Nontraded REITs feel heat despite sales

Although the $84 billion nontraded-REIT industry continues to post booming sales, some product sponsors, both large and small, recently have shown signs of stress.

Increased legal scrutiny over valuations, the desire to keep costs down and market forces have led at least one independent broker-dealer to tighten distribution, a major REIT sponsor to reduce head count and one smaller REIT — unable to achieve scale — to look at exiting the business altogether.

Summit Brokerage Services Inc., an independent broker-dealer, last month suspended its selling agreements with sponsor KBS Holdings LLC following a recent lawsuit against one of the latter's real estate investment trusts.

Meanwhile, Wells Real Estate Funds, an industry powerhouse, in the past month laid off its executive sales staff in a move to cut costs.

And one smaller nontraded REIT, Paladin Realty Income Properties Inc., last week told investors it is ending the sale of its stock next month — after raising $78.7 million over more than four years — because it lacks the scale needed to cover expenses.

The REIT could be sold, merged or have some other type of “liquidity event,” the company said.

“This is something everyone expected” for Paladin, said Nicholas Schorsch, chief executive and chairman of American Realty Capital. “It never got enough traction. And there's going to be more bloodletting” for smaller REITs, he said.

Nontraded REITs, however, are still raising a formidable amount of capital from investors attracted to the steady 5% to 7% yields that nontraded REITs provide, REIT investors noted.

The industry raised $897 million in April and $805 million last month.

PULLBACK FOR SOME

Despite such sales, which translate roughly into $10 billion on an annualized basis, the pullback for some broker-dealers and REIT sponsors is real.

Last month, a group of investors filed a prospective class action complaint against the $3.6 billion KBS Real Estate Investment Trust Inc., or KBS REIT I, and other related companies and their executives. The suit, which was filed May 8 in U.S. District Court for the Middle District of Florida in Fort Myers, alleged that KBS made misrepresentations about the REIT, including its investment objectives, the dividend payment policy and the value of the REIT's investments.

KBS will file a motion to dismiss the complaint and regards it as “frivolous,” according to company spokesman Jonathan Thomas.

In March, KBS REIT I announced a new valuation of $5.16 a share, down from $7.32 a share. Investors had purchased the REIT at $10 a share.

At that time, the REIT also cut its distribution to zero.

That suit spurred Summit Brokerage Services to suspend its selling agreements with KBS.

“We're doing additional due diligence,” said Marshall Leeds, owner and chief executive of Summit, which produced $70 million in revenue last year and has 370 affiliated representative and financial advisers.

He said that his firm had a good relationship with KBS and had suspended other product sponsors in the past.

Suspending a sponsor could lead to ending a selling agreement, Mr. Leeds said.

“If we don't have a comfort level, we walk away,” he said.

Nontraded REITs make up less than 2% of the firm's total sales, Mr. Leeds said, so the suspension of KBS has little impact on Summit.

Other broker-dealers with a larger exposure to nontraded REITs may face concerns.

“I think that firms that are heavily loaded in REITs might have some issues,” Mr. Leeds said, adding that the broad decline in commercial real estate has led to the decline in valuation for some REITs.

KBS declined to comment about Summit's decision to suspend sales, spokeswoman Cindy Tullues said.

Wells Real Estate Funds, which counts the $6.1 billion Wells REIT II as one of its REITs, has gutted its sales staff in order to cut costs, according to industry executives who asked not to be identified.

In response to those comments, Robert Kennedy, president of Wells Real Estate Funds, said in a statement that the cost cutting will benefit shareholders.

“Wells Real Estate Fund's retail-sales distribution channel is in the process of transitioning from a fixed-cost to variable-cost model,” he said.

“The transition has not yet been completed, so details are unavailable at this time. The new model is expected to reduce the fixed overhead associated with fundraising activities, with the goal of benefiting shareholders,” Mr. Kennedy said.

“As part of the new model, the sales leadership team has been restructured,” he said.

Steve Franklin, who has been with Wells since 1999 and previously served as its chief of sales, has stepped back into that role.

He is also president of the firm's broker-dealer, Wells Investment Securities.

LACKING SCALE

Paladin Realty Income Properties lacked scale, its chief executive James Worms, wrote to investors in a letter dated June 12.

“We have been successful in building a solid, well-performing real estate investment portfolio with the offering proceeds we have raised to date,” his letter said.

“However, we have not been as successful as we anticipated in raising sufficient offering proceeds for us to achieve economies of scale such that portfolio revenue alone is sufficient to cover all property and company level expenses (i.e., the general and administrative expenses of operating a public company) and also pay the current distribution,” according to the letter. “As of March 31, 2012, our funds from operations, or FFO, are sufficient to cover the majority, but not all, of these combined expenses and distributions.”

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