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Getting Real About Real Estate

Hard to believe, but true: Real estate wasn't always the hot dot. Just five years ago, the average real estate investment trust (REIT) traded at a big discount to the value of its assets by about 25 percent, on average, according to Charlottesville, Va.-based research firm SNL Financial. Of course, during the past five years, REITs and REIT mutual funds outperformed most other asset classes during

Hard to believe, but true: Real estate wasn't always the hot dot. Just five years ago, the average real estate investment trust (REIT) traded at a big discount to the value of its assets — by about 25 percent, on average, according to Charlottesville, Va.-based research firm SNL Financial. Of course, during the past five years, REITs and REIT mutual funds outperformed most other asset classes during that time. These days the words “real estate” provoke a Pavlovian buy response in investors.

Which is why even your most disinterested client understands the beauty of having real estate exposure in his portfolio. But remember: REITs have trebled in value since 1999 (compared to the negligible returns in the S&P 500) and may be looking somewhat vulnerable to a devaluation, especially if long-term interest rates rise, according to a recent real estate report by Morgan Stanley, which runs one of the best-performing REIT funds in the U.S. Savvy retail advisors are moving their clients beyond listed REITs and into nontraditional real estate investments like “private” REITs and tenant-in-common programs (TICs), which, because they don't trade, aren't volatile and offer attractive yields, averaging 7 percent to 8 percent.

There is good reason for increased interest in these somewhat esoteric products: REITs are now included in the S&P 500 index and are popular among hedge funds, which has contributed to their increased volatility to almost twice that of the S&P 500, the report goes on to say. Further, REIT stocks' correlation to the S&P and to interest rates has increased. While there isn't much downside (save for rising interest rates), one might begin to look in less-efficient corners for opportunities.

Exploring Alternatives

Unlisted REITs, often referred to as private REITs, are not listed on any stock exchange but are regulated by the SEC and NASD as registered securities. The most recognized nontraded REIT is Atlanta-based Wells Real Estate Funds, which has tapped a network of financial advisors to sell shares in its REIT funds. Others private REITs with selling agreements at brokerage houses include Inland Real Estate Group, W.P. Carey & Co., CNL Group, Dividend Capital and Apple Hospitality.

TICs are investment vehicles that permit up to 35 investors to jointly own commercial, residential real estate or land. The main attraction of TICs is that they qualify for 1031 exchanges, referring to section 1031 of the Internal Revenue Code that allows investors to defer capital gains taxes on a property sale if they reinvest the proceeds in a 1031 approved property. Not surprisingly, sponsors of REITs and TICs are actively recruiting financial advisors to sell these products to individual investors. Unlisted REITs, for example, offer reps commissions of 6 percent to 8 percent or more. But the broker/dealers who do offer TICs tend to be small boutique firms, notes Peter Kalmus, an advisor with OMNI Brokerage in Jersey City, N.J. One factor that keeps TICs off wirehouse platforms is size: The deals are too small for the majors to do due diligence efficiently.

David Hays, president and lead consultant of Bloomington, Ind.-based Comprehensive Financial Consultants, a registered investment advisory firm with long experience in alternative real estate investments, warns these are a lot more complex than REIT funds. “Most people who are suggesting real estate to their clients don't understand it like they do stocks or bonds,” he says. “They're making recommendations on just a bit of information.”

Nontraded REITs and TICs are indeed attractive for investors who desire a steady dividend check, but they also have to be willing to tie up their money for at least seven years. Aaron Cook, managing director of private offerings for Triple Net Properties, one of the most active sponsors of private REITs and TICs, cautions: “These options are not going to be suitable for everyone. But if you're not exploring these opportunities, you're doing a disservice to your clients.”

The Beauty of Illiquidity

Like many small businesses, the private REITs sector is growing rapidly. In 2005, nonlisted REITs raised about $6 billion of investor capital, according to Robert Stanger & Co., a Shrewsbury, N.J.-based investment research and real estate investment banking firm. And 12 more nonlisted REITs are raising money right now. Yes, nonlisted REIT portfolios can be similar to publicly-traded REITs in terms of quality, size and tenant base, and private and public REITs often compete for the same institutional properties in major markets. Wells, for example, is one of the largest owners of Class A office properties, including such trophies as Chicago's AON tower. Inland has become one of the largest owners of institutional-quality retail space and has a presence in nearly every state.

