The unlisted REIT sector is getting crowded. A field that consisted of just four firms in 2003 is now teeming with more than two dozen — and the ranks are still swelling even as the capital flow into this sector has slowed. While unlisted REITs are registered securities, their shares do not trade like stocks (which is why they also are known as public, non-traded REITs).

Unlisted REITs are operated by sponsors, independent securities firms that earn fees from the REIT. Marketed directly to small investors through legions of financial advisors, unlisted REITs promise guaranteed dividends without trading volatility, in exchange for high fees and limited liquidity.

“They [unlisted REITs] burst onto the scene a few years ago with a very smart strategy,” says Ralph Block, a longtime REIT investor and author of the book “Investing In REITs.” In 2003, a handful of existing sponsors raised $7 billion through unlisted REITs, largely by offering financial advisors two or three times the commissions they could earn selling listed REITs or REIT mutual funds.

The Big Four sponsors — most notably Wells Real Estate Funds — became legendary buyers of everything from strip centers to trophy office towers in 2003. Other members of the Big Four include W.P. Carey & Co., Inland Real Estate Group and CNL Group. During the first five months of 2005, they raised $1.75 billion, or more than half of the total $2.46 billion raised by all unlisted REITs.

Their knack for raising billions in 2003 led many other sponsors to register new unlisted REITs with the Securities and Exchange Commission (SEC) the following year. Since the registration process can take anywhere from 6 to 8 months, it's no surprise that so many new unlisted REITs have hit the market since the end of 2004.

Wells alone raised $1.1 billion during the first nine months of this year. But it now appears that 2003 was a peak year. Fund-raising volume for all unlisted REITs fell to $6.3 billion in 2004 and it's tracking lower this year. Facing an investigation by the Securities and Exchange Commission (on an undisclosed area of its business), W.P. Carey has raised no money for its unlisted REITs in 2005. Curt Ritter of W.P. Carey says that the company has been investing funds rather than raising them.

What's happening? Block speculates that the market is already becoming saturated. “The financial planners have picked the low-hanging fruit, meaning the retirees and mom and pop investors,” he says. “The question is: Who will they tap next? Anyone forming an unlisted REIT now better have a very good reputation and a solid client base that hasn't been exhausted yet,” continues Block. “But those two qualities are very hard to find now.”

Opportunity knocks

That hasn't stopped new entrants from testing the waters. New Jersey-based Lightstone Group, headed by David Lichtenstein, has launched a $300 million, no front-end load unlisted REIT. Investors can purchase shares of Lightstone Value Plus REIT from financial advisors without paying an upfront sales commission. Lichtenstein says he is putting $30 million of his own money into the REIT, and he will not bank any return until his investors have earned a 7% return. Much of his $30 million — or the equivalent of a 10% load on the $300 million offering — will cover financial planners' fees.

The minimum investment in Lightstone is $1,000. He expects the Value Plus REIT to make its first acquisition later this year when it will buy either apartment, retail or office properties with value-added potential. Fund-raising is still in the embryonic stages — the REIT's total fund-raising volume as of late October was roughly $1 million.

“Our structure has the sponsor carrying the load, which makes much more sense for the investors,” says Lichtenstein. Lightstone, a private real estate firm, controls an office and retail portfolio worth roughly $3 billion. Lichtenstein says that unlisted REIT sponsors have been criticized for charging exorbitant fees — but he also believes the bad rap is well deserved. “If my investors don't make money, I don't make money. That's the way it should be,” he says.

After the REIT has bought a stable of assets, however, the sponsor will absorb both property management and acquisition fees on the back end. None will exceed 5%, while acquisition and closing cost fees will be capped at 2.75%.

Texas hold 'em

Another new unlisted REIT focusing on value-added properties is sponsored by Behringer Harvard Funds of Addison, Texas. Its $400 million Opportunity REIT, which was launched in September, plans to find value-added properties across the country and hold them for a three- to six-year period. The fund had not made its first acquisition or raised a single dollar as of late October.

“We think this is a unique approach since we are the first ones to create an opportunistic unlisted REIT,” says Jason Mattox, senior vice president at Behringer Harvard Funds. “Most of the unlisted REITs focus on core properties in major markets, and we're looking at a much more opportunistic approach.”

The strategy hinges on gobbling up office, hotel, retail, apartment and industrial properties likely to appreciate rapidly over a three to six year period, says Mattox. The new approach reflects a market reality — namely, that it's very difficult to compete successfully for stabilized assets in major markets. Apparently there is more opportunity to generate high returns by fixing underachieving properties.

Harvard Property Trust and Behringer Partners merged in 2001, forming Behringer Harvard Funds. Behringer Partners, which was founded in 1989, sponsored real estate limited partnerships and other private funds. Harvard Property Trust launched an unlisted office REIT in 1995. Its $800 million REIT I was launched in 2003 to buy office buildings in markets that included Boston and Chicago, with plans to hold the assets for roughly 8 to 12 years. REIT I raised $310 million during the first five months of this year — well ahead of the $125 million that it raised in 2004. “Nobody else is doing this right now,” Mattox says. “There's plenty of capital out there, but it's going into the stabilized assets. This will be a popular fund.”

For the investor, the price of admission is high: Like many of its peers, Behringer Harvard Opportunity REIT will absorb roughly 13% of its investor capital in the form of front-end fees, split between the sponsor and the distributors.

The come-on for ordinary investors — the minimum net worth required for investors to qualify in Behringer Harvard — they must either have $150,000 in net-worth or $40,000 in annual income. This is a chance to play the way wealthy clients do. But these clients of modest financial means also must bear in mind that the typical unlisted REIT investment offers little liquidity and even less transparency.

