Non-Traded REITs Are Designed to be Sold, Not Bought

by REIT Wrecks on May 26, 2009

There is no real estate investment I would work more diligently to avoid than a non-traded REIT. They routinely pay dividends using money from new investors peter or paul? and one of them, Wells Timberland REIT, doesn’t even qualify as a REIT. So what gives? It’s pretty simple: your friendly neighborhood broker is paid handsomely to sell them, regardless of whether it’s in your best interest to buy them.

Almost $9 billion in non-traded REIT equity was raised in 2008, a record that was easily eclipsed in 2009 after 11 non-traded REITs registered to raise a combined $19 billion. Officially, these non-traded REITs are gearing up to capitalize on opportunities arising from the recession and the distressed property market. Unofficially, it’s a commission and fee bonanza for everyone involved, and hapless retail investors are paying the freight.

Indeed, it would be easier and cheaper to hire Johnny Cochran to bail you out of a murder charge than to somehow come out ahead on a non-traded REIT investment. You would also be leaving much less to chance. In addition to the upfront commissions of 7 percent paid to your broker and a dealer/manager fee of up to 3 percent paid to the sponsor, there are individual property/asset acquisition fees of up to 2.75 percent, property financing fees of up to 1 percent, disposition fees of up to 1 percent, and asset management fees of up to 1 per annum, plus expense reimbursements. The net result is that out of a $10,000 initial investment, only about $8,000 would remain to buy property.

Obviously, these fees encourage only two things: sales of non-traded REIT shares and purchases of property – any property – at almost any price. David Swensen, Yale Endowment’s chief investment officer, singles out the Wells REITs in his book, “Unconventional Success” (pages 70-75). Swensen obviously knows his way around alternative investments, and his opinion of Wells is unambiguous:

“No rational buyer can compete with the Wells acquisition machine’s willingness to overpay for product. As a consequence, investors suffer the double indignity of high fees and poor investment prospects.”

How then, are investors convinced to suspend common sense and buy these commission-laden pigs? In theory, non-traded REITs offer price stability and a reliable source of income, and those are the major selling points. But a quick glance glance at almost any prospectus reveals these key “features and benefits” to be nothing more than highly profitable gimmicks.

Officially, the share price is almost always set at something remarkably close to $10 by the REIT sponsor, and almost as remarkably, it never ever changes no matter what. This is true of almost all non-traded REITs, regardless of the quality of their assets, their location, leverage, current market conditions or how long the REIT has been in operation. This lack of transparency is somehow supposed to provide investors with comfort.

Realistically though, how could a brand new REIT with no assets and unproven management be worth the same $10 a share as a 5 year old REIT with $3 billion in diverse assets spread across the country, and the same as a 10 year old REIT with just $200 million in assets concentrated in one small market? It’s a $10 coincidence that is just as impossible as it is unbelievable.

In fact, the latter example is Whitestone REIT, a non-traded REIT that was the product of one real estate entrepreneur’s efforts to consolidate his real estate holdings in Houston. The result was a bitter dispute with Whitestone management that lasted almost a decade. Could this REIT still be worth $10 a share to the investors whose dividends were cut and whose shares can no be longer redeemed? It’s improbable, and recent Whitestone insider transactions value it at $5.15 a share, about half the “official” price paid by outside investors.

If egregious fees and lack of transparency weren’t enough to perfect this foul smelling stew, why not add conflicts of interest and fraud? For an example of the former, look no further than Inland American REIT, and Inland Western REIT, two non-traded REITs managed by the Inland Group in Chicago. Inland Western needs to repay $1 billion in debt this year, which may be an impossible feat. In fact, as we type, Inland Western is rather desperately trying to raise cash to avoid bankruptcy (see What Are Inland Western Shares Really Worth?).

But that’s no matter, especially since Inland Western can easily raise cash by selling its kryptonite to affiliates. Inland Western did just that earlier this year, pocketing $99 million in cash by selling two properties to Inland American. This was done at a time when commercial real estate sales volumes reached all time lows. Whether any of this was truly arms length and representative of fair market value is difficult to tell, but it seems unlikely.

Fraud and misrepresentation complete this cancerous portrait. This particular example is brought to you courtesy of the SEC which recently settled a non-traded REIT kickback scheme with W.P. Carey. According to the settlement, W.P. Carey paid nearly $10 million in undisclosed compensation – using the assets of the REIT – to a broker-dealer that sold shares of W.P. Carey’s non-traded REITs to the public. Carey executives then used fake invoices and misrepresented the payments in securities filings to keep it all secret. The arrangement benefited not only the broker-dealer, but also W.P. Carey, because the broker-dealer’s sales of REIT shares increased the management fees paid to W.P. Carey. In the settlement, W.P. Carey and 2 senior executives agreed to pay $30.3 million in disgorgement, interest and penalties.

In terms of the other key selling point, reliable income, non-traded REITs are not so reliable. Many, like Cornerstone Core Properties REIT, are busy funding their dividends from borrowings and returns of capital. Grubb & Ellis Healthcare REIT is a great (but not isolated) example of the lengths to which non-traded REITs will go to maintain their dividends. For example, for the three months ended March 31, 2009, Grubb & Ellis paid distributions of $14,247,000, as compared to cash flow from operations of $5,895,000. In many cases, distributions paid in excess of cash flow ponzi scheme are paid using proceeds from new investors. Slowly but surely, these fictitious dividends are starting to be cut.

OK, so you made a mistake, and now you want out. Good luck brother – you’re stuck. As of the end of May, the six largest non-traded REITs have shut down their share repurchase programs. These include Behringer Harvard REIT I, Cole Credit Property Trust II, Inland American Real Estate Trust, Inland Western Retail Real Estate Trust, Piedmont Office REIT and Wells Real Estate Investment Trust II.

Other nonlisted REITs that have either stopped repurchasing shares or that have been unable to repurchase all the shares submitted include Behringer Harvard Opportunity REIT I, Desert Capital REIT, Dividend Capital Total Realty Trust, Grubb & Ellis Apartment REIT, KBS Real Estate Investment Trust and Whitestone REIT. It may be years, if ever, before investors experience a so-called “liquidity event” with these REITs (see Piedmont Office REIT Finally Goes Public…Sort Of ).

There seems to be no boundary around the financial sleight of hand deceit employed by some non-traded REIT sponsors. For example, Lightstone Value Plus REIT claims to be on investors’ sides by allegedly allocating 100 percent of investor proceeds toward real estate investments and co-investing alongside shareholders. This is quite far from the real economic truth, and even a cursory read of the Lightstone “Value Plus” prospectus shows otherwise (read more on Lightstone’s investment prowess midway through this post, or click here for an update on Lightstone Value Plus I REIT’s financial condition, which is not so great). There’s really nothing not to like about these non-traded REIT scams, except everything.

Non-Traded REITs
Update: This post received almost 30 comments before I had to migrate the entire site to a new platform. Not all of the comments ported over during the move, so I republished all 30 or so under my name in one “bulk” comment below. Even more comments have followed. If you have additional questions or comments,you can post them here or on the Non-Traded REIT Forum. The forum is searchable, you can upload documents and images (charts, graphs) and publish links. Cheers RW

Click here for a list of non-traded REITs


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