Nonlisted REITs have earned a slightly shady reputation for sales practices that include massive loads of 10 percent to 15 percent. Half, or more, of that is broker commissions, creating conflict-of-interest concerns. In 2003, the NASD fined Wells for giving reps noncash gifts in excess of $100, and W.P. Carey is under investigation by the SEC over b/d payments.

Indeed, none of the major wirehouses has thus far signed a selling agreement with unlisted-REIT sponsors. But that may change this year, predicts Triple Net Properties' Cook. Most of the private REIT sponsors have been working to persuade firms like Merrill Lynch and Morgan Stanley to approve their investments. To date, some larger firms, such as American Express and Raymond James among them, have approved CNL Financial and W.P. Carey. But most private REIT transactions are completed by independent registered reps or RIAs, such as Hays' Comprehensive Financial Consultants.

Some sponsors are trying a more investor-friendly approach. Last October, New York-based Lightstone Group launched the Lightstone Value Plus Real Estate Investment Trust, a nontraded REIT that has no front-end loads. According to Lightstone's sales material, all legal, sales and offering costs will be paid by the proposed REIT, which hopes to raise $300 million. Lightstone's literature describes the fund as appropriate for fee-based financial advisors. So far, only independent and regional firms have agreed to market Lightstone.

Nontraded REITs have also come under fire for lack of transparency and liquidity. Since there's no secondary market for private REIT shares, investors are typically locked in until the sponsor sells out, pays off investors or lists the shares on a public exchange. The sponsors usually specify a date on which such a liquidity event will occur, but those deadlines are not binding.

That said, some of these criticisms are overstated, says Rick Imperiale, portfolio manager of Forward Uniplan Real Estate Investment Funds and author of Real Estate Investment Trusts: New Strategies for Portfolio Management. He points out that listed and nonlisted REITs are subject to the same regulations and requirements when it comes to disclosure; nonlisted REITs must register and make timely filings with the SEC and must provide investors with a prospectus and details about supplemental offerings.

Hays, who has put $40 million into nontraded REITs for his clients, says liquidity is only a problem if you don't market the product appropriately. “Liquidity is not a product issue, but a portfolio issue,” he says. “Investors just need to be aware that they are looking at a longer hold horizon of five to seven years. My position is that a nontraded REIT is similar to a bond investment because of its lack of liquidity.”

And, Imperiale says, REIT sponsors are getting better about spelling out how and when investors can sell. “This is clearly a change from older programs that had very vague exit plans,” he notes.

Inland Real Estate, for example, was launched as a nontraded REIT in 1996. It listed its shares on the NYSE last year, so investors who bought into the REIT at $10 per share and received cash flow in the 6 percent-to-7 percent range for nearly 10 years, then held publicly traded shares priced at $13. In January the shares were trading at $15 per share — a 50 percent premium to the price investors originally paid.

How do you determine performance? The investment's internal rate of return (IRR) is a combination of dividend growth plus any upside achieved from liquidating the portfolio. Dividend growth can be measured by adding the dividend rate minus the core inflation rate, while any additional upside can be calculated from the per-share liquidation price for the underlying assets. Using that formula, Imperiale says, the IRR for nontraded REITs today averages from 9 percent to 11 percent.

Dissecting TICs

If private REITs strike you as exotic, the TIC will seem alternative indeed — but not for much longer. Thanks to the real estate boom, wealthy individuals are looking for strategies that will let them realize gains, keep a chunk of their portfolio in real estate and defer taxes. TICs can do that.

“TICs were something that reps used to bring to the investors, but we're finding that some investors are coming to their reps knowing that they have these huge capital gains time bombs,” says Craig Cooper, Southwest regional director of DBSI Securities, a sponsor of both private REITs and TICs.

Even though capital gains rates are at historic lows, for many investors effective rates are often higher — up to 32 percent in states with high income tax rates, says Alexander Szilvas, partner in the Cleveland office of law firm Baker & Hostetler. “People look at that tax rate and decide to reinvest,” Szilvas says.

