Unlisted REITs turned heads in 2003 after sponsors raised $7 billion from retail investors. Since 2003, however, average fundraising volume has fallen by roughly $300 million each year — and it’s unlikely that the 2006 take will register anywhere near $7 billion. Three culprits are rising interest rates, increased competition for funds and limited distribution channels, which have made it harder for unlisted REIT sponsors to raise cash.

“We feel that the capital flows into unlisted REITs will be down over the next few years,” says Charles Hazen, president and COO of the two-year-old Hines REIT, a $2 billion unlisted fund.

Despite these obstacles, institutional-savvy outfits like Hines and others have tapped the unlisted REIT market as a way to diversify across capital sources. If their forays into the unlisted REIT market are any indication, more established sponsors could be waiting in the wings, too.

Hazen was one of five unlisted REIT executives featured on a panel at yesterday’s third annual East Coast Non-Traded & Private REIT Industry conference, sponsored by IMN. According to Hazen, who is also president of Hines’ U.S. Core Fund (an institutional fund that acquires core quality office properties across the nation), the Hines REIT was established to reach a broader capital base—namely, retail investors with a minimum net worth of $200,000. But limited upside on the pension fund side of the aisle was also a consideration.

“We really got into this business because we see little growth in defined benefit plans over the next 10 to 20 years, so the idea was to diversify our capital sources,” says Hazen, referring to parent company Hines’ heavy involvement with institutional investors.

Unlisted REITs raise money through financial planners and other advisors who market to retail investors — in many cases, retirees seeking steady dividends. Critics, many of whom advocate listed REITs, have blasted unlisted REIT sponsors as being solely interested in raising funds and charging steep front- and back-end fees to investors. The same critics also believe that these exorbitant fees weigh down returns and enrich sponsors regardless of the REITs performance.

Panelist James Worms, president and CEO of Paladin Realty Income Properties, says his company launched its $2.6 billion unlisted REIT in 2003 to attract new investors, as Hines did. Parent company Paladin Realty Partners manages more than $1.5 billion in institutional real estate — much of it on behalf of U.S. pension funds.

“We’ve been in the investment management business for more than a decade, so the idea was never to just raise money and buy or sell properties to an affiliate,” says Worms.

Still, Worms believes that unlisted REITs such as Paladin could raise more funds if established firms like Merrill Lynch and Morgan Stanley begin marketing their shares. Until that happens, he believes it will be difficult to get adequate “shelf space” to reach a broad investor audience. There is clearly room to grow. According to panelist Frank McCarthy, vice president and general manager of Ameriprise Financial Services’ external products group, only 5% of the so-called “mass affluent” (anyone with a net worth of $150,000 to $1 million) owns unlisted REIT shares.

So why haven’t the distribution channels opened up more? Panelist David Lichtenstein, chairman of the $300 million Lightstone Value Plus REIT, has this response: “Most unlisted REITs are more about selling the sizzle than the steak. They are better at marketing their shares than running a real estate portfolio,” says Lichtenstein, who launched his no-load, unlisted REIT in 2005.

Style over substance is one thing, but Worms of Paladin offered another reason why established wirehouses might not jump want to sell unlisted REIT shares: “It’s the absence of liquidity that explains why they won’t sell these shares.”

Parting Shot: Compared to public (listed) REITs, shares of non-listed REITs offer higher dividend yields. But there is a catch, according to IMN panelist Spencer Jeffries: “Unlisted REITs pay out a much higher percentage of their operating cash flow relative to traded REITs,” says Jeffries, president and founder of limited partnership and unlisted REIT research firm Partnership Profiles, Inc. Analysts typically flag REITs that use excessive amounts of operating cash flow to cover their dividends, not that it’s uncommon. Some REITs (listed and non-) actually borrow money to pay out their dividend. This is generally regarded as an unhealthy practice, since analysts would prefer to see a REIT cover its dividend with earnings as opposed to debt.

“While traded REITs often have payout ratios of 50% to 70%, most non-listed REITs distribute at least 90% of cash flow,” says Jeffries. “For newer non-listed REITs, this payout ration sometimes exceeds 100%.”

The average non-listed REIT dividend yield is currently 6.35%, according to Jeffries. By comparison, the NAREIT Equity REIT index through the end of March was only 4.06%.