Non‐exchange traded real estate companies have become another avenue for investors seeking the
benefits of real estate. With their own set of risks and opportunities, are these companies a good
option for most investors?
[May/June 2003]
By Phillip Britt

Faced with a difficult investment market, investors have been attracted to publicly traded real estate investment trusts because of the solid dividends and portfolio diversification they provide. These same benefits have led some investors who want peace of mind from the fluctuations of the public market to publicly registered, non‐exchange traded real estate companies. And while there are similarities to publicly traded real estate companies, these non‐exchange traded companies carry their own set of pros and cons investors must weigh when deciding to put their money in public‐exchange traded or nonexchange traded real estate companies.

The sponsors of non‐exchange traded companies, which are registered with the Securities and Exchange Commission (SEC) but not traded on any of the public exchanges, tout their high yields and steady  returns while marketing them to investors who have been burned elsewhere in the market and seek relative stability.

"People are sick of being at the market's mercy," says Gordon DuGan, co‐chief executive and president of W.P. Carey & Co. LLC, a leading non‐exchange traded REIT sponsor. "With [non‐exchange traded REITs] people aren't trying to time the market. They're not waiting for the latest uptick or downtick."

In addition to W.P. Carey, some of the leading sponsors of non‐exchange traded companies include CNL Financial Group, Inland Real Estate Corporation and Wells Real Estate Funds, Inc.

These sponsors promote their non‐exchange traded companies as providing insulation from market fluctuations that can negatively impact publicly traded equities. Non‐exchange traded REITs are marketed, in part, as fixed‐income investments offering better returns than bonds, certificates of
deposit, money market funds and similar financial instruments, according to their sponsors.

Liquidity and Capital Preservation

However, as with all investments there are risks and limitations—and lack of liquidity is a prime issue. There isn't a readily available market if an investor wants to liquidate his non‐exchange traded REIT investment, according to Robert Parks, chairman and CEO of Inland. So the investor will pay a substantial penalty, much like a life insurance surrender charge, if he liquidates early. Shares in a publicly traded REIT, on the other hand, can be bought one minute and sold the next, with only a commission charge.

In addition to issues surrounding liquidity concerns, the fees associated with these investments are the most common concern voiced by investors and industry analysts. Up‐front fees can climb to 15 percent or more (including financial planner or broker charges which are discussed later in this article), while early surrender charges range from 7 percent to 10 percent, according to industry analysts. The earlier an investor surrenders the stake, the higher the charge. Therefore, the non‐exchange traded investment is typically better suited to the investor who has money he or she won't need for 10 to 12 years, the typical lifespan of one of these investments, according to Barry Vinocur, publisher of Realty Stock Review and Property magazine.

"They're like any other illiquid, long‐term product," DuGan says. "There's a high, one‐time, up‐front fee. IIt's a buy‐and‐hold strategy. These [companies] offer good, safe dividends." DuGan adds that investors in W.P. Carey's first nine non‐exchange traded REITs earned an average annual total return, excluding fees of about 11.5 percent, including dividends and appreciation.

Stephanie M. Krewson, a REIT analyst with BB&T Capital Markets, questions whether the reward is worth the risk. "Investors in these [non‐exchange traded] structures have very limited liquidity," Krewson says. "Unless investors want to use these structures as a form of forced savings, I don't know
why they would assume this level of risk when they have a viable, liquid alternative available in publicly traded REITs."

One reason proponents give for investing in non‐exchange traded REITs is value preservation—the idea that investors are willing to trade some liquidity for the perceived peace of mind that they will not lose value in their investment. Steve Hamrick, managing director of W.P. Carey, says his company has the value of their REITs appraised once a year.

"[The appraisers] take the value of each of the REITs and divide that amount by the number of outstanding shares," he says. "It's not practical to do the appraisal more than once a year because the process is very extensive. More frequent appraisals would serve no purpose other than to cost
shareholders money."

Safety and Significance of Dividend

Rather than comparing themselves to their publicly traded REIT counterparts, most providers of nonexchange traded REITs market them as an equity alternative to fixed‐income investments like bonds and government securities. The sponsors offering shares in these companies say that a high level of income is paramount to their investors and what separates them from other fixed‐income investments.

