Here's why the real estate market is too shaky even for spiffed-up REITs

The nontraded real estate investment trust industry has spent years rebuilding its product to be a better mousetrap that's kinder to investors by giving them more chances to get their cash out of an illiquid investment. But the current market for commercial real estate is turning into a mouse so bloated that even Steve Jobs would be challenged to design a trap that could snare this rodent.

Since 2017, brokers and financial advisors have been selling tens of billions of dollars worth of the new generation of nontraded REITs, many designed as net asset value REITs, meaning that they're structured to generate long-term returns and provide greater transparency than past generations of the product. Investors buy the product for steady returns, often in place of a fixed-income investment.

Rising interest rates and a work force that's not returning in full capacity to offices in American cities are the chief hurdles right now for commercial real estate investments like nontraded REITs. A lack of investor confidence related to this year's spurt of bank failures could limit financing in the near term, and that has to hurt commercial real estate investors, too.

In 2008, years before nontraded REITs that featured added liquidity, like the Blackstone Real Estate Income Trust Inc., launched, the older version of the product suffered in the commercial real estate downturn. Because of archaic industry rules about pricing illiquid investments, investors believed that nontraded REITs were worth $10 per share one day only to discover their values seemingly overnight had been slashed by 10%, 20%, 30% or more, with little explanation from the REIT companies or their financial advisors.

And right now, the numbers are bad for commercial real estate investors.

Over the past year ended Monday, the Dow Jones U.S. Real Estate Index was down almost 15.7%, while the S&P 500 index increased a little more than a percentage point over the same period. According to a report this month from real estate data firm CoStar Group Inc., the U.S. office vacancy rate hit a new high of 12.9% in the first quarter, which exceeds the peak during the 2008 financial crisis.

That's a lot of empty cubicles — bad news for any kind of REIT that buys office buildings.

Not all REITs, of course, invest in the same sectors of real estate. Those that have avoided buying office buildings in big cities, like Blackstone REIT, could wind up faring better in the current downturn than others.

But at least one critic of the newfangled REITs remains unconvinced. Is this new mousetrap really better than the old?

Unlike listed REITs, nontraded REITs don’t trade on exchanges and investors have limited liquidity, although Blackstone REIT and other new NAV REITs have a much better ability to pay investors cash for their shares and make them liquid. Because nontraded REITs aren't priced daily, like listed or traded REITs, their true values remain opaque despite the fact they have a NAV, said Phil Bak, CEO of Armada ETF Advisors.

"Regarding Blackstone REIT and other NAV funds, I think that the damage hasn’t come to pass but it unquestionably will," Bak said in an interview Monday. He said his firm's analysis of publicly traded REITs and nontraded REITs shows the latter are overvalued by as much as 30%.

"The publicly traded REITs are priced on the market and have an executable price, meaning that's what the buildings are worth because that’s what you can sell the REIT for," Bak said. "With nontraded NAV REITs, you don’t know what it’s really worth. Remember, the building doesn’t know who owns it."

Bak is not a disinterested observer in this iteration of the nontraded REIT wars. Armada ETF Advisors has registered with the Securities and Exchange Commission to launch a new real estate exchange-traded fund.

The $70 billion Blackstone REIT is the largest of the NAV REITs and has faced intense scrutiny since December, when it told investors that redemptions had exceeded the monthly limit of 2% of its net asset value in October and 5% for the entire quarter. That pushed the company to prorate, or limit and portion, investor demands. That means some investors who wanted to get their money out of the fund were turned away — at least for the short term.

Investors continue to try to pull money out of the Blackstone REIT. The company reported last week that it had again limited investor redemptions for the month of April, according to published reports.

"Strong performance is what matters and BREIT has delivered: 12% annualized net return since inception over six years ago," a Blackstone spokesperson wrote in an email. "BREIT is a semi-liquid product and is working exactly as designed. Approximately 96% of our U.S. investors and 93% of investors overall chose to remain in the fund in April."

Meanwhile, performance of the spiffed-up NAV REITs has been steady despite the recent turmoil in commercial real estate, according to investment bank Robert A. Stanger & Co. Inc. For the year ending in March, the Stanger NAV REIT Total Return Index grew 1.8%, according to the investment bank.

The question is, does the liquidity-focused REIT mousetrap continue to work, even with certain sectors of commercial real estate seeing these extreme market conditions? Or does the updated REIT mechanism buckle, to the cost of investors and financial advisors who sold the product as a safe and steady investment?

The longer workers stay away from office buildings and out of their cubicles, the more likely it is the latter will occur.