Non-traded REITs may hurt indie B-Ds

The real estate boom and bust is hanging over many independent broker-dealers and their financial advisers as the market for non-traded REITs soured this year.

Investing largely in commercial real estate, many of the largest non-traded real estate investment trusts have had a tough year, slashing dividends to investors and shutting redemption programs. Some independent broker-dealers and their registered representatives have significant exposure to the non-traded REITs, which are illiquid, high-commission products.

An analysis of leading independent broker-dealers shows that non-traded REITs accounted for as much as 12% of a handful of firms’ revenue last year. Some independent broker-dealers didn’t sell the product, according to a listing in an industry publication, while non-traded REITs accounted for 2% to 6% of other firms’ gross revenue last year.

The market for non-traded REITs has grown substantially, many noted, with a high of $12 billion in sales or funds raised in 2007, followed by sales of $10.1 billion last year.

This year, sales to investors are expected to be $6.4 billion, closer to levels before the real estate boom, according to Direct Investments Spectrum, an industry publication. “Not bad for an off year,” the publication said in its July/August issue.

In general, private and non-traded REITs operate like closed-end funds in that they purchase assets to be held for a fixed amount of time — usually seven to 10 years — and either sell off the properties or do an initial public offering at the end to deliver returns to shareholders.

Non-traded REITs must register with the Securities and Exchange Commission but aren’t listed on an exchange or over the counter.

They are designed to pay investors a dividend, which in the past has averaged 6% to 7%. Stock sell-offs in the broader market don’t lower the value of shares during the life of the investment.

BIG NAMES ARE HURTING

That changed this year as some of the biggest and most prominent non-traded REITs cut dividends. Among the largest that have made the cuts are Behringer Harvard REIT I, Inland America Real Estate Trust, Inland Western Retail Real Estate Trust and Piedmont Office Realty Trust.

Inland Western told investors last week that it is cutting its dividend to 1% of its share value, the second cut this year. A year ago, the dividend was 6.5%

Officials with the non-traded REITs say that the setbacks are temporary, and others noted that dividend cuts were prudent and could help REITs pay down debt.

But the problems create difficult talks with clients about a product that was supposed to be steady and stable, advisers and executives said.

“It is a tough conversation, but [clients are] aware of what’s going on in the real estate market,” said John Tyler, a registered rep with Capwest Securities Inc.

Negative factors affecting the REITs include reduced values of the instruments and lost income because of vacancies. The REITs are cutting dividends to hang on to cash, said Mr. Tyler.

“But they have real assets,” he said.

Some of the REITs are even more illiquid than usual, worth perhaps 30% to 40% less than their price, and dividends have gone down the drain, many observers said.

“Another problem is that they sit on a client statement forever,” said John Rooney, managing principal of Commonwealth Financial Network.

Commonwealth is one of the biggest sellers of non-traded REITs among independent broker-dealers; revenue from non-traded REITs accounted for about 2% of its gross revenue of $519 million last year. Mr. Rooney said that sales this year through June were down about 30% compared with last year.

The upside, however, to non-traded REITs is clear, many say. Commercial real estate is bound to bounce back, and now may be an opportune time to invest in commercial properties that have seen their values plummet.

“Commercial real estate is, and always has been, a lagging economic indicator,” said James Paulsen, chief investment strategist with Wells Capital Management.

The commercial-real-estate market could reach its bottom in the middle of next year, he said. And lagging indicators often are balanced by more positive economic news, such as growth in profits and an increase in jobs, Mr. Paulsen said.

“Now is a good time to buy non-traded REITs,” said Don Beary, executive vice president and chairman of VSR Financial Services Inc. The product accounted for about 12% of VSR’s gross revenue of $90.4 million last year and will probably account for 9% of revenue this year, he said.

REITs that have too much debt could struggle, industry observers said.

“For non-listed REITs that have manageable debt levels, they can simply hunker down and wait until the economy rebounds and commercial-real-estate values recover from the 25% to 35% decline that has occurred since 2007. Holding on until better days will be more difficult for highly leveraged REITs, especially those with debt maturing over the next two to three years,” according to Direct Investments Spectrum.

“Overleveraged properties and funds are dying under the weight of the excessive leverage,” Mr. Tyler said. Funds that bought commercial real estate at the top of the market in 2007 and the first half of last year, in particular, could be struggling, he and others said.

Regulators have taken an interest in the product.

In March, the Financial Industry Regulatory Authority Inc. reviewed broker-dealers’ sales and promotion of non-traded REITs, and asked firms for a variety of information, including descriptions of sales contests and cash and non-cash incentives.

To date, Finra hasn’t taken any enforcement actions based on that information, according to spokes-man Herb Perone.

E-mail Bruce Kelly at [email protected].