Real estate has been a real bad investment for the past year or so. At least that's been the case with publicly traded real estate investment trusts (REITs) as measured by the FTSE NAREIT equity index, which nosedived 38% last year, followed by a whopping 32% loss in this year's first quarter.

But there's another way to invest in real estate that's not tethered to the vagaries of the public markets—non-traded REITs, also known as private REITs. Both types of REIT operate in similar ways: They own-and in most cases, manage-income-producing real estate; they distribute at least 90% of their taxable income to investors as dividends; and they're registered with the Securities and Exchange Commission.

But non-public REITs significantly differ from their public counterparts in how they are priced and traded, and in how liquid and transparent they are. Non-traded REIT prices, for example, are set by the REIT sponsor, and the industry standard is $10 per share. That price will remain constant during the life of the fund, which can last anywhere from five to ten years (or more). After that, its investors hope to cash out through an initial public offering, by selling the fund to another portfolio or by selling off internal properties.

Detractors say the pricing of non-traded REITs is much less clear than it is for publicly traded ones, where prices are set by the open market. "The number one issue is visibility," says Paul Puryear, a REIT analyst with Raymond James Financial. "I'm not sure that investing in something you know less about is advantageous. Intuitively, it doesn't make sense."

Proponents recognize that a lack of transparency can be negative for some investors, but they believe non-traded REIT prices more accurately reflect the value of the underlying real estate than do public REITs, whose prices are set by the whims of Wall Street. "That's a fairer valuation process than the fear and greed that drive equity prices," says Michael Phillips Black, a wealth manager in Scottsdale, Ariz. "A lot of REITs lost 60% to 80%, but the value of the underlying real estate didn't go down that much."

Price stability and dividends are seen as major selling points for non-traded REITs. "They're designed to produce consistent income streams, and they could be an alternative to diversify your portfolio because they're not correlated to the broader equity market," says John Towle, chief marketing officer at Cole Real Estate Investments, a Phoenix-based real estate investment company.

Non-traded funds currently pay dividends ranging from 5.5% to 8%, though most fall within 6% to 7%, which is the group's historical average. That's a couple of percentage points higher than what public REITs typically pay, though the latter have recently plunged in price, which has boosted their collective yield to about 9%, according to the National Association of Real Estate Investment Trusts.

Heavy Load
Public REITs can be bought for as little as $7 with a Scottrade account, while non-traded REIT investors can expect to pay a front-end load of 7% that goes to the advisor, plus another 3% that goes to the company selling the product. Tack on additional fees such as organization and offering costs, along with acquisition fees to buy properties, and total fees could run as much as 12% to 15%.

"I don't know why an investor would want to go that direction when you have much less costs with public REITs," Puryear says.

"There are no fees in the publicly traded world other than traditional trading fees."

Others downplay the costs, saying they average out to be lower for those people who invest early and stay with them for the duration. "Given that this will be a seven- to ten-year hold and that it's a 7% commission, it's very comparable to a fee-based account at around 1% of assets under management," says Jeff Shafer, president of CNL Securities Corp., a real estate investment company in Orlando, Fla.

"People always complain about the front-end load," says Kevin Gannon, managing director at Robert A. Stanger & Co., a Shrewsbury, N.J.-based investment banking firm specializing in real estate, REITs and direct participation programs. "It is seemingly high, but so is the exit opportunity when you exit in a positive market."

Only seven private REITs have gone full cycle since 1998, meaning they've gone from the initial funding to payout. The typical private fund might take three to seven years to raise capital before it closes, and depending on market conditions, it might wait another year or three for the right time to liquidate.

According to Stanger, two of those seven full-cycle funds went public and the others either merged or closed by selling properties. These seven funds averaged a total return of 64%, or $16.43 on every $10 per share invested. Investors who participated in a dividend reinvestment program saw average gains of 89%, or $18.86 per share. Those figures assume that the investment is made at the approximate midpoint of a fund's multiyear offering period; the gains could be more or less depending on when an investor entered the fund.

Those successful full-cycle funds began raising money in the '90s and were ready to cash out before the real estate market crashed. Others will have to wait for their hoped-for payday. "A number of REITs who wanted to go public in '07 and '08 missed their chance," Black says.

Meanwhile, a number of non-traded funds are raising cash and scooping up real estate at favorable prices. "Given the valuations of property and the lack of liquidity in the market, now could be an ideal long-term opportunity," Towle says.

