Non-Listed REITs - Yield Heaven or a Bad Dream?

by Kathleen P. Chimicles, ASA

Non-listed REITs, publicly-registered, non-listed real estate investment trust (REITs), are a popular investment vehicle that requires close scrutiny.

While proponents of this investment vehicle cite attractive dividends and the potential for capital appreciation with little volatility as investment inducements, the reality is that non-listed REITs are an expensive and illiquid type of investment that affords little, if any, disclosure to the investor and no independent analyst coverage¹. These investments are not sold through the established investment banks but are aggressively promoted by brokers and financial advisers encouraged by attractive sales commissions. These brokers and financial advisors target investors seeking higher yields than offered by other investment options. Read below to understand how they work, where your money actually goes, and the significant undisclosed risks that await an investor in these securities.

Offering Expenses and Sales Commissions
Typically 15% of the amount invested in a non-listed REIT pays for sales commissions, fees and offering expenses. It is like driving a new car off the lot, immediate depreciation in value. If you thought you were buying $1 worth of real estate, you are actually only buying $0.85 worth of assets

When is a Dividend not a Dividend?
When the dividend is greater than the operating cash flow generated from the real estate is it really a dividend? If the real estate cannot generate cash from operations sufficient to meet the represented dividend then other cash sources are used including loans, cash reserves, and proceeds from the sale of new securities and/or assets. Cash received from all of these sources is a return of your capital, not a dividend. Even if the articles of incorporation for the non-listed REIT permit the use of such cash sources, if the dividend exceeds operating cash flow the REIT is eroding assets or increasing debt to pay the dividend thus jeopardizing capital preservation and appreciation. If short term variable rate debt is being used to support the dividend then the future dividend and value could be materially eroded with an increase in interest rates. Analysis of the dividends paid by non-listed REITs reflects that over time, an increasing percentage of the dividend is comprised of a return of investor capital.

In the current environment where real estate is being purchased at high prices and debt is cheap, it is not easy to generate operating cash flow that can support a 6% or 8% yield, a typical dividend rate for non-listed REITS. A common ploy is to increase the dividend rate over the time new securities are being sold. Watch carefully what happens after the offering period ends. If the dividend remains the same but is greater than operating cash flow, then you have a capital erosion and/or an increasing leverage problem. If the dividend drops then you have an operating problem that cannot be “fixed” by using asset liquidation or debt to finance the dividend.

You can do a simple calculation to determine how much of the dividend is supported by the operating cash flow; go to the financial statement titled “Statement of Cash Flows”. Look about half way down the page for a line titled “Net Cash from Operations” or a similar title. This is the operating cash flow. Look further down the page to the section titled Cash Flows from Financing Activities; look for dividends. Compare the two numbers. If operating cash flow is greater than dividends, the real estate alone is supporting the dividend. If the operating cash flow number is less than the dividend, then other sources of cash are supporting a portion of the dividend. Look to the section titled Cash Flow from Financing Activities to identify the new debt and new securities sales.

High Purchase Price means Low Capital Appreciation and Possibly Depreciation
In most real estate markets, prices are at or near historical highs. Billions of dollars have been invested in real estate securities in the last several years. This is a lot of money chasing a limited number of properties and fuels high prices. High prices today leave little room for capital appreciation in the future. Many of the non-listed REITs have liquidation provisions, see below, requiring a liquidation about the same time. If many properties are on the market at the same time in the future, it will have a depressive effect on market values for the real estate.

Liquidity is Severely Limited, even if the REIT offers a Redemption Program
Some non-listed REITs promise a redemption program where a small portion of the outstanding shares are purchased by the REIT each year, often at a price approximating book value. The Board of Directors of the REIT has tremendous discretion with respect to such programs. Typically the number of shares that can be purchased each year is very small, the terms of the redemption can be changed without notice, and the entire repurchase program can be suspended or terminated without notice.

It is not unusual for a limited trading market to develop in the shares of non-listed REITs. In such a market, third parties offer to purchase shares of non-listed REITs at significant discounts to the initial offering price or book value. In addition, the seller pays fees to the intermediary firm that facilitates the transaction, and sometimes a transfer fee to the REIT. Even if you are willing to accept the steep discount, liquidity is not guaranteed. Such transactions plus the redemptions are typically limited each year to less than 5% of the total shares outstanding.

List or Liquidate Provisions
Often, but not always, the articles of incorporation for non-listed REITs include provisions requiring the REIT to list its shares on a national securities exchange, such as NASDAQ, by some specific date in the future or be required to liquidate its assets. Read these provisions carefully; not all are created equal. Some provisions require the REIT to automatically begin liquidating if their shares have not been listed for trading by a certain date. Other provisions trigger nothing more than a vote by the board of directors as to whether to begin liquidating assets or to continue to operate indefinitely. Depending on market conditions at the time the List of Liquidate provision is triggered, neither type of provision is a definite win for the investor.

Listing is not always a win for the Investor
Transforming a non-listed REIT to a listed REIT where the stock trades in an active liquid market is not without its complications. Most significant is that in many of such transactions the Board of the REIT recommends that the REIT purchase the manager of the REIT that up to then has been operating as a separate entity. This manager is often comprised of the senior management of the REIT and possibly some of the Board. Conflicts abound. The liquidity transaction for the benefit of the investors becomes a vehicle for the senior managers to take a large amount of capital from the REIT and enter into a long term management contract with the REIT.

Want to Learn More?
The representation of investors who purchased non-listed REITs is a growing area of practice for Chimicles & Tikellis LLP. If you would like to discuss an investment you have made in a non-listed REIT, e-mail us at Chimicles.com. We will respond promptly. Be sure to include a contact phone number or e-mail address.

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¹    Although each carries risk, in contrast to the non-listed REITs, publicly-traded REITs offer immediate liquidity and low transaction costs without a front end fee. Many publicly-traded REITs offer competitive yields that are fully supported by operating cash flow. Most publicly-traded REITS also offer some analyst coverage where an investor can obtain an independent analysis of the REIT’s operations. A qualified investment advisor can assist you in evaluating the merits of publicly-traded REITs.