In the first quarter of 2010, equity REITs returned 10.02%, a figure that dwarfed the relatively miniscule 5.39% gain for the S&P 500 index during that period, according to the National Association of Real Estate Investment Trusts.

Such numbers might delight real estate investors, but at the same time they're giving pause to the industry's watchdogs, those who think that the excitement over REITs may attract unsophisticated investors into troublesome securities in which they have little protection and might be ripe for abuses.

Denise Voigt Crawford, president of the North American Securities Administrators Association, is one of those people who worry about the explosion of real estate investment trusts (REITs) in the depressed real estate market, though it's the private placement REITs that worry her the most.

"I'm less concerned about the registered offerings because they have gone through a process whereby the regulators have actually looked at them," says Crawford, who doubles as the Texas securities commissioner.

Take one case involving Naples, Fla., law firm Vernon Healy, which recently filed a FINRA arbitration claim charging that a stockbroker with CapWest Securities Inc. of Lakewood, Colo., negligently urged a retired couple to plunge more than $1 million of their nest egg into income-producing "alternative investments." Those investments, according to the law firm, included non-traded (or private) REITs. Since then, those REITs have largely suspended distributions and forbidden redemptions, depriving the couple access to their retirement savings, according to attorney Chris Vernon.

CapWest denies that its broker acted recklessly, as the lawyers contend. "The self-released press release of the attorney is ... pumped up and inaccurate," says Edward Price, a vice president with CapWest Securities. "It will be addressed in arbitration based on the facts."

REITs may own or invest in real estate, real estate-related loans or both. Though all REITs must meet a set of IRS conditions to qualify as REITs, they fall into three broad regulatory categories. One of these is a "public listed" REIT, which is registered, generally with the SEC, and publicly traded. The second is a "public unlisted" REIT, which is registered, but not listed or traded on an exchange. The third is a private placement REIT that is neither registered nor traded on an exchange. Private placement REITs often file an SEC "Reg D" form that exempts them from most disclosure documents, and thus their marketing is largely limited to wealthy or "accredited" investors.

Crawford is concerned about private placement non-traded REITs because regulators don't scrutinize them that closely. Some private non-traded REITs may be in an advantageous position at present if they have lots of cash because they can buy properties at attractive prices, but it's unlikely investors are capable of conducting the necessary research to find out.

The market doesn't have a ton of information to base decisions on. "There are many more private REITs than there are publicly traded or non-traded REITs," says Michael Grupe, NAREIT's executive vice president. "But they're private. There's no filing requirement-no disclosure documents." The last records on them Grupe says he can recall were pulled from the IRS in 2007, and showed something like 1,200 private REITs.
One concern is that non-traded REITs-both public and private, which many lump together-may be finding their way into the portfolios of those retirees desperately seeking higher dividends. Such investors may be unaware that non-traded REIT prices might not accurately reflect the price fluctuations in the underlying portfolios. Nor may investors realize that these securities can be illiquid.

The prices of non-traded REITs are set by the REIT sponsor rather than a national exchange. The funds typically run about ten years, after which investors generally cash out in one of three ways: The fund can go public, it can be sold or the underlying investments can be liquidated. Redemptions may otherwise be limited until then. And non-traded REITs lack the daily market-set prices of REITs that trade publicly.

Registered non-traded REITs have grown from eight sponsors and nine products in 2000 to 42 sponsors and 54 products in 2010, says Keith Allaire, a managing director at Robert A. Stanger & Co. in Shrewsbury, N.J. Fundraising went from $583 million in 2000 to $7 billion in 2003. In 2009 alone, $6.1 billion was raised.

The latest figures, according to Allaire, show that nine SEC-registered non-traded REIT deals liquidated in 2007-near the peak of the real estate market. They provided internal rates of return averaging about 13.5% to investors.

The later, more depressed real estate market, however, paints a less clear and possibly less rosy picture of the performance of unlisted REITs.
The only example since, experts say, is Piedmont Office Realty Trust (PDM) in Atlanta, an owner of Class A properties. That company went public on the New York Stock Exchange. On February 15, it issued 7.5% of its year-end outstanding shares as common stock.

The offering came after its board suspended its share redemption plan on November 24, 2009, and then afterward recapitalized its common stock, in what was, in effect, a one-for-three stock split.

The company said that the goal of the public offering was to attract institutional investors, according to its February 16 stockholder letter. If instead Piedmont investors had put their money in public office public traded REITs from around 2002 until Piedmont's first trading close at $15.60 per share, they would have fared far better, according to Newport Beach, Calif.-based Green Street Advisors.

