Is a slowing of interest just a pause, or something more?

    With an uncertain outlook for stocks and bonds, an alternative investment that promises to deliver dependable, attractive returns from real estate investments without the uncertainty of stock market noise is enjoying a steady flow of capital from financial advisors. But it also faces strong headwinds, including intense competition for properties, rising interest rates on the fixed-income investments it competes with and criticism for high fees.
    Unlisted real estate investment trusts, also called non-publicly traded REITs, have some characteristics similar to the more familiar publicly traded REITs. Like their better-known cousins, they invest in office buildings, hotels, restaurants and other types of properties, and they generate fat dividend yields. Unlike publicly traded REITs, they do not trade on a stock exchange. Instead, the sponsor sets the value and terms of their redemption.
    Redemptions are often allowed quarterly and terms vary among sponsors. Wells REIT II, a large nonpublic REIT, allows redemptions within two years of death or qualifying disability at $10 per share or the original price paid, whichever is lower. For ordinary redemptions, investors may apply to redeem their shares at $9.10 per share after one year, a price that is fixed for at least three years after the offering. After that, the redemption price "will equal 95% of the share value as estimated by the Advisor or another valuation firm," according to the firm's fact sheet.
    Larry Goff, executive vice-president of CNL Securities Corp. and a board member of the Investment Program Association, an industry trade group, cautions that "these are long-term investments and redemptions should be considered only as an emergency exit strategy." The liquidity event that ends the life of a nonpublic REIT may be a public offering, a merger or a liquidation of properties. Sponsors aim to have those events occur within ten years of the offering, although it may take more or less time than that.
    Don't expect a big IPO pop here, says Goff.  "A REIT will usually go public at par, or maybe a little higher," he explains. "The bulk of returns over the life of a nonpublic REIT come from dividends." Yields for nonpublic REITs are in the 6% to 7% range now, compared with about 5% for publicly traded REITs. In both cases, some of that income is subject to favorable tax treatment.
    While some might consider the illiquid nature of nonpublic REITs a negative feature, sponsors cite it as a selling point for investors who want exposure to real estate without the fluctuation inherent in the stock market. Although the value of the properties in the portfolio will rise and fall over the life of the trust, investors, for better or worse, don't see the swings on a daily basis in the newspaper.
    "Liquidity brings volatility," says Goff. "Aging baby boomers are becoming increasingly concerned about volatility, and they don't want to see their real estate stocks drop 30% in a down year."
    The same holds true for the seniors who make up the bulk of the 40 or so clients who invest in nonpublic REITs at Mitchell Walk's firm, Asset Management Partners in Orlando. Most of them are high-net-worth individuals, with a net worth of $1 million or more, who are looking to supplement their income from bonds, says Walk, who views the investment as a fixed-income alternative rather than a real estate play. "In the three years I've been using nonpublic REITs, the dividends have been dependable and within one-half of a percent of the original yield," he says.  He allocates no more than 10% of the bond portion of a portfolio to the investments, and believes they offer a worthwhile alternative to bonds for elderly individuals who may not be prepared to weather the impact of sharply rising interest rates.
    Unlike some of Walk's clients, many investors don't use dividends for current income. About 70% to 75% of investors in the two nonpublic REITs offered by Wells Real Estate Funds choose to reinvest dividends, according to founder and president Leo Wells. He adds that the average investment in his firm's two nonpublic REITs is around $25,000, although the minimum initial investment is just $1,000. "These people see this as a good long-term investment and as a place to park their money that has a good dividend yield," he says. "They don't necessarily need the income to pay living expenses."
    Different private REITs pursue disparate strategies. While Wells focuses largely on the corporate office market, some like Phoenix-based Cole Companies concentrates primarily on the retail area"We buy single-tenant freestanding outlets where the space has already been built and we can lock in long-term leases," says Derek Peterson, a Cole executive.
    Cole's tenants include major retailers like Walgreens, Home Depot and Lowe's, which typically commit to sites for several decades. The firm is  also selective about the properties it purchases. "Right now, we're avoiding properties in California and Arizona where people are overpaying," Peterson says.

