow at the Urban Land Institute. “Nothing indicates a quick turnaround for commercial real estate, but it is improving. Those who are patient and willing to rethink their expectations are expected to come out ahead this year.”

Some areas, such as New York, Philadelphia, Cleveland and Atlanta, are showing more commercial real estate growth than others, according to the Federal Reserve’s “Beige Book” report for the third quarter of 2012.

The Green Street Advisors “Commercial Property Price Index” shows that mall and apartment values have surpassed their 2007 highs. This even though, on average, property prices are just 5% shy of those highs.

Morningstar’s Martin says the aging population will be a boon to health-care REITs, companies such as Ventas, HCP, Senior Housing Properties Trust and Alexandria Real Estate Equities.

Nick Schorsch, chairman of New York-based American Realty Capital Trust, a publicly traded REIT, cites the positive signs for commercial real estate. Among these are continued low interest rates, low inflation and the lack of new supply in many property sectors. More securitized financing is also available, which lets sponsors leverage properties.

He expects property prices to rise once unemployment falls below 6.5%, so he believes now could be the time to buy. “The opportunity is quite unique and could last until [Fed chairman Ben] Bernanke’s term expires in 2015. Not much is done in the first year after the presidential election.”

Schorsch also predicts modest growth over the next couple of years—particularly for high-quality triple-net-lease properties. Occupancy rates are slowly rising. Leases range from five to 10 years. In addition, REIT yields are trading at an attractive spread to the 10-year Treasury bond.

Martin Cohen, the co-manager of the Cohen & Steers Realty Shares fund in New York, also favors commercial real estate. “We believe the combination of positive economic growth, low borrowing cost, moderate inflation and essentially no new supply in most sectors should provide a favorable backdrop for REITs to continue generating high-single-digit cash-flow growth,” he says.

Cohen sees value in hotel and industrial real estate businesses, which, he says, are selling at a discount to their underlying assets. He is underweighted in the health-care sector.

His fund’s largest holdings include Simon Property Group in the regional mall sector; Prologis Inc. in the industrial sector; Boston Properties in the office sector; Public Storage in the self-storage sector; and AvalonBay Communities in the apartment sector.

Not everyone is enamored of REITs. Jeff Kolitch, manager of the Baron Real Estate Fund, New York, believes that non-REIT commercial real estate companies have better expected rates of return. REIT stock prices are overextended, he says, because of investors’ demand for high yields.

He owns a smattering of high-quality REITs. But most of his fund’s money is invested in real estate service and operating companies. He does this for a number of reasons. The demand for space is strong. Supply is limited because there is little new construction. Plus, rents and occupancy rates are rising.

“We are very optimistic on the prospects for commercial real estate,” Kolitch says. “We believe we are in the early stages of a multiyear recovery fueled by low interest rates, improving credit conditions and demand. This is the second year recovery in commercial real estate that could last another three to five years.”

His largest holdings include CB Richard Ellis, the world’s largest commercial real estate company; Hyatt Hotels; and senior living operators such as Capital Senior Living, Brookdale Senior Living and Emeritus Corp.

Although REIT fundamentals look good, advisors must be aware of ever-prevalent risks. Zacks Investment Research, Chicago, says that REITs are raising a lot of capital through property debt and equity offerings. This has put pressure on already-leveraged balance sheets and diluted earnings.

Martin, of Morningstar, says that REITs are trading at a premium to fair market value—particularly REITs that invest in multifamily properties. Investors still need to be concerned about global economic problems and volatility.

In addition, financial advisors shouldn’t have overly optimistic expectations that REITs will improve a portfolio’s return per unit of risk. REIT correlations to stocks hit 0.90 and REITs lost 55% during the bear market from October 2007 through March 2009, according to research published in the June 2012 issue of the AAII Journal. A 2011 study by Sebastien Lleo, finance professor at the Reims Management School in Reims, France, shows that the correlation between REITs and other asset classes worldwide historically rises during periods of high volatility.

On the bright side, there may be some investment opportunities in newly offered non-traded REITs, suggests David Steinwedell, managing partner of Blue Vault Partners in Cumming, Ga. Newer products are more investor-friendly after the regulatory crackdowns of the past year. But advisors must scrutinize blind pool offerings; they must look at sponsors’ track records and their ability to generate solid net cash flows from previous operations.

Advisors must also tread carefully selling these products to retirees. Finra issued an alert on non-traded REITs last October. Its examinations found investors were getting misleading information from brokers about the investments. Brokerages also did a poor job determining non-traded REIT suitability.

Inland American Real Estate Trust Inc., with $11.2 billion in assets, was reported to be under investigation by the Securities and Exchange Commission for charging excessive fees and valuing properties at the purchase price rather than the net asset value (the market price of the properties). The company responded that it was fully cooperating with the SEC and had not committed any wrongdoing.

Financial news reports are also littered with articles on non-traded REITs that, because of falling property values, racked up big losses when they finally valued their holdings, liquidated, merged or went public. Meanwhile, several of these REITs have faced lawsuits by individual investors. In September, the Behringer Harvard REIT I and Schorsch’s American Reality Capital Trust (which had been a non-traded REIT until March 1), were hit with lawsuits over their valuations and dividend payments. Both companies publicly said the suits were without merit.

Regulatory crackdowns have improved the non-traded REIT climate. Where older non-traded REITs charged front-end fees as high as 15% and early redemption fees as high as 5%, some new offerings have lowered the exit fees to 2%.

Steinwedell says the entire non-traded REIT industry, yielding 5% to 7%, is on track to raise $10 billion this year. Most of these are blind pools (the properties have not yet been acquired). Unlike older non-traded REITs, Steinwedell notes, the newer investments have more liberal redemption privileges and often publish daily net asset values. Investors typically can redeem shares quarterly at net asset value. In the past, non-traded REITs generally were also required to liquidate, merge or list on a stock exchange after 10 years, a long time for investors. Today, some are choosing to liquidate in as little as five or six years.

Newer non-traded REITs furthermore have lower fees than their older counterparts—an average of 12% compared with 15%, he says. REITs targeting fee-only advisors have been launched with fee structures as low as 4%.

Many non-traded REITs are now waiving the “internalization fee.” This generally was paid when the contract between the non-traded REIT and its outside advisor expired, and the outside advisor assumed duties within the publicly traded REIT. Depending on the contract, though, non-traded REITs, after being listed for several months, may opt to pay the advisor a performance fee.

Several non-traded REITs provide daily net asset values and quarterly redemptions at net asset values. Among such REITs currently raising capital are: 

• Cole Real Estate Income Strategy REIT
• American Realty Capital Daily Net Asset Value Trust
• Jones Lang LaSalle Income Property Trust
• Dividend Capital Diversified Property Fund
• Clarion Partners Property Trust

Steinwedell says that now may be a good time to invest in non-traded REITs whose management teams have already run successful deals.

“Look at the sponsor’s track record of previous successes,” he stresses. “Commercial property is down as much as 50% from the peak in 2007.”