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Illiquidity Is Good. Illiquidity Is Bad.

Illiquidity Is Good. Illiquidity Is Bad.

Which is it? Depends on who you talk to, but public non-traded REITs are building a war chest. The pros and cons.

The public non-listed REIT sector grew dramatically in 2010, raising $7.6 billion in equity versus just $6.5 billion in 2009. A record 42 deals were offered in 2010 versus 30 deals in 2009. (Note: This is still way below $11.8 billion in equity raised in 2007.) New public non-listed Real Estate Investment Trusts — REITs that are registered with the SEC but not traded on an exchange — have about $70 billion in total market capital, according to Blue Vault Partners, which tracks the industry. (That figure includes public non-traded REITs that are fully invested and “closed” to new investors.)

So why the upswing in interest in non-traded REITs? Well, for one, investors are searching for yield, for income. The median distribution, according to Griffin Capital, a privately-owned real estate investment company, is 6.7 percent. Compare that yield to, say, a Treasury or a corporate bond.

Also, this appeals to contrarians since many investors are betting on a potential bottoming of the various sectors of the real estate market. Non-traded REITs can be attractive for several other reasons: Their value is tied to their properties, and not subject to the whims of stock market investors. (Publicly-traded REITs are volatile; the FTSE NAREIT index has a standard deviation that averaged 19.7 percent over the past 20 years, higher than the S&P 500 but lower than the Nasdaq over that time period, according to Griffin Capital.) And, like listed REITs, they have tax benefits and can help diversify a portfolio.

One big downside can be summed up in one word: Illiquidity. Naturally, that gives non-traded REITs a low beta — they don't trade until the REIT is revalued pursuant to FINRA Release 09-09. Investors are typically locked in for seven years or more. They also require much more due diligence from the advisor than with listed REITs. Plus, there's the criticism by some financial advisors that they charge too much in fees. Others say non-traded REIT sponsors tend to be very aggressive and successful marketers, which explains the ability to raise lots of capital. Ron Carson, of Carson Wealth Management with $3 billion in AUM, says these days the space is “too crowded” and difficult to research.

Like many independent advisors, Debra Brede, head of D.K. Brede Investment Management Co. in Needham, Mass., steers clear of the space altogether. She says she's seen too many people lose too much money in public non-traded REITs, and their payouts unfairly weighted toward the general partners over investors. She describes a secondary market for investors looking to sell their shares as “non-existent.”

With a publicly traded REIT, when the stock falls apart, management feels pressure from the marketplace, Brede said. But with non-traded REITs, “where's the pressure?” she asks.

The payout practices and fee structures of some public non-listed REITs are attracting lawsuits. Chris Vernon, an attorney in Atlanta, says he plans to file legal complaints against several sponsors and broker/dealers that pitched the investment vehicles, accusing them of fleecing investors by taking huge profits out in fees and in their end-game liquidity events.

Real Estate Sector Plays

Like their listed cousins, non-traded REITs can make narrow industry bets, such as medical office buildings, says Laila Marshall-Pence, an independent advisor in Newport Beach, Calif. with $500 million under management. Currently, the most active sector in the space is multi-family housing, with four new apartment REITs launched in the last six months of 2010, according to Blue Vault.

“Any client I talk to today knows that real estate is at a low point,” Marshall-Pence says. If those clients had the time and expertise, they would buy up foreclosures and other distressed properties themselves, but the new non-listed REITs are the next-best alternative, she says. Because commercial leases typically include a Consumer Price Index provision, these REITs can also be seen as an inflation hedge, she says.

In past years, too many REITs were chasing too few deals, which made the space less attractive, Marshall-Pence says. And now, says Dreyden Pence, her husband and business partner, new public, non-listed REITs aren't stuck with legacy financing issues that some of the older publicly traded REITs face. That means the new vehicles can find the best deals on commercial properties, buying near the bottom of the market. Also, they can buy them for cash, and as a cash buyer, close on deals that no one else can, he says.

Also, when they do finance their property portfolio at attractive interest rates at some point in the future, the new non-listed REITs can leverage the debt into even more attractive yields, he says. “We think it's a great current income play.”

There are also the tax benefits: REITs have the advantage of not having to pay corporate taxes. REITs are required to pay at least 90 percent of their taxable earnings to investors, and those REIT dividends are typically taxed at the investors' ordinary income tax rates. (Of course, publicly-traded REITs offer this advantage as well.)

The Drawbacks

Because of the illiquidity, investors who may for whatever reason redeem shares in the first few years would typically be forced to do so at a loss, Pence says.

In addition to fully understanding the liquidity features, it's also important for the financial advisor and client to know the REIT manager, the types of property it will buy, and how well the manager has stuck to those parameters in the past, Pence says.