“Part of choosing to invest in a TIC is defensive,” adds Todd Pajonas, president of New York-based Security 1031 Services. “It's not how much am I going to make, but how much am I going to save.”

Although the 1031 market in the U.S. has reached $80 billion, only 300 to 400 registered reps have actually done a TIC deal, estimates Greg Paul, president of Salt Lake City-based OMNI Brokerage. And, he says that 80 percent of those were done by 60 reps.

TICs are relatively new. They only became possible in 2002, when the IRS ruled that the interest in a 1031 exchange property (and the tax deferral) could be split. The industry quickly mushroomed from nine sponsors and about $300 million in equity raised in the first year to 70 sponsors and $3.2 billion in 2005, Paul says.

Typically, TIC programs require a minimum investment of $250,000, although some may go as high as $1 million. “This is the only form of group investment where you can own the real estate through the deed and have a say in it, but it's still passive because someone else is managing it,” Paul explains. That, he says, appeals to aging baby boomers, who are selling out of high-maintenance investments like multitenant office buildings.

Clients will be attracted by their high yields. In 2005, the average first-year cash yield for a TIC deal was 7 percent. Yields differ according to industry subsector. For example, there were 21 TIC office deals available in mid-January with an average first-year yield of 6.35 percent; 11 TIC multifamily deals with a yield of 6.01 percent; five TIC industrial/warehouse deals with a yield of 7.09 percent; and three TIC retail deals with a yield of 6.75 percent, according to data compiled by Omni Brokerage. The firm also tracks another TIC category that includes self-storage, hospitality, oil and gas, assisted-living and health care assets, which offers a yield of 8.15 percent or higher.

TIC investments are governed by an operating agreement, which has provisions for refinancing, selling and management. Any decisions related to the investment must be approved unanimously by every single investor. That may not help with liquidity, but it gives investors the upper hand. “People think they give up total control and that the sponsor controls the investment, but the owners have the right to elect new management and they can all agree to sell or refinance,” says Brad Watt, executive vice president of Cole 1031 Exchange Advisors, one of the most active sponsors of 1031 exchange properties. Over the past four years, the Phoenix-based TIC sponsor has raised roughly $400 million.

William Obeid, CEO of New York-based Gemini Real Estate Advisors, acknowledges that transparency can be an issue with TICs. “Some sponsors do a better job than others,” he says, adding that there is an industrywide effort to standardize financial reporting for TICs.

“When it comes to investing in real estate, the mindset of registered reps and investors has to change,” Paul says. “In general, all investors should have some real estate in their portfolios — not just listed REITs or funds. There are alternatives that are just as good.”


In 2005, REIT stocks had an average return of 8.29 percent — the sixth year in a row that REITs outperformed the S&P 500, which improved by 4.91 percent‥

Year S&P Returns REIT Composite
2001 -11.89% 15.50%
2002 -22.10 5.22
2003 28.68 38.47
2004 10.88 30.41
2005 4.91 8.29
Source: National Association of Real Estate Investment Trusts

The Bigger Deals

The top private REITs in 2005 in terms of capital raised.

Untraded REIT Price Per Share Minimum Investment Reallowed Commission to Rep Current Dividend
Apple REIT Six, Inc. $11.00 $5,000 ($2,000 Qual. Plan) 7.5% 8.0%
Behringer Harvard Opportunity REIT I $10.00 $2,000 7.0 NA
Behringer Harvard REIT I, Inc. 10.00 2,000 7.0 7.0
CNL Income Properties, Inc. 10.00 5,000 ($1,000 Qual. Plan) 6.5 5.5
CNL Retirement Properties, Inc. 10.00 5,000 6.5 7.1
Dividend Capital Trust 10.50 2,000 6.0 6.1
Hines Real Estate Investment Trust 10.00 2,500 6.0 6.0
Inland American Real Estate Trust, Inc. 10.00 3,000 ($1,000 Qual. Plan) 7.0 NA
Wells Real Estate Investment Trust II, Inc. 10.00 1,000 7.0 6.0
Source: Robert A. Stanger & Co.
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