As the Federal Reserve has cut short‐term interest rates 12 times in the last few years, yields on investments like CDs and money market funds have dropped precipitously, says Leo Wells, III, chairman, president and CEO of Wells Real Estate Funds "That's like getting 12 pay cuts in less than two years for these people," Wells says. "If that was to happen to someone on a job, the average person would leave. MMany of these people are on a fixed income. This isn't something they want, it's something they have to have."

Like many publicly traded REITs, the non‐exchange traded companies take steps to protect the dividend by locking in long‐term leases with their tenants. Wells' leases include automatic increases to protect the company against inflation. Wells believes that his company's non‐exchange traded REIT holding is diversified enough that the softness of a particular industry or sector of the country isn't likely to affect the payout.

Wells holds enough long‐term leases on its properties that if half of its office and industrial tenants didn't pay their obligations, it could still pay a 3.75 percent dividend, a little more than half of the 7 percent it is currently paying, Wells says, adding that even a 3.75 percent payment is better than what individuals are receiving in most other types of fixed‐income investments today.

"Even if we stopped raising money today, we would still be able to pay out a 7 percent dividend," Wells says. The concept here is that using little or no leverage protects the value of the portfolio, and therefore the value of the income return, according to a Wells spokesperson.

Maintaining its dividend is also a priority for W.P. Carey, and the company says it has never missed a dividend in its 30‐year history, nor seen one of its REITs lose money. Company officials say they take a long‐term approach to investments, and the non‐exchange traded format fits well with that philosophy.

Fitting the Investor Profile

Due to their focus on reliable dividends, W.P. Carey's DuGan says that non‐exchange traded REITs were once thought of primarily as "widow and orphan" investments, much like utilities were a little more than 20 years ago.

But since the market started dropping in the second half of 2000, an increasing number of Baby Boomers entering or nearing retirement are eyeing these investments along with many retirement funds. Sixty percent of the investors in W.P. Carey's non‐publicly traded REITs are IRAs and 401(k) plans, DuGan reports.

Still, proponents of these investments caution that investors counting on fixed income shouldn't be looking to put all, or even most, of their money into these investments. Wells says that most investors who consider putting money into non‐exchange traded REITs can remember the double‐digit inflation of the late 1970s and early 1980s. If inflation and high interest rates return, investors don't want to have their money tied up in investments like these that typically yield 7 percent to 9 percent. He recommends investors limit their exposure to non‐exchange traded REITs to no more than 10 percent to 30 percent of their portfolio.

Once an investor determines that these companies are worth adding to his or her portfolio, the next step is to find a way to invest. Though not offered on the public exchanges, it's easy enough for investors to find non‐exchange traded REITs. Several brokerage firms, like A.G. Edwards, UBS Warburg
and Paine Webber include them as part of their options available to clients.

Independent financial planners and brokers also offer non‐exchange traded REITs. Working with a sophisticated advisor, like a financial planner or broker, is important for the individual considering this type of investment, according to Wells.

Wells offers schools to teach financial planners and pension plan advisors and other financial consultants about the nuances of its non‐exchange traded REITs, real estate limited partnerships, likekind exchanges and other real estate investments. Wells, like many other companies offering nonexchange traded REITs, provides other real estate services as well.

"I like the idea of people having a financial advisor, then they're smarter with their money," Wells says. ""Education is the key. Investors can do themselves the most good by hiring a financial planner. Not doing so is like trying to be a doctor without going to medical school. We want our investors to be educated."

Factoring in Fees

For their work, the financial planner and broker earn fees totaling about 8 percent to 10 percent. This is typically more than he or she would earn from a sale involving a publicly traded REIT (there are much lower commissions applied to each transaction, although publicly traded equities may be traded more frequently). With the non‐exchange traded REIT transaction, the fee, although much higher, is earned once, according to DuGan.

Wells, for example, pays a 9.5 percent fee to the broker, according to its prospectus. In addition, the company pays 1.5 percent for organization and offering expenses, 3 percent for acquisition and advisory fees and 0.5 percent in acquisition expenses, according to its prospectus.

"That leaves 85.5 percent of each dollar ‘going into the ground' as a real estate expense," a Wells spokesperson says.

Some industry observers have equated the increase in popularity of non‐exchange traded REITs to the substantial commission fees brokers and planners receive from selling them to clients. "These investments aren't bought, they're sold," says Vinocur, pointing to the commissions that financial
planners and others receive for selling non‐exchange traded REITs to investors.

