When Cole Real Estate Investments bought a trophy tower housing Microsoft's Bing division in downtown Bellevue, Wash., in July 2010, the commercial real estate industry took notice for a few reasons.

Cole paid a hefty $310 million for the 26-story office building in suburban Seattle, making it one of the largest sales nationally of 2010. The deal also made clear just how flush with cash non-traded real estate investment trusts (REITs) like Cole had become.

According to Atlanta-based researcher Blue Vault Partners, non-traded REITs raised an estimated $7.6 billion in 2010, compared with $6.4 billion in 2009. Nationwide, the industry has 57 non-traded REITs with $70 billion in assets, or about 20% of the total market capitalization for all publicly registered REITs.

“In this economic environment investors are looking for steady income and yield, and non-traded REITs provide that,” says Mark Goldberg, managing director at W.P. Carey & Co. The New York-based firm has raised $10 billion through a series of non-traded REIT programs since 1973.

Non-traded REITs are registered with the Securities and Exchange Commission (SEC) as public companies, but registered financial advisors rather than stock exchanges manage sales of their shares. The typical investor has a net worth of at least $150,000 and prefers a long-term investment strategy of up to seven years.

The most recent data reveals that the industry took in $2.1 billion from investors in the third quarter of 2010, a drop of $100 million from the prior quarter, but still on pace to top the total of $6.4 billion raised in 2009.

The biggest fundraiser in 2010 was Phoenix-based Cole Credit Property Trust II, with nearly $1.2 billion raised through September 2010.

Cole's purchase of the office tower housing Bing, its largest purchase to date, fits the intended sweet spot for acquisitions, core real estate assets with high-credit tenants on long-term leases.

Microsoft's lease runs through 2024, and the deal is expected to generate a 7.7% capitalization rate for Cole over the remainder of Microsoft's lease term.

Other non-traded REITs have been prowling as well. Mere days after Cole's mega deal near Seattle, KBS Realty Trust II bought 300 N. LaSalle, a new 60-story office tower in downtown Chicago, for $655 million. The figure set a record in the local market of $504 per sq. ft.

Déjà vu all over again?

In many ways, the current state of the non-traded REIT sector mirrors the last go-go acquisition spree of 2003-2005, when the sector was dominated by four leading players: Wells Real Estate Funds, Inland Real Estate, CNL Financial Group and W.P. Carey & Co. They raised boatloads of cash and became the top purchasers of commercial property.

They also were often accused of bidding up prices. When any entity is raising an average of $100 million to $150 million per month, the impetus is to put the money “in the ground” through property acquisitions.

“You can't let it sit in cash, you have to buy something,” says Nicholas Schorsch, chairman and CEO of New York-based American Realty Capital, which sponsors 15 non-traded REIT programs that have raised an estimated $15 billion. He believes the firm can raise $2 billion to $3 billion in 2011 alone.

Certainly the size of the non-traded REIT pie is growing. A record 15 new offerings filed registration statements with the SEC in 2010, surpassing the previous record of 12 in 2009. In the third quarter of 2010, five new non-traded REITs received the SEC's blessing to begin raising money.

If all the offerings come to market in 2011, the number of non-traded REIT offerings will be 33% more than in 2009.

According to David Steinwedell, partner in Austin-based investment management firm Stoneforge Advisors, there are clear-cut winners and losers in the space.

“Cole is probably the leading example of a firm that is riding the wave,” says Steinwedell, the former chief investment officer at Atlanta-based Wells Real Estate Funds from 2001 through 2007.

“The challenge is the new folks coming out don't have the extensive distribution network and established relationships with all of the broker-dealers. They are going to have a real spotty time at best breaking into some of those channels.”

In November, two non-traded REIT offerings, Bluerock Enhanced Multifamily Trust and Cornerstone Core Properties REIT, voluntarily suspended their fundraising programs due to accounting and performance-related issues.

“All ships don't float,” says Schorsch, referring to companies that have entered the non-traded REIT market. “It is areally important cleansing process for the industry that some of these deals are having problems, or not raising money.”

Answering the critics

Since non-traded REITs first spawned from the popular limited partnership programs of the 1980s, they have not experienced any dramatic changes in their financial structures. But now some new thinking is on the way.

A big criticism of the non-traded REIT sector centers on the traditionally high fees charged upfront, called “front-end load” in mutual fund parlance.

Most non-traded REITs charge fees totaling 12% to 16% of the money investors plow into the programs. The bulk of the fees defray the costs of establishing internal sales organizations through broker-dealers, who then sell shares in the REITs to individual investors.

In an effort to make non-traded REITs more attractive to a wider audience of financial advisors, several sponsors are launching new products that eliminate fees and provide better liquidity for investors. They include ING Clarion Partners, Bank of America-Merrill Lynch, Cole and American Realty Capital.

Cole has registered two new non-traded REITs with the SEC, one for “necessity corporate properties,” predominantly net-leased office and industrial buildings, and the other for retail properties. Both are expected to gain SEC approval to start raising money in 2011.

Unlike most non-traded REITs that have a defined date on which they must list on a public exchange or liquidate, the new Cole offerings are structured as open-ended entities, meaning they have no defined life span and can theoretically remain open indefinitely.

“A lot has changed since 2005. We're really trying to lead the way in terms of innovation and taking this industry out of the realm of being an alternative asset class and making it a mainstream one,” says Marc Nemer, president of Cole. “You're going to see significant evolution over the next couple of years.”

