Investors have been spooked by global economic weaknesses, to put it mildly. Those economic concerns, coupled with the U.S. credit downgrade, have driven many investors to look to non-traditional investment vehicles, including non-traded real estate investment trusts. In fact, non-traded REITs raised roughly $2.2 billion during the first quarter of 2011, a whopping 22 percent increase over the $1.8 billion raised in the first quarter of 2010.
Before investors and their advisors sink their green into non-traded REITs, they should have a clear understanding of the distribution yields that these vehicles offer and the various factors that can affect a non-traded REIT's ability to pay out its distributions.
“You need to make sure you understand the source of the dividend, as well as where the REIT is in its lifecycle,” says Keith Allaire, a managing director with Robert A. Stanger & Co., a Shrewsbury, N.J.-based investment banking firm that focuses on real estate. “Investors and their advisors shouldn't be afraid to ask management how it plans to cover the distribution once the REIT has fully invested its cash.”
Juicy Distribution Yields — Sometimes
The non-traded REIT world continues to grow, according to Blue Vault Partners, an Atlanta-based research firm that focuses on non-traded REITs. Today, there are 63 non-traded REITs in existence. Of that total, 44 are currently fund raising (known as “effective”) and 19 are closed to new investments. As of March 31, non-traded REITs had $73.5 billion in assets under management, an increase of 14 percent from a year earlier.
The annualized distribution yields for effective non-traded REITs range from 5 percent to 8 percent, while the distribution yield for closed non-traded REITs range from 1 percent to 8 percent. Distribution yields are calculated using the distribution amount per share, as declared by the board of directors, and dividing the annualized amount by the current share price.
According to figures from Blue Vault Partners, the median distribution yield for effective non-traded REITs was 6.5 percent at the end of the first quarter. For closed non-traded REITs, the median distribution yield was 6.25 percent.
Figuring out how non-traded REITs pay their distributions is not difficult, although it does require a fair amount of homework and more than just basic knowledge of REITs. Allaire says that all non-traded REITs explain the source of the capital for their distributions. “The regulators have been very scrupulous about requiring disclosures about distributions and where they are coming from,” he says.
FFO vs. Earnings
In an ideal situation, non-traded REITs are able to pay their dividends solely with funds they generate from operations, also known as FFO. Instead of reporting earnings like other companies, REITs report FFO, which usually comes from rental payments. For example, a non-traded REIT that owns shopping centers would generate FFO from its tenant base and the amount of rent collected from those tenants.
REITs report FFO instead of earnings because their assets — properties — have high depreciation expenses. Unlike a piece of equipment, for example, property doesn't fall in value to zero. So real estate depreciation charges, which are required accounting, are somewhat unfair given that real estate assets have historically appreciated and been sold for a profit. FFO adds back the depreciation expenses and makes other adjustments as well.
It's important to note, however, that FFO is a non-GAAP financial measure of REIT performance and not every REIT calculates FFO the same way, so it's often difficult to compare apples to apples.
Sources of Distributions
When evaluating a non-traded REIT's distribution, a handy metric is the payout ratio. This metric, which calculates the cash distributions paid as a percentage of the REIT's FFO, helps to determine the source of the REIT's distributions.
For example, if the payout ratio is over 100 percent, this typically indicates that the REIT is using money from sources other than FFO to pay distributions. The non-traded REIT's lifecycle plays a big part in its distributions, experts note.
“One of the challenges for sponsors with new non-traded REITs is that they're setting a dividend in advance without knowing how many properties they're going to buy and what kind of return they'll offer,” says David Steinwedell, of Blue Vault Partners. “It's not surprising that newer REITs don't cover the distribution although most will overcome that deficit and cover it once they invested their cash. The real warning bell is when they're not covering dividend after they've invested their cash.”
In the non-traded REIT world, it is common for organizations that have been fund raising for less than two years to have payout ratios that are higher than 100 percent since the main objective during this initial fund-raising period is to acquire properties as new capital is raised. Once the REIT has closed to new investments and the rental income becomes more stabilized, the payout ratio tends to decline toward a ratio of 100 percent or less.
That means investors are taking a bigger risk with their distributions when they invest in newly-established non-traded REITs — those that have not made any acquisitions to create a portfolio of properties. Savvy investors note that non-traded REIT sales typically ramp up near the end of their fundraising periods.
Distribution Vulnerabilities
Non-traded REIT distributions also are dependent on the overall economy, along with the availability of debt. When the economy plummeted into the Great Recession in 2008 and the credit markets froze, REITs, both traded and non-traded, were severely impacted. Most if not all REITs cut dividends. In fact, some of them were forced to suspend dividends in order to survive the credit crisis.
As the capital markets thawed, traded REITs were able to issue both debt and equity to improve their leverage and balance sheets. By and large, most traded REITs have re-established their dividends.
Non-traded REITs, on the other hand, have not recovered to the same level as their traded brethren. Experts point to their inability to access the capital markets as the primary reason why they still lag on their distributions.
For example, KBS Real Estate Investment Trust III and KBS Strategic Opportunity REIT didn't declare distributions for the first quarter of 2011, according to Blue Vault Partners. (A KBS spokesman said the company did not tell investors when it launched REIT III in January 2011 that it would make distributions in the first quarter, although KBS made distributions after the first quarter. KBS Strategic Opportunity REIT aims for capital appreciation and does not promote itself as an income-producing investment, the spokesman said.)
In addition to the overall economy, the type of property a REIT owns or acquires, when it acquired those assets and how much it paid for them affects its ability to pay distributions, of course. “Non-traded REITs that bought properties at the height of the market are having a harder time covering their distributions than those that bought in 2009 and 2010 after real estate values fell,” Allaire explains, adding that there are some non-traded REITs that have had to give back their properties to lenders because both property values and rental rates had fallen dramatically.
CNL Macquarie Global Growth Trust, Resource Real Estate Opportunity REIT, and Wells Timberland REIT declared equity distributions in the first quarter of 2011. An earlier version of this story said the three REITs did not declare distributions for the quarter.
The current version of this story also includes reaction from KBS.