Keep a Stake In Real Estate: Despite subprime woes, clients might do well to hold commercial REITs.

Is nothing right with real estate? Depending on whom you ask, commercial real estate investment trusts (REITs), which held onto their value after residential markets started to sag, are the next domino poised to tumble in the wake of this summer's subprime mortgage meltdown. Careful selection of the right REITs, however, may still offer shelter from the storm.

The commercial REIT market ended 2006 with an annual return of 45%, capping four years of double-digit growth, according to NAREIT. But returns hit negative territory, at about -9.9% by the end of October.

The MIT Center for Real Estate, which, in association with the national Council of Real Estate Investment Fiduciaries, uses its proprietary Transactions-Based Index to track the performance of commercial property investment, released data on the sector's performance in the third quarter of last year that has some observers worried.

"Results for the third quarter of 2007 are highlighted by a negative 2.5% capital return, the first negative quarterly price change in the TBI since the third quarter of 2003, when prices fell 2.4%," states a release from the MIT Center.

Speaking at the National Association of Realtors' annual convention in November, the organization's chief economist, Lawrence Yun, painted a grim picture. Noting that the average return on commercial REITs has been hovering around 6.5% for the past quarter-down from 8.5% at the start of the year-Yun warned of outflows from the sector.

"People are questioning whether to buy a CD with a guaranteed 5% return, or an office property with a cap rate of 6.5%," he said. (Cap rates are the ratio of cash flow from rents to the capital costs of the building.) The small differential between CD returns and cap rates is raising concerns that investors may move out of commercial properties.

Another concern for the commercial REIT sector is slow growth in new properties. "My perception about the office market is that it is going to slow down quite a bit from a construction standpoint-it sounds as though it has already become more difficult for developers to get financing," says Ken Simonson, chief economist for the Associated General Contractors of America. "Even six months ago, there were a lot more sources of funds and they were a lot more willing to depend on the expectation that there would be an easy exit. I think those assumptions have gone by the boards-people want to see that you have enough [credible] tenants to cover the costs now."