“You really have to have a greater level of due diligence than with publicly-traded REITs,” he says.

Non-traded public REITs typically have a fund-raising period of two to three years, when their operation costs and distributions are partly covered by incoming investor capital because the property portfolio hasn't been filled out yet. Pence says he prefers fairly new non-traded public REITs that are late in their fund-raising cycle, so that he can get a good understanding of their cost structure and their business strategy.

States set the minimum income and net-worth requirements for public non-listed REITs: typically $70,000 in annual income plus $70,000 in liquid assets, or at least $250,000 in liquid assets with no income requirement. Private REITs that do not register with the SEC are essentially hedge funds, which are required to limit themselves to institutional investors and high-net-worth individuals.

Richard Wagener, an independent advisor who manages about $220 million in Columbia, Md., says he hasn't seen much interest in non-traded REITs in his practice recently, nor has he recommended them much — because of their lack of daily liquidity. Non-traded REITs typically allow limited redemptions on a quarterly basis.

“Most people don't like the idea of having an illiquid investment,” Wagener says. “From a professional advisor's point of view, I prefer the publicly traded REITs to the privates, even though I think the privates have more attractive features over the long term,” such as better returns and lower costs over the long-term.

During the 2008 market crisis, some non-traded REITs cancelled their buy-back features that had allowed investors to redeem on a limited basis. That soured a lot of investors on the entire sector, similar to the hedge fund managers who gave their investment category a black mark by blocking redemptions during the market meltdown, Wagener says.

Despite his clients' overall skittishness with public non-listed REITs, Wagener says he has been pleased with the performance of particular investments in the sector.

Judith McGee, whose McGee Financial Strategies in Portland, Ore. manages $315 million, says she has reservations about the space overall — liquidity issues, including suspension of redemptions; a lack of transparency; and loss of value when some of the REITs are rolled up. But she has recommended REITs that she considers of high quality, including those managed by Hines Real Estate Investment and Wells Real Estate Funds, to some of her more sophisticated high-net-worth clients.

Similar but Different

So, why would you want to go with public non-traded REITs when traded REITs do just fine? Part of the answer is that they are really two different asset classes, though they both invest in real estate. Investors shouldn't try to compare the two as similar products, says Mark Goldberg, a managing director at W. P. Carey & Co., which sponsors non-listed REITs.

One is a stock; one is a long-term hard-asset play, Goldberg argues. “They're two different animals,” he said. “The only thing that's similar is what they buy.”

The illiquidity of public non-listed REITs actually drives what makes them popular with many investors — that they are valued based on appraisals of their underlying properties, and can't be sold on an exchange for instant liquidity, Goldberg says. Because their returns are not correlated to publicly traded securities, they can be attractive for diversifying an investor's portfolio.

“I think in large part that's what's fueled the interest,” Goldberg says.

Another attraction of non-traded public REITs is the income factor — they can offer substantial dividends. W.P. Carey has sponsored 16 public non-listed REITs since 1979, including 12 that have gone full cycle, three that are operating, and one that is raising capital. The average annual return for the 12 that completed their cycle was more than 10.5 percent. According to Blue Vault, the median distribution yield for non-traded REITs that are currently open to investors is 6.7 percent.

Waiting for the Liquidity Event

Public non-listed REITs are managed with a liquidity event in mind, typically eight to 10 years after launching — either turning it into a public listing, merging it or selling the underlying assets. Publicly traded REITs could, in theory, hold their properties forever.

Unlike a publicly traded REIT, which can be analyzed like a stock, a non-traded public REIT should be evaluated based on how it executes its business strategy, or has in the past, Goldberg says. How does the sponsor manage the registration and fundraising stage; how is the property portfolio managed; and how is the endgame/liquidity event executed?

On a case by case basis, it's probably fair to criticize the decision-making by certain public non-listed REITs and the independent boards charged with overseeing them on behalf of the investors, Goldberg says.

One example of a criticism that incorrectly compares non-listed and listed REITs is about the higher fees charged by non-listeds, Goldberg says. While publicly traded REITs are typically self-advised and self-managed, non-traded public REITs generally are advised and managed externally, similar to a fee-for-service model.

For the costs of staffing in a REIT, for example, the expense would be netted out of operating profits in a publicly-traded REIT, and therefore somewhat hidden from the investor. With a non-listed REIT, those same staffing expenses would be paid for through fees, and may appear to the investor as an added cost that isn't required by a publicly traded REIT, Goldberg said.

According to the NAREIT, public non-traded REITs typically charge distribution fees of up to 10 percent of the investment for broker/dealer commissions and up-front costs. That doesn't include ongoing management fees, which are typical, and the back-end fees that may be charged.

As Carson says, “It's rare to want to give up liquidity, but there are times when it makes sense. But you have to do your due diligence.”

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