Both of Cole's programs closely mirror traditional open-ended mutual funds, with no front-end fees, meaning nearly all of the invested dollars go into property acquisitions.

Another criticism of non-traded REITs is their lack of liquidity. Since they are not traded on a stock exchange, investors cannot liquidate the investments as easily as with publicly traded REITs. To counter the criticism, the stock price on Cole's programs will be based on daily valuation of the REIT's real estate assets. Also, there will be no traditional cap on the pool of money set aside for share redemptions for those investors who wish to “cash out”.

“Those changes are absolutely what is needed to break through and make this a more mainstream product,” says Vee Kimbrell, managing partner with Blue Vault Partners.

Not everyone agrees. “I think at this point we're going to step aside and not do that kind of product. We want to see how it shakes out,” says Timothy Seneff, president of Orlando-based CNL Capital Markets.

American Realty Capital is launching a similar non-traded REIT, but it will have a defined lifespan of five to seven years. “We're not sure how it's going to work, but we want to be in it. We love the idea of giving more choices to the investor,” says Schorsch.

One major tradeoff with the new structure is a lower dividend yield. That has huge implications for many existing investors, since the traditional non-traded REIT stock has been sold as a long-term, fixed-income investment with a steady dividend but virtually no liquidity.

Taking innovation a step further, Schorsch launched Realty Capital Securities (RCS) in 2008, creating an “open architecture” platform to sell multiple non-traded REIT programs under one umbrella.

The idea is to have one company focus on selling a variety of programs to broker-dealers and registered investment advisors, or RIAs. Currently there are 10 programs sponsored by American Realty Capital in the RCS platform.

Single-minded focus

The consensus among market watchers is that companies focusing exclusively on one property type are likely to be winners in the battle to win the hearts and minds of the financial advisors who sell their products to investors.

According to Blue Vault Partners, of the 57 non-traded REITs, 27 were classified as “diversified” at year-end 2010. “This tells me that arena is saturated. Those companies that can invest in specific sectors will do best at standing out from the crowd,” says Kimbrell.

One example of this approach is Strategic Storage Trust Inc. (SSTI), the only non-traded REIT devoted to the self-storage industry. Launched in 2008, the company has raised about $200 million and manages $300 million in assets with 43 properties in 15 states.

“Back in the 1990s and early 2000s, there were fewer sponsors but each sponsor had their specialty,” says Michael Schwartz, chairman and CEO of SSTI based in Ladera Ranch, Calif. “When new entrants came and raised a lot of money, you saw variations.”

Schwartz describes the self-storage sector as having all of the characteristics of core real estate. Still, operating in the sector is not without its challenges.

“Self-storage is not an asset class you can dabble in. It is a fragmented industry, and the size of the average self-storage acquisition is $3 million to $5 million,” says Schwartz. “You have to be committed to it since it takes you the same amount of work to buy a $5 million self-storage facility as it does to buy a $50 million office building.”

The commercial mortgage-backed securities market is reviving, sparking interest in property sales, says Schwartz. “We're seeing a lot of new quality acquisitions come to the market.”

For its part, Cole is shifting the investment strategy of one of its new offerings to the office sector. Currently it owns $7 billion worth of real estate, with about 80% of it in the retail sector and 20% in non-retail properties.

Cole plans to flip those percentages around as it looks to bulk up on office and industrial, says Nemer. “We want to make the different asset classes available to our client base with this very conservative core investment strategy running through all of them.”

A Diversified Strategy Still has a Place

One “old-school” player in the non-traded REIT world, CNL Financial Group, founded in 1973, has weathered several market cycles thanks to its contrarian and diversified investment strategy. From the fall of 2006 through spring 2007, CNL sold off $15 billion in assets, or 80% of its portfolio, at the peak of the cycle.

Today, Orlando-based CNL sponsors three non-traded REITs and has one more in registration with the Securities and Exchange Commission. CNL's acquisition strategy is quite diversified indeed.

Of its three programs, one is devoted to lifestyle properties that include golf courses and marinas, and another is in partnership with CB Richard Ellis Investors targeting industrial, retail, multifamily and office properties. Two other non-traded REITs are in partnership with Australian investment firm Macquarie and focus on global acquisitions.

The diversified focus has not slowed the firm's popularity among investors. Company president Timothy Seneff says he expects CNL's fundraising to increase up to 30% in 2011.

“We're seeing an increase across the board from the distribution channels where they are saying they want diversified, growth-oriented or income-producing tangible assets in this chaotic environment,” says Seneff. “You have a real tailwind in the space because people want to have tangible assets like real estate in their portfolio.”

The challenge today is not overpaying for the few buying opportunities that exist. “The last thing we're going to do is get in a bidding war and overpay,” says Seneff. “Some will be tempted to do so, but you have to avoid it. Anybody who buys real estate has to be careful.”

Regarding the stampede of new competitors entering the non-traded REIT industry, Seneff says it is similar to other markets that see new entrants.

“Over time you potentially see consolidation and you see the cream rise. Like anything, you're going to see four or five key players go to the top — those that are thoughtful about how they're buying, the leverage they're using, and the experience they bring to the table.”

Ultimately, CNL hopes to build on its longevity and its focus on opportunities at home and abroad. “We have a number of opportunities to invest globally. That's the model we're looking to build out with multiple products,” says Seneff.

“Some of the smaller players will at some point have to say the math doesn't make sense, and they will turn the lights off,” emphasizes Seneff. “The top managers with the most experienced platforms will win from a market share perspective.”

Ben Johnson is a Dallas-based writer.