Non-traded REITs, cousins of publicly traded REITs, are a growing trend in the real estate investment industry

By Ryan Chittum

Following seven years of investment returns exceeding other sectors of the broad equity market, publicly traded equity REITs experienced appreciable share price declines in 2007. This was due to investors' lowered expectations with respect to real estate investment in light of deteriorating conditions in credit markets. Consequently, the FTSE NAREIT Equity REIT Index posted a total return of -15.69 percent for the year.

However, despite last year's disappointing share price performance for publicly traded REIT equities, public, non-traded REITs had a record year raising new capital. Through the end of September 2007, non-traded REITs had raised $9.3 billion and raised approximately $11.5 billion for the year as a whole, according to Robert A. Stanger & Co., a Shrewsbury, N.J.-based investment banking company that focuses on the non-traded REIT sector.

Because shares of publicly traded REITs trade daily in public markets, the prices of those shares quickly record changes to investor expectations as new information becomes available. This is in respect to developments in the overall economy as well as real estate and financial markets. However, the shares of non-traded REITs cannot be traded in public markets. Thus, changes to investor expectations and the effect those changes could have on the shares of non-traded REITs are not recorded in the market.

2007 Non-traded Income

The demographic tidal wave of the baby boom generation is swelling demand for stable, income-producing investments as they move away from growth-oriented stocks. With Treasury bonds trading just above 4 percent, the high-dividend yields that non-traded REITs offer—along with the chance of capital appreciation—look appealing.

However, the main factor driving the soaring investment in non-traded REITs last year was the largest wave of liquidations of existing non-traded REITs that the young industry had seen. More than 40 percent of the cash produced by these liquidations flowed back into non-traded REITs, according to industry executives.

In addition to recycling capital from these liquidations back into non-traded REITs, the returns produced by the liquidations further legitimized an industry that many investors view with skepticism. “One of the great things that happened in 2007 is the non-traded REIT business plan was further validated,” says Martel Day, executive vice president and director of business development for Inland Securities Corporation, part of the Oakbrook, Ill.,-based Inland Real Estate Group of Companies, Inc. that has sponsored four non-traded REITs, one of which is now publicly traded and another sold to a traded REIT. He says Inland recaptured approximately half of the money shareholders received from the Developers Diversified Realty (NYSE: DDR) deal for Inland Retail.

All in a Name

Non-traded REITs are public companies, but their shares aren't listed on any stock exchange. Non-traded REITs are required to report earnings and other events to the Securities and Exchange Commission (SEC), which regulates them like their traded brethren, even though they aren't liquid investments. Additionally, they don't escape Sarbanes-Oxley accounting regulations. The North American Securities Administrators Association (NASAA) adds an additional layer of state-level regulation not imposed on traded REITs.

Non-traded REITs raise money for two years before they start buying assets. After that, they can, and often do, register to raise more money. Assets are typically purchased quickly to get income flowing to investors, and non-traded REITs on average offer dividend yields on initial investments that are significantly higher than those available on average from publicly traded equity REITs. This is a premium necessary because of the illiquidity of the investments.

Non-traded REITs in the marketplace now offer initial dividend yields that are on average between 6.0 percent and 6.5 percent. “I think all other things being equal, this would have been a tremendous incentive to get into non-traded REITs,” says Keith Allaire, managing director at Stanger. While the gap separating them from publicly traded equity REITs widened in February 2007 when yields on traded REITs dropped to 3.25 percent, the yield spread narrowed again by the end of 2007 as the dividend yield for publicly traded REITs rose on average to 4.88.

Like private equity funds, non-traded REITs are created with a limited life in mind, usually seven to 10 years, at which point the REIT must list its shares, sell to another company or liquidate its portfolio of assets. All offer some type of redemption plan—often limited to 3 percent of all outstanding shares in a year—for shareholders who want to get out of the fund. The catch is that those who cash out early typically pay a stiff penalty that can approach 10 percent of their principal.

Hard Assets

While investors in publicly traded REITs can get in or out of their investments in a mouse click's time, non-traded REIT shareholders aren't assured that they'll be able to get out of their investments in months, or even years. Executives in the industry argue that the illiquidity is a positive, not a negative. “One of the advantages to the non-traded REIT format is that it behaves more like a hard asset on a daily basis,” Day says. “The market perception is not reflected immediately in the way non-traded REITs act and react.”

