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 (behringerharvard.com)
Boston Capital (bostoncapital.com)
CNL Financial Group (cnlonline.com)
Cole Companies (colecapital.com)
Dividend Capital (dividendcapital.com)
Hines Real Estate (hines.com)
Inland Real Estate Corporation
(inlandgroup.com)
W.P. Carey & Co. (wpcarey.com)
Wells Real Estate Funds (wellsref.com)