Joe Harvey, senior analyst with Cohen & Steers Capital Management, agrees with Vinocur. "I think investors are turning to the non‐exchange traded companies out of a need for income and out of a need by their financial planners and brokers to generate commissions," Harvey says. "The front‐end
commissions that are paid on these type of investments are quite high. And we're in an environment where there are not a lot of ways for the broker or financial planner to generate business in terms of putting their clients in investments that they feel good about."

Bill Peterson, a certified financial planner in the Boise, ID‐based office of Brookstreet Securities, says it isn't the commission, which he admits is good, but the stable net asset value that has him recommend IInland's REIT to his retired investors. Peterson has had clients invested in both exchange and nonexchange traded REITs, but is slowly migrating most to Inland (he hasn't sold other non‐exchange traded REITs) due to the significant dividend and the value the security maintains until it is sold.

Arlene Moore, a fixed‐fee financial planner with Financial Strategies of Southwest Florida LLC, says the commission is a plus but not the main reason non‐exchange traded REITs are being recommended. "While the higher commission is nice, that certainly isn't the reason I have been looking at non‐exchange traded REITs for my clients," she says. "My clients are looking for diversification. A real estate investment trust, especially the non‐exchange traded ones, hopefully will have less fluctuation in the share price because it isn't a traded REIT. The ones I have been looking at have no debt, seem to be a little less volatile and more secure, and the dividend right now certainly is attractive to the client."

Looking Ahead

Given the increased interest shown by investors in these non‐exchange traded REITs, will we see an increase in the number being offered? Officials at the top non‐exchange traded REITs expect more brokerages, like Merrill Lynch, to look closely at offering their own non‐exchange traded REITs,
particularly if the broader stock market remains weak.

"I would be very surprised if by the end of the year some of the large wire houses hadn't gotten into the business," Parks says.

Cohen & Steers' Harvey says it is likely these companies will continue the momentum they've built. "If a public company makes a bad acquisition their stock price is going to go down, and investors are going to know it," he says. "But because non‐exchange traded REITs are not traded, investors won't see the mistakes and the aggressiveness for a long time. So because of that, the momentum is going to carry forward until investors start to see some of the mistakes that are made."

Dave AuBuchon, an analyst who follows W.P. Carey for A.G. Edwards & Sons Inc., adds that there has been little competition in this part of the market to date, and a continued strong performance through the rest of this year could bring more competitors.

"You're going to see some copycats," says AuBuchon, adding that he expects this sector to cool off by the beginning of 2004.

Wells, Parks and DuGan agree that there is enough room in the market for more non‐exchange traded REITs. However, they do express a concern that too much capital could create an imbalance in the real estate market.

That's happened already, according to Krewson. "Prices have been driven up by an oversupply of capital chasing a stagnant pool of assets," she says. "This is a very dangerous situation, and one that we've seen before, specifically in the 1980s. Though today's private valuations are nowhere near the indefensible levels of that decade, they are on the verge of disconnecting from the rental revenues supporting them."

Phillip Britt is a freelance writer based in suburban Chicago.

Established Exit Strategy
While the operators of non‐exchange traded REITs say they use the format rather than the public markets due to the long‐term nature of the investments, they don't last forever. That is why most sponsors have an exit strategy in place from the start.

W.P. Carey combined its first nine REITs and took them public as a limited liability corporation in 1998, providing investors with a total yield of 11.5 percent, exclusive of tax benefits. Converting the nonexchange traded REITs into a single limited liability corporation enabled investors to time their
recognition of capital gains for tax purposes, DuGan says.

While one investor may have wanted to sell his shares and recognize the gain in 1998, another investor in a different tax bracket may have wanted to wait until 1999 or later. Converting the non‐exchange traded REIT into a public REIT or a C‐corporation would not have provided investors with the same tax advantages, according to DuGan. Ninety‐eight percent of the investors in those funds approved the deal, DuGan says.

The last of Carey's non‐exchange traded companies debuted in mid‐January 2003 with a gross yield of 6.15 percent. The company's prospectus says that the companies will be taken public or liquidated by 2008.

Other sponsors offering non‐exchange traded REITs have similar long‐term plans for the investments: planning to go public, liquidate, or, in the case of Inland, for example, to combine with a separate publicly traded REIT.