Buy-N-Hold
Non-traded REITs emerged in the 1990s from the ashes of failed real estate limited partnerships, which were promoted as tax shelters but ultimately fell apart because of changing tax laws and a real estate downturn. The sector got off to a slow start, but non-traded REITs-and real estate in general-zoomed after the dot-com implosion. The amount of equity raised in non-traded REITs roughly doubled in size each year between 2000 and 2003, and then basically plateaued for the next few years. It spiked to $11.4 billion in 2007, followed by $9.9 billion last year. Gannon says equity-raising started slowly this year, but in March it rose 23% over the prior month. He expects the sector to raise $6 billion to $7 billion in 2009.

Despite the industry's growth, some investors have soured on non-traded REITs. "I learned this is a big 'trust me' investment," says Phillip Cook, a financial planner in Torrance, Calif., who invested in the sector during the early days. "As in, 'Trust me, we'll have the money to take you out if you want to get out, or that we'll do the right things by you even if you don't have immediate liquidity.' Because of that 'trust me' aspect, I can't see the return justifying the risk."

Some non-traded REITs require as little as $2,000 to invest, but they're structured as long-term investments that place limits on the investors' ability to sell and get their money back whenever they want. "You pay a price for non-traded REITs, and that price is liquidity," says Michael Dowd, senior vice president of the United Group of Companies, a Troy, N.Y.-based firm specializing in real estate and debt financing. "You have to decide what portion of a portfolio you want to be in sticky stuff that's hard to sell."

Indeed, these vehicles aim to put the "hold" in "buy-and-hold." "We want to attract capital that'll be here for the length of the program," says Shafer, whose CNL Securities is currently raising cash for two non-traded funds. One is a global REIT the firm launched with partner CB Richard Ellis Investors, which manages it. The other is a lifestyle properties REIT focused on ski resorts, golf courses and theme parks.

"We sell our products as a way to own hard assets that provide stable cash flow," he says. "We don't sell them as liquid investments. They're not meant to be trading vehicles, unlike publicly traded REITs."

Shafer provides a checklist of things to consider before investing in private REITs: the financial strength of the offerings; the funds-from-operations payout rate (FFO measures a REIT's ability to generate cash); debt levels and maturities; and the investment thesis of the REIT and when it acquired its properties.

But redemption demands have recently increased in non-traded REITs, raising fresh concerns about their inherent liquidity problems. "Most of the major sponsors have suspended their share repurchasing programs because redemptions overwhelmed them," says Gannon from Robert A. Stanger.

Cole Real Estate Investments hasn't suspended redemptions yet, but it could. "Cole and a lot of non-traded REITs typically retain the right to either terminate or adjust their redemption schedule," says Towle. Cole operates three non-traded funds-including one that's currently raising cash-focused on big-box retail centers anchored by the likes of Wal-Mart and Home Depot.

In Cole's case, redemptions aren't allowed in the first year, and in the second year the redemption rate is 95% of the $10 per share purchase price. That rises to 97.5% in the third year, followed by 100% after that. Even then, Cole puts a cap on the number of shares that can be redeemed in one year to an amount not exceeding 5% of the weighted average number of shares outstanding in the 12 months before the redemption date. Most other non-traded REITs have similar restrictions.

New Product
People think of non-traded REITs as something sold rather than bought. "It wouldn't be unfair to say that the average person doesn't wake up in the morning and says, 'Buy me a non-traded REIT,'" Gannon says.

Still, sponsors of non-traded REITs have raised $60 billion in equity since 2000, according to Commercial Real Estate Direct, an online news service. For now, they're sold in the advisor channel, mainly through broker-dealers, although Gannon says they are starting to penetrate the fee-based market in wrap-type accounts where advisors waive the up-front commission and get their fee from the account itself.

Gannon says a new non-traded REIT from Merrill Lynch might accelerate that trend. The product, NorthEnd Income Property Trust, was filed with the SEC in January and will employ BlackRock Realty Advisors as a subadvisor. According to its regulatory filing, the fund hopes to raise up to $2.25 billion to invest in a mix of commercial properties across the U.S. and Canada.

The minimum investment will be $1,000, and the share price will be set at $10.25. After the escrow period, the share price will vary daily based on the net asset value divided by the number of shares outstanding. The front-end commission will be 2.5%, and advisors will get 35 basis points per year from the account until they earn a total fee of 10.5%. In addition, the fund will allow for daily redemptions on any portion of their shares.

"If this catches on, I think more guys will do this," says Gannon, referring to non-traded REIT product sponsors such as Wells Real Estate Funds, Behringer Harvard, Grubb & Ellis Realty Investors and the like. He also thinks it could entice other financial services companies to join the fray, such as UBS and JPMorgan Chase & Co.