Challenges Ahead
    Although private REITs have been around for more than a decade, they didn't really take off until about three years ago, when investments with returns that were not correlated to equities started to appeal to advisors and investors. Sales of nonpublic REITs rose from $900 million in 2000 to a peak of $7 billion in 2003, but have drifted downward since then. Sales totaled $6.3 billion in 2004, and are expected to trend only modestly higher in 2005.
    "I expect to see some sales growth this year, but a lot depends on what happens with interest rates," says Keith Allaire of Robert A. Stanger & Co., which tracks the nonpublic REIT market. Between 2000 and 2003, the years of strongest sales growth, interest rates were scraping bottom and investors viewed REIT yields as attractive by comparison. But with interest rates on the rise, "people may view other fixed-income investments as more viable options." Recently, plain vanilla ten-year Treasury bonds had a yield of 4.5%, while a AAA-rated municipal bond of the same maturity had a taxable equivalent yield of 5.8%, assuming a 39.6% federal tax rate.
    Goff says rising rates are less of a concern for private REITs than public ones because the former pay higher dividends to compensate for their reduced liquidity. While the spreads may narrow as rates rise, he notes, the dividends paid by unlisted REITs will still be higher than competing money market instruments.
    Goff attributes the recent flattening of sales to the lag between the time that sponsors close down old offerings and start up new ones. He says the entrance of new sponsors into the business in recent years "will create more options for investors and more competition overall. It will make business more efficient and will challenge sponsors more on the performance side."
    Although nonpublic REITs have been heavily criticized for their high program fees, Goff says increased competition has helped lower them. Fees have fallen from 15% to 16% four years ago to somewhere in the 10% range, he says, and the increased volume of investments in nontraded REITs has enabled sponsors to reduce both sponsorship fees and brokerage commissions. "The fee structure for an industry dealing with $1 billion is necessarily very different from the structure possible in the $7 billion industry direct investments have become. The industry is getting more efficient and investors are benefiting from that change," he insists. 
    Even if the controversy over fees dies down, a crowded net-lease market poses a hurdle to REITS, both public and private. REITs make money from lease income as well as property appreciation. Under a triple-net lease, the most sought-after arrangement for investors, the tenant is responsible for maintaining, insuring and paying real estate taxes on the property. Most net-lease deals are structured with long terms.
    With too much money chasing fewer quality real estate projects and high-quality tenants, the competition for good investments has driven up the bidding war for net-lease properties. And higher property prices have meant lower rates of return for investors. "Five years ago, a good deal offered a 10% annual return," says Leo Wells. "Now, a 6% return is considered good. But it's a dependable return that you know you can get over a long period of time. And the definition of 'good' depends on what's available from other investment alternatives."
    Goff says that while some areas of the real estate market are approaching the "overbought" condition, that is not true across the spectrum. He puts office buildings generally in the "overbought" category, but thinks it is still possible to find opportunities in the hotel, retail and residential sectors, depending on where the projects are located. However, he concedes that even in those sectors,  finding solid investments remains a "huge challenge" for the industry.
    There is evidence that some firms have had trouble finding enough quality properties to keep pace with money coming into their offerings. At least one private REIT suspended fund-raising late last year "in order to bring into balance the rate of fund-raising and the rate of investment," according to the sponsor's Web site.
    In the future, the ability of the nonpublic REIT industry to grow will depend not only on the continuing appeal of real estate as an investment, but on a proven track record of providing a steady, attractive level of income to retirees or those nearing retirement. "Think about how the boomers have managed their lives," says Goff. "They didn't ask how much the Mercedes would cost. They asked how much it would cost them each month to lease the Mercedes they couldn't afford to buy. Baby boomers have lived their entire lives based on income streams. And they will retire on income streams, too."

Some Unlisted REIT Sponsors
Behringer Harvard (
Boston Capital (
CNL Financial Group (
Cole Companies (
Dividend Capital (
Hines Real Estate (
Inland Real Estate Corporation
W.P. Carey & Co. (
Wells Real Estate Funds (