High yields don’t always mean high value, says Matthew Collins. Some Real Estate Investment Trusts (REITs) now yield an attractive 16%. But commercial real estate is in a perilous position right now. And Matthew says investors should resist the temptation to go bottom fishing just yet. Later in the year, there could be some great opportunities to cash in on a recovery bounce.

This from Sovereign Society:

In a previous A-Letter, we talked about the three attributes necessary to make a portfolio successful in this kind of market. One of those attributes was yield…something that’s become easier to find as equity markets take more and more of a beating. But you have to be careful, because yield isn’t always the mark of a high-value investment. Sometimes it can be the siren’s song that lures you – and your portfolio – onto the rocks.

Doubting Those 16% Yields

On October 7th, Investment Director Eric Roseman wrote to you about Real Estate Investment Trusts (REITs), one of investors’ favorite asset classes, “One of the biggest casualties of the global financial crisis is the big bust now underway in REITs, or real estate investment trusts. Until mid-2007, U.S. REITs dominated global investment performance in the post-2000 tech stock “bubble” era with eye-popping 25% annualized returns.”

If they’re new to you, then think of a REIT as an index fund for real estate. Instead of holding a bucket of commodities or currencies, REITs – as their name implies – hold a variety of real estate titles and allow shareholders to profit from the appreciation of said real estate. And since 2008 was a bad year for real estate, you can imagine how these trusts are faring today.

Since peaking in 2008, Real Estate Investment Trusts have fallen in value by as much as 70%, and many investors are wondering whether it’s time to start picking up the pieces. And with distributions as high as 16% or more on some commercial-property-based REITs, it can be a pretty tempting proposition.

Having already declined 70%, wouldn’t you expect that a rebound might be in the works? Not necessarily…

Commercial Real Estate goes “Subprime”

Most Commercial Real Estate (CRE) in the U.S. is financed and developed by large REITs. And conversely, many REITs are dominated by CRE holdings, so one could say their fates were relatively intertwined. So what’s in store for CRE?

Close watchers of the mortgage market and insider experts have been warning about problems in CRE since before the subprime bubble gained critical mass. And as the subprime mess started to unfold, they continued to warn of the hazards in CRE loans.

To be sure, the underwriting standards weren’t as lax as they were for subprime paper, but there are different psychological factors at play here too. While a homeowner is likely to fight tooth and nail to keep a roof over their heads, small business owners are more likely to throw in the towel when they know they’re faced with a losing proposition. Some can set up shop at home, consolidate their operations, or even just sell off for fear of losing even more – like their house – in such a terrible marketplace.

That we’re already seeing a “terrible marketplace,” is painfully clear. In the words of one anonymous web-poster, Q4’s retail sales “jumped off a cliff, hit the ground and started digging.” The Baltic Dry-Shipping Index – an esoteric indicator of the levels of total demand, measuring the total number of containers shipped overseas – sustained a horrifying and unprecedented 93% drop this past autumn.

Businesses & consumers are already starting to gear up for the worst. Granted, you might not be able to call it “Depression Mentality” just yet, but “Bubble-based Optimism” is wearing off quickly. As a result, the CRE sector is rapidly deteriorating.

CoStar – one of the best sources for information on CRE – is reporting an alarming rise in the number of CRE loans being moved into “special servicing.” According to CoStar, this is “generally an indication of a delinquency or failure to pay off a mature loan.”

Looking at data like this, you can’t help but think CRE – and in turn, the REITs holding Commercial Real Estate – have still got a ways to go before putting in a bottom. Despite the fact that they’ve already taken a serious blow in the last year and some of the trusts are yielding double-digit dividends, it’s likely still too dangerous to go bottom-fishing.

But Eric believes there might be some handsome deals for individual investors on the way there, “The United States can expect more government auctioned foreclosures in 2009, and that means big bargains for speculators and investors alike. Banks are desperate to remove non-performing loans from their clogged portfolio of real estate deals.”

We’ll give all this a few months to unwind and then re-visit it mid-year. Eric believes that the U.S. REIT sector could lead the rest to recovery. It’s also possible that real estate could lead market recovery in general. If that’s the case, then REITs could offer a windfall opportunity to cash in on a recovery, or even just a short-term bounce. Just not yet.

Source: WARNING: The 16%-yielding Asset that You Should NOT Invest In