Non-traded REIT industry executives say the illiquidity is a good thing because of this hard-asset investment quality. According to this line of thinking, publicly traded REIT stocks are more correlated than non-traded REITs with the direction of the overall stock market, making them less effective that non-traded REITs for portfolio diversification into real estate.

“In part, the price of stock is based on the demand and supply of that stock. If people want to rotate out of REITs, they may sell everything and it may not reflect the true value of the assets in that company,” says Gordon F. DuGan, CEO of W.P. Carey & Co., a publicly traded real-estate company that sponsors three non-traded REITs.

Some argue the format can protect investors from their own worst instincts. “You're not marking to market all the time, so real estate can do what real estate does without people getting crazed because the stock drops,” says Judy Fryer, co-chair of the national REIT practice at Greenberg Traurig LLP, a New York-based law firm.

Truth in Numbers

Although it can't be said for the whole industry, Day says liquidity has never been a problem for Inland's non-traded REIT shareholders who needed to sell out.

Unlike the traded REIT space, aggregate data for the non-traded REIT industry is sparse. Few third-party sources of information are available, and there are no independent analysts, even though the companies must file with the Securities and Exchange Commission as traded REITs do.

Allaire says the industry raised a record $6.7 billion in 2006. Non-traded REITs surged past that mark when they raised $7.3 billion in new investments in the first half of 2007, up 185 percent from the $2.55 billion raised in the first half of 2006.

Defending Reputation

Non-traded REITs may have had a bad name with some in part because they evolved from the ashes of the real estate partnership industry in the late 1980s. “The partnership debacle was enough to make everybody step back, and some partnerships decided that the REIT format would be a better approach,” Fryer says. “The REIT name hadn't been besmirched. These partnerships lacked the independent management that REITs have. A majority of the board of a REIT has to be independent.”

Non-traded REITs differ from the old partnerships in another important way: size. “Today, the non-traded REIT industry has $3 billion to $5 billion deals,” Allaire says. “That means these REITs can buy the highest quality real estate and still get diversity.”

Non-traded REITs also come with front-end loads that can reach 15 percent of a shareholder's initial investment. That's largely because of the commissions, often 7 percent or more, where REITs pay brokers and financial planners to sell investors their shares. In an age where online competition has eviscerated trading fees, critics say these large commissions provide brokers incentives to push non-traded REITs on clients who may not fully understand their investment alternatives.

The Other Side of the Fence

Mike Kirby, chairman of Green Street Advisors, says non-traded REITs are simply inferior products to traded REITs. “They're sold, not bought,” he says. “Sold to unsophisticated retail investors, and I think the fact that an investor is using a commission-based financial planner is de facto proof that they're unsophisticated.”

Few institutions or top-tier investment banks have invested in non-traded REITs. The bigger brokerage firms like Merrill Lynch or Morgan Stanley don't sell them to clients. The industry relies largely on smaller brokerages and financial planners to sell their shares.

“The fact that commissions and front-end fees are high has lent an aura of something unsavory,” Fryer says. “However, front-end fees are coming down, and suddenly Wall Street and regional firms have taken an interest. They've been sniffing around and haven't figured out how they're going to play.”

Kirby says the industry's pitch that its illiquidity is a positive makes little sense. “One of the first things they teach you in business school is that liquidity is a good thing,” he says. Besides, the value of a non-traded REIT ebbs and flows just like a public REIT because that value is whatever the market says real estate is worth at any given time, he says. “They would like to pretend that's not the case.”

Indeed, most firms don't revalue their net-asset values every year, though more are beginning to do that, including Hines Real Estate Investment Trust, Inc. and W.P. Carey.

However, regardless of the “cons,” investors may see the “pros” as they are pouring billions of dollars into non-traded REITs, and the flows don't look to slow anytime soon. Additionally, many in the industry don't see themselves as competing with traded REITs for investment dollars.

“What we really share in common is much greater than what differentiates us,” Day says.

2007 Non-Traded REIT Deals
Date	Acquirer	Acquisition Target	Price
January 2007	Morgan Stanley	CNL Hospitality & Resorts Inc.	$3.22 billion, including debt
February 2007	Developers Diversified Realty Corp.	Inland Retail Real Estate Trust	$6.2 billion, including debt
May 2007	ING Clarion Partners LLC	Apple Hospitality Two Inc.	$809 million including debt
October 2007	Inland American Real Estate Trust Inc.	Apple Hospitality Five Inc.	$700 million including debt
Source: NAREIT Data