Despite real near-term challenges -- and in some ways because of them -- there is a compelling case for private real estate in a diversified portfolio, according to Philip Conner, U.S. office principal of Prudential Real Estate Investors in a new report released this past week.

Although the risks and challenges of executing an investment program in the current environment are real, the dramatic correction in commercial property values since the market peak in late 2007 provides an attractive entry point for long-term investors seeking exposure to the asset class, Conner argues.

The fallout from the credit market crisis and severe global recession in late 2008 and early 2009 took a heavy toll on commercial real estate. Property values plunged as risk and capital were re-priced, while vacancies soared as tenant demand contracted. The upside, Conner writes, is that with the capital and space market cycles both near trough levels, there would appear to be less downside risk for property values.

The risks are primarily related to properties that were acquired or refinanced with high leverage during the peak of the market cycle. The decline in property values has wiped out most or all of the equity that was invested. Even assets that have equity remaining will face challenges at refinancing due to the deterioration in property income and more conservative underwriting by banks.

Yet today, the economy is adding jobs again, and most major asset classes are up sharply from the lows during the crisis. Thus, Conner argues, real estate values and tenant demand will follow, and the only questions relate to the timing and strength of the recovery.

What makes investing in real estate at the bottom of the cycle attractive is not much different from in the stock market, Conner writes. Investors can acquire assets at relatively low multiples (i.e., high capitalization rates) based on depressed earnings, and capture gains from both the improvement in income and the higher multiples (i.e., lower cap rates) investors assign to that income.

Lastly, although it may not qualify as a "risk" per se, Conner writes that investors face serious challenges deploying capital today. Transaction activity remains depressed across the board, but the volume of distressed deals in the direct market is a tiny fraction of the amount of distress known or believed to exist in the U.S. alone. Much of the distressed activity to date has involved trading paper -- particularly investors buying discounted positions in the debt capital stack, from senior debt to mezzanine. Deploying capital may get easier as more troubled assets come to market, but the more complex capital structures that became commonplace during the height of the boom will make it far more difficult to acquire properties directly.