Investors are pouring funds into unlisted real estate investment trusts (REITs) at an unprecedented pace, fueling an acquisitions binge that shows no signs of decelerating. Wells Real Estate Funds, which sponsors an unlisted REIT, was the largest buyer of Class-A office buildings in the nation last year with more than $1.4 billion in acquisitions. The only listed REIT to come close to that number was Boston Properties, which spent $1.06 billion on acquisitions last year. This year, Wells is looking to acquire $2.5 billion worth of new properties.

Critics of unlisted REITs — often confused with private REITs — say they are expensive, illiquid investments that offer little disclosure to the investor. And many of these REITs are being inundated with funds, prompting critics to wonder if they are overpaying for properties in their frenzied efforts to deploy capital.

Proponents, however, say that unlisted REITs have advantages. They are insulated from the public market's volatile swings, for example, and are perfect for institutions and private investors with a long-term investment horizon, they say.

Unlisted REITs such as Wells issue shares at $10 a piece, a fixed price that does not fluctuate because their shares are not traded on an exchange. Wells is not obligated to repurchase shares at that value, or at all.

No Liquidity

“Investors really have to decide about liquidity. These private REITs just keep issuing shares at the same price when it's impossible that the shares have remained the same value,” says Doug Poutasse, chief investment strategist at Boston-based AEW Capital, a pension fund advisor. “There is no liquidity here.”

The four leading unlisted REIT sponsors are Wells, W.P. Carey, CNL Real Estate Advisors and Inland Real Estate, each offering current yields of 6% to 8%. These four REITs raised 175% more investor capital last year than they did in 2001, according to Spencer Jeffries, editor of “The Partnership Spectrum,” a newsletter that tracks limited partnerships. These REITs are public to the extent that they are all registered with the Securities & Exchange Commission (SEC) and file quarterly reports.

Wells, which created its REIT in 1998, is perhaps the most high profile of the bunch. By last year, with demand for real estate investments high, the office and industrial property owner was raising more than $100 million a month through financial advisors.

Wells' acquisitions tear has not slowed this year. The company, which says it has a simple strategy to buy and hold Class-A office and industrial properties with credit tenants on long-term leases, recently snapped up the nation's third largest office building. In May, Wells paid $465 million for Chicago's 2.7 million sq. ft., 80-story Aon Center. Unlike other Wells properties, which are net-leased to single tenants, the Aon Center includes a 600,000 sq. ft. chunk for BP, which is up for renewal in a few years.

While the new Aon deal is a slight departure from Wells' strategy, it is regarded as a solid investment. “This was a pretty good buy for that price, and the fact that it's multi-tenant is a positive given what happened to anchor tenants like Enron and WorldCom recently,” says Brian Nagle, executive director at Cushman & Wakefield.

Still, the number of Class-A buildings that meet Wells' criteria is limited. Wells' $2 billion office and industrial portfolio, already has about 120 office tenants scattered throughout more than 75 properties nationwide.

And its appetite is growing. The Aon Center purchase followed several major acquisitions in April, among them the purchase of the U.S. Bancorp Center in Minneