Nontraded REITs: The bigger they are, the harder they fall?

InvestmentNews analysis shows that eight largest dropped 37% in value in last seven years

By Bruce Kelly

Aug 15, 2012 @ 2:56 pm (Updated 2:37 pm) EST

REITs, studies

Eight of the largest nontraded real estate investment trusts have lost $11.3 billion, or 37% of their equity value, over the past seven years, according to an analysis conducted on behalf of InvestmentNews.

On Tuesday, CNL Lifestyle Properties Inc., which initially raised $2.7 billion at $10 a share, became the latest large nontraded REIT to report a sharp decline in value; its share price dropped to $7.31. (See related story for chief executive Stephen Mauldin's comments.)

Last month, the Dividend Capital Total Realty Trust Inc., which raised $1.8 billion in equity at $10 per share, revised its value to $6.69 per share. In March, the REIT said its value was $8.45 per share.

Guy Arnold, president of the Dividend Capital REIT, did not return phone calls Monday or Tuesday seeking comment.

Industry observers noted that the revaluation of CNL Lifestyle Properties is likely to be the last substantial nontraded REIT to see a substantial decline in value. The eight REITs analyzed for InvestmentNews by MTS Research Advisors were notable because they had raised more than $1 billion in equity, and their declines in equity value were greater than 20%.

The calculation of the decline in estimated equity value of the eight REITs does not take into consideration the “distributions,” or dividend yields, that the REITs have been paying clients. Such yields typically range from 5% to 7% annually. Based on $30.7 billion of equity raised, annual distributions to investors could range from $1.5 billion to $2.1 billion. Accounting for those distributions is important in the discussion of nontraded REITs returns, industry executives noted. In fact, from 2007 through the first quarter of this year, the eight nontraded REITs cited have distributed $7.1 billion to investors, according to Monty Hagler, a spokesman for CNL Lifestyle Properties. (See related chart.)

The eight REITs examined are a large part of the nontraded-REIT and “direct participation program” investment industry, which will raise between $9 billion and $10 billion from investors this year through independent broker-dealers.

One exception: The family of REITs known as the Apple REITs was not included in MTS' analysis, because their share prices are currently listed as “not priced.” The Financial Industry Regulatory Authority Inc. last year filed a complaint against David Lerner and Associates Inc., alleging that since at least 2004, "the closed Apple REITs have unreasonably valued their shares at a constant price of $11, notwithstanding market fluctuations, performance declines and increased leverage.” over sales of the REITs.

David Lerner, the exclusive sales agent of the Apple REITs, has said the Finra allegations are baseless.

During the surge in the commercial real estate market, which peaked near the end of 2007, some registered reps sold nontraded REITs to clients and characterized them as bond alternatives, industry observers noted.

Indeed, some reps sold these investments appropriately, and some reps fell short, said Anthony Chereso, chief executive of FactRight LLC, a due-diligence firm that focuses on direct investments such as nontraded REITs.

The industry is working to educate reps who sell such REITs, Mr. Chereso said.

“There's a huge focus on wholesalers' and advisers' appropriately positioning these investments,” he said. “Some of the programs will look like a bond alternative, while others are growth vehicles. From broker-dealers to the sponsors, there's been greater delineation and definition to the nuances of the product.”

After taking into consideration the distributions paid to investors and the standard 7% commission clients pay advisers to buy nontraded REITs, Mr. Chereso also noted that the 37% decline of equity value of the eight major REITs was not that far out of line with the broad downturn in commercial real estate.

For example, the Moody's/RCA CPPI National All Property Index declined 22.6% from the end of 2007 through the April 1 of this year, Mr. Chereso said.

“This is not a sponsor or operational issue,” he said. “The degradation in share value [of the eight large REITs] is akin to the drop in the Moody's/RCA CPPI National All Property Index. The issues we're facing in nontraded REITs are no different than global issues in real estate as a whole.”

Mr. Chereso also noted that because non-traded REITs' valuations aren't changed often, their decline in value may seem amplified. “The important thing is to look at REITs as individual programs and not to toss them all into one bucket,” he said.

Kevin Hogan, CEO of The Investment Program Association, an industry group, said that the eight nontraded REITs in the InvestmentNews analysis are representative of the industry but are a small sample. “There are significantly more [nontraded] REITs in the market today,” he said.

He pointed to CNL Lifestyle Properties as an example of when a nontraded REIT buys assets when the market is near or at its height. Nontraded REITs often have life cycles of seven to 10 years and need that time to go full-cycle, he said.

“Products have a life cycle that extends multiple years.” Mr. Hogan said. “It's true that they've lost value, but remember that it's a point in time of their life cycle.

“A lot of these assets were purchased in the past, and many real estate experts would say the market has troughed out,” he said. “But the outlook is looking brighter, for real estate in general and such REITS, as the market continues to improve.”