Piedmont shareholders earned nothing, based on the total return during that period, which represents an average time/dollar weighted investor, according to Green Street Advisors. By contrast, it says, the public office public traded REIT median total return was 5% annually during that period. (Green Street both acts as a consultant for REITs and trades in them.)

Piedmont trading opened at $14.75 on February 10. Only time will tell if its move will improve the fortunes of the non-public shareholders. Nearly two months after the offering, the stock had attracted no institutional investors, according to information posted on Yahoo Finance. The largest public stockholders were Piedmont directors and officers, and the stock price had risen from its opening $14.75 to around $20.

Meanwhile, many REIT investors have suddenly found their dividends slashed and their redemptions suspended. Allaire says that in 2010, 61 SEC-registered traded REITs slashed dividends by an average of 57%, while 13 SEC-registered non-traded REIT programs cut dividends by an average of 32%.

Attorney Chris Vernon is weighing whether to represent investors on additional private REIT claims. "Fixed income investors are looking for return and to protect their principal," Vernon declares. The private REIT, he says, "is sold as an alternative to a bond. All of a sudden, they find their dividends are reduced or taken away altogether and they're being told they can't switch investments!"

Vernon doesn't distinguish between registered non-traded REITs, which often charge 13% to 15% in fees and commissions, and private placement non-traded REIT deals. Even though registered non-traded REITs may be examined by different U.S. states, the examination doesn't necessarily ferret out a bad investment, Vernon says. "The [state] vetting process has to do with whether they meet all the criteria for being issued as registered securities-not the quality of the product within the REIT."

Mark Heuerman, registration chief counsel for the Ohio Division of Securities and chair of NASAA's direct participation products group, reviews SEC-registered non-traded REITs. But the National Securities Market Improvement Act has severely limited each state's ability to review private offerings, he says.

Heuerman expects the same problems with public non-traded REITs to surface in the private non-traded REITs area, but perhaps on a grander scale. One thing that troubles him about registered, non-traded REITs is the trend toward longer offering documents-which already run up to 200 pages. They're becoming, he says, tougher to read and understand.

While some public non-traded REITs offer redemptions, these come at the discretion of the advisor. And Heuerman says many REITs have shut down these redemption privileges in the depressed market in order to conserve cash.

Heuerman provides written comments when public non-traded REITs are submitted for review. He looks for conflicts of interest and ensures that any transactions involving a sponsor's affiliates are fair. "We look at fees and expenses. We look at certain investor democracy voting rights. There are some suitability standards applicable to the program.

"There have been programs that have appeared to disclose increased incentive fees payable to advisors-but after the advisors have received a return of invested capital in a stated percentage," he says. NASAA guidelines, he notes, limit incentive fees on public non-traded REITs to 15% on net sale proceeds.

Nevertheless, even if a non-traded REIT gets a state's clearance to go public, that doesn't mean the offering is clear of risks, Heuerman says. Often, it is up to financial advisors to determine whether the investment is appropriate for clients.

Some of the public non-traded REITs, he warns, have paid distributions from the offering proceeds or borrowings. Advisors must beware this signal that the REIT might be short on cash.

Federal regulators have already been acting on these controversial deals. In July 2009, Minneapolis-based Ameriprise Financial Services Inc. agreed to pay $17.3 million to settle SEC charges that it received millions of dollars in undisclosed compensation as a condition for offering and selling REITs to its brokerage customers. These offerings included $100 million of unregistered REIT shares.FINRA last year began reviewing broker-dealers' sale and promotion of non-traded REITs-both public and private placements-in a targeted examination request. "The inquiry to the firms has led to a number of investigations, although I cannot provide further detail," FINRA spokesman Brendan Intindola says.

FINRA member notice 09-09 issued in February 2009 clarified the rules on public and private placement non-traded REITs. Member firms, FINRA says, may not use par value in a customer account statement for more than 18 months after the conclusion of an offering. Plus, before participating in a public offering, they must determine whether all the material facts have been adequately and accurately disclosed-including whether the promised dividend distributions are sustainable.

Vernon says the high commissions on private REITs provide a built-in incentive for them to be oversold. The salespeople are "suggesting that the fact that they don't have to tell you daily what you can sell a portfolio for somehow makes it less volatile," Vernon says. "It's a great sell! That's what bothers me."