Another point: Unlisted REIT sponsors structure these vehicles as blind pools — meaning that sponsors haven't identified any properties to buy during the early stages of the REIT — so investors have even less certainty about the type of portfolio they are buying into. That, in turn, puts a lot of pressure on the sponsor's management team to unlock opportunities in the market. It bears an uncanny resemblance to a real estate limited partnership.

“These unlisted REITs are certainly similar to the real estate limited partnerships of the 1980s,” says Michael Frankel, who runs the Americas REIT division at Ernst & Young. “They are incredibly private vehicles with high fees and many investors.”

The credibility factor

There are similarities between unlisted REITs and real estate limited partnerships, to be sure. Some critics label outfits like Wells and Inland as limited partnerships masquerading as REITs — not something that unlisted REIT sponsors like to hear. Even so, Houston-based Hines, a well-respected institutional real estate player, launched its $2 billion unlisted REIT last year. With its 48 million sq. ft. office portfolio and reputation for classy buildings, Hines' debut as a player in the unlisted REIT market came as a surprise to many industry watchers.

“Hines is a thoroughbred in the real estate world, and they've decided to raise capital in the unlisted REIT market,” says Frankel, who considers Hines to be one of the shrewdest real estate development and investment companies in the nation.

Charles Hazen, president and COO at Hines REIT, says that the negative publicity surrounding unlisted REITs is of great concern and acknowledges that it's a difficult time to enter the market given the number of players. “But if the business is operated the right way, these types of investments can provide retail investors a good way to invest in real estate without being subject to stock market volatility,” he says reassuringly.

The Hines REIT charges up-front fees as high as 10%. “In structuring our product, we were very focused on lowering the front-end sales load from that historically charged in the marketplace,” Hazen says. The Wells REIT I, which predates any other Big Four-sponsored REIT, charged front-end fees as high as 16%.

Hazen is aware that the Big Four sponsors carry much weight yet he's encouraged by the shifting landscape that's led to the emergence of more players. “We can't predict the future, but our intentions are to continue raising capital and increasing our market share,” says Hazen.

The Southern giant

Atlanta-based Wells Real Estate Funds, which launched its first unlisted REIT in 1998, has long been the market leader. In 2003, Wells led in total acquisitions, spending $2.3 billion to snap up dozens of properties, including Chicago's Aon Center for $465 million, Chicago's second largest office building with 2.7 million sq. ft. of leasable space. The all-cash deal capped a stellar fund-raising stretch for the REIT, which brought in $2.5 billion through the first five months of 2003 alone.

In April, Wells sold off $760 million in assets, its first major portfolio sale after years of acquisitions. Despite this large disposition, Wells Real Estate Funds' chief real estate officer Don Miller says that acquisitions remain a priority. Wells raised $1.1 billion during the first nine months of this year, according to Miller. He admits that a deep war chest is required to buy anything these days given the run-up in prices.

“It's very competitive out there, and we are also aware that there are many new players looking to buy properties in this market,” says Miller. In response to this added competition, Miller says that front-end fees on Wells REIT II (which was launched in 2003) are only 10%.

That REIT raised $666 million through the first six months of 2005, putting it on track to exceed $1 billion by the end of December.

Wells, which must choose in 2008 to list or liquidate REIT I, has until 2015 to make that judgement on REIT II. Founder Leo Wells abhors debt and only carries $1.3 billion in total debt on both REITs. The question for sponsors like Wells, however, is how much longer until the volatile stock market calms down — and, if that happens, will it be a time of reckoning for vehicles that sell against it?

“People refer to our product as a trade-off between liquidity and volatility,” says Miller, who adds that buying shares of listed REITs these days means paying a premium.

Analysts do believe that many listed REITs are trading at a premium to their net asset value (NAV) given strong investor demand that has kicked up shares. “The value of the public market is interesting,” he says, “but our investors want something different.”

But with the unlisted REIT market only a few years old, it may be too premature to gauge investor satisfaction. What could change that is a massive liquidity event wherein thousands of panicked investors decide to get their capital back from sponsors.

To Frankel of Ernst & Young, that will be the ultimate test of these vehicles. “A liquidity event would tell the real tale here,” says Frankel. “Whether or not these shares are good buys really remains to be seen.”

Parke M. Chapman is senior editor of NREI

Sponsors take heat over fees

Critics routinely blast unlisted REITs as poor investments, citing illiquid shares and exorbitant fees as chief culprits. Yet the REIT sponsors disclose in their offering materials that only long-term investors need apply. They promote this approach as a selling point, arguing that fixed-price shares cannot lose value. But by the same token, these share prices can't rise either.

Then there's the fee structure. Most unlisted REIT sponsors extract selling commissions, dealer manager fees, and offering expenses from their investor capital. These fees can add up to as much as 17% of an investor's basis in the REIT. The Wells REIT I, for example, consumed nearly 13% of its investor capital this way — and that was before asset management and disposition fees were extracted.

Starting in 2002, Wells REIT I raised $3 billion from more than 130,000 retail investors. Wells Investment Securities and Wells Capital — the external advisers to the REIT — devoured roughly $375 million of that offering.

“What you have here is a philosophical problem,” says Ralph Block, author of “Investing In REITs.” “Are the financial planners explicitly offering their clients the pros and cons of buying listed versus unlisted REITs?”

Rather than strongly regulating the unlisted REIT sponsors, Block believes more attention should be paid to the cadres of financial planners that market these shares. He believes this free-market approach makes far more sense than cracking down on the sponsors.

Says Block: “Investors need as many options as possible, and I'm all for that. But they need to know what those options are, too.”
— Parke M. Chapman