Jones Lang LaSalle

A Real Estate Investment Moves to the Mainstream
By VIVIAN MARINO

WALL STREET has embraced real estate investment trusts as an asset family that adds diversification to portfolios, but some financial advisers still regard so-called private, or unlisted, REIT's as a kind of black sheep.

The critics say they are troubled by what they see as high up-front fees, a lack of liquidity and limited transparency in these investments, which are publicly registered but not listed on any exchange. Others, though, view them as rich income sources that provide an exposure to real estate equity without the nail-biting fluctuations of the public markets.

Both camps seem to agree on one point: These specialized REIT's, which have been around for only a decade or so, have been inching their way from the financial periphery toward the mainstream as demand for real estate investments continues to grow.

Unlisted REIT's — operated by independent companies, or sponsors, and marketed by brokers and financial planners — have been attracting a steady flow of investment dollars. An estimated $6 billion was raised in 2005, down from its peak of $7.2 billion in 2003 and just below the $6.3 billion in 2004, according to Spencer Jefferies, publisher of Direct Investments Spectrum, a newsletter.

At Wells Real Estate Funds, one of the biggest sponsors with more than 35 million square feet of space in 163 buildings, sales rose by 30 percent in 2005 from the previous year, said Tom E. Larkin, the senior vice president for sales. (The CNL Financial Group, the Inland Real Estate Corporation and Dividend Capital are among the other big sponsors.)

At the same time, the portfolios have grown. Altogether, unlisted REIT's acquired about $9.4 billion in commercial property in 2005, up from $7.9 billion in 2004 and $1.2 billion only five years ago, according to Real Capital Analytics, a research and consulting firm.

"There has been a significant surge of interest in these types of investments," said Ralph L. Block, author of "Investing in REIT's" (Bloomberg Press, 2002) and senior REIT portfolio manager for the Phocas Financial Corporation. "The main reason is that people are looking for income, especially the baby boomers as they near retirement."

Indeed, one benefit of owning an unlisted REIT is that the regular quarterly dividend tends to be higher than those paid by the traded ones. According to the National Association of Real Estate Investment Trusts, dividends paid by unlisted REIT's have averaged roughly 6 to 7 percent, compared with 4 to 5 percent for traded ones.

The group puts the universe of nontraded REIT's at 16. (True private REIT's, usually much smaller in size and numbering about 800, neither register with the Securities and Exchange Commission nor trade shares.)

"Nonlisted REIT's are looking for income-oriented investors, and they pay out most or more of their cash flow, which is why they have higher dividends," Mr. Jefferies explained. "This is a controversial aspect."

Of course, there are other factors to consider besides income. "There are advantages and disadvantages to owning them — the key is for the investor to be educated on all of them," said Hank Madden, a money manager from Jacksonville, Fla., who occasionally sells private REIT's to his clients. "It's really a matter of personal preference."

Sponsors, in fact, caution that only long-term investors need apply.

Stuart J. Beebe, the chief executive and president of CNL Retirement Properties, an unlisted health care real estate investment trust, which acquired around $400 million in property last year, said investors should be prepared to hold onto their shares for around 10 years. "It's clearly a much longer time horizon" than other investments, he said.

Mr. Larkin agreed. "They're not for everyone," he said. "What our investor sees is an opportunity for diversification and long-term income." He described the typical shareholder as someone in his or her 50's with $20,000 to $25,000 to invest (although minimum investments for private REIT's range from $1,000 to $5,000).

Share redemption programs vary, but they usually place tough limits on a holder's ability to cash out. Many unlisted REIT's have "list or liquidate" provisions. These specify that after a defined holding period, usually 7 to 12 years, the sponsors must decide either to list the shares on a public exchange or to liquidate the properties and return the prorated proceeds to shareholders. (In some cases, they may opt to extend the list-or-liquidate deadline.)

The holding period for CNL Retirement Properties, for example, is set to end in late 2008. Wells, meanwhile, must also decide in 2008 whether to list or liquidate what it calls REIT I, which was established in 1998; it has until 2015 to make that decision on REIT II.

While investors who stay the course could potentially profit from either listing or liquidation, those who may need to cash out earlier are likely to have a difficult time because there is no public market to sell their shares. This is perhaps the biggest criticism of unlisted REIT's.
Some sponsors offer "distress" redemption opportunities to shareholders who need to liquidate because of emergencies, though the shares are bought back at a discount.

"The problem I see with private REIT's is the lack of liquidity," said Dan Fasulo, director of market analysis at Real Capital Analytics. "If you really need to sell out before the time expires, then you will take a hit."

But sponsors say the main advantage is the greater stability involved in not having to buy and sell on the public REIT market, which has a total capitalization of $336 billion. Fixed-price shares, after all, cannot lose value — or gain, for that matter. "The value on a listed stock can fluctuate on a day-to-day basis," Mr. Larkin said.

That may be true, Mr. Block countered, "but that doesn't mean that the valuation doesn't go up and down." (In fact, the underlying value of the properties held is likely to fluctuate.) "It just means people don't know what the value is," he said.

That brings up another criticism: less transparency. Unlisted REIT's are public to the extent that they are registered with the S.E.C. and must file quarterly reports.

But as Stephen M. Coyle, the chief investment strategist for Citigroup Property Investors, said, "Investors won't be able to truly look day to day at how they're doing." That, of course, also gives unlisted REIT's freedom from analysts' microscopes.

"Daily market-to-market valuations and transparency are very important for most retail investors," Mr. Coyle said.

The financial planners and brokers who sell private REIT's can help provide relevant financial data, but dealing with them can be expensive. Most sponsors of unlisted REIT's take selling commissions, along with dealer manager fees and offering expenses, from their investor capital; those can add up to 10 to 17 percent of the initial investment.

"You really have to look closely at exactly what the fee structure is," Mr. Block said.
Lately, though, some fees have been declining. And REIT executives say that their fee structures may not be all that different from those of front-end-load mutual funds. Still, high fees can dilute returns and exacerbate poor performance, especially for highly leveraged REIT's, the critics warned. Some recalled the problems associated with real estate limited partnerships, also closely held, during the 1980's, when property values plummeted.

"We haven't really seen them in action in a down market as yet," Mr. Fasulo said of private REIT's. "In order to prove themselves as a capital source, they have to go through one down cycle and survive the complications that would be involved."