REIT dividends at issue in suit

Despite the attractive yields that nontraded real estate investment trusts offer, financial advisers and their clients need to have a firm handle on how the popular real estate investments pay for and account for their dividends, because the risks might be higher than what they expected, according to industry experts.

Dividends, known in the business as distributions, and the practice of borrowing money to pay for them, are at the center of a potential class action filed last month in U.S. District Court for the Northern District of Texas by an investor in a large nontraded REIT that has suffered a steep drop in value.

According to the complaint, Behringer Harvard REIT I generated only $172 million in “funds from operations” from 2003 to 2011 but paid distributions of $569 million, leaving a shortfall of $397 million.

The lawsuit alleges that the REIT has “sought to mask the poor performance of [the REIT] by paying investors back with their own money, while at the same time draining the company of millions of dollars” for the benefit of Behringer Harvard and its executives. It also alleged negligence and a breach of fiduciary duty by the trust, its executives and members of its board.

“Distributions [of nontraded REITs] are not guaranteed and often exceed operating cash flow,” said Richard G. Schaefer, a principal with the Reznick Group PC, an accounting firm that has worked on real estate transactions. “If distributions are also covered by additional borrowings, that's another indication of additional risk.”

Indeed, some REIT sponsors have maintained strong distributions despite lackluster performance during and after the real estate collapse. Sponsors have been afraid to cut distributions on trusts that are “closed,” meaning no longer for sale, because that could hurt sales of products their wholesalers are discussing with financial advisers, industry executives said.

“That's the game they've been playing for some time,” said Pendleton White, president and chief investment officer of Plymouth Opportunity REIT Inc., a newly launched nontraded REIT.

“The prospectus language allows [REITs] to pay dividends from capital raised or refinancing,” he said.

The Plymouth Opportunity REIT pays a 6% dividend in stock.

“We'll go to a cash dividend when we earn it,” Mr. White said. “We say we will never pay dividends from proceeds raised or refinancing — that's pure and simple.”

Distributions from borrowed money are problematic because such practices “degenerate the value [of the REIT] significantly,” Mr. White said.

According to the Behringer Harvard REIT I lawsuit, plaintiff Lillian Hohenstein bought 1,275 shares of Behringer Harvard REIT I from 2004 to 2008 at $10 a share. It is now valued at $4.64 a share.

“The lawsuit is without merit and we will contest it vigorously,” said Jason Mattox, chief operating officer of Behringer Harvard.

According to InvestmentNews data, Behringer Harvard REIT I has $4.4 billion in assets, ranking it fourth-largest among such REITs that are no longer raising money.

More than a half-dozen large nontraded REITS suffered significant declines in value in the wake of the collapse of the real estate market.

STRONG DEMAND

Nontraded REITs are popular with advisers because of investors' fierce demand for income-producing investments in the near-zero interest rate environment. Dozens of nontraded REITs are sold through independent broker-dealers.

Behringer Harvard REIT I wasn't the only large trust to pay substantial portions of distributions to investors using money not from cash flow.

According to its annual report from March, CNL Lifestyle Properties, which has $3.1 billion in assets, paid $188.4 million in distributions last year. Some $105 million was in cash, with $22 million of that “funded from borrowings.”

NEW SHARE VALUE

Meanwhile, $83.4 million in distributions was reinvested in the REIT, which “may be dilutive to stockholders to the extent they are not covered by cash flows from operations … and such shortfalls are instead covered by borrowings,” according to the annual report.

In August, the REIT said that it was adjusting its estimated per-share value to $7.31, from $10, and cutting its distribution to an annual payment of 5.81% of the new estimated value.

“Information on CNL offering distributions and their sources is always provided to investors through each offering's SEC filings,” spokesman Monty Hagler said. “While circumstances are different for every REIT, CNL is focused on overall return for investors and on effective management of the distribution process.”

Kevin Hogan, chief executive of the Investment Program Association, an industry trade group, noted that two years ago, the IPA created an industry best-practices guideline on reporting the distribution coverage and ways to assess that coverage.

“Clearly, sponsors' distribution policies vary,” he said.

“With new REITs, boards want to set an attractive yet sustainable distribution rate,” Mr. Hogan said. “For such new REITs, time is ultimately needed for assets to mature and support the dividend for the long term.”

Along with the quality and potential of the underlying real estate assets owned by such REITs, advisers can focus on the yields of new investments and interest rates on financing to get some understanding of a REIT's distribution coverage, said Michael Stubben, president of MTS Research Advisors.

Advisers should look at each REIT individually without regard to a sponsor's distributions on prior products, he said.

“Advisers should understand the yields on real estate investments and dividend sustainability,” Mr. Stubben said.

Nontraded REITs are “all blind pools paying a dividend, and advisers need to understand if that's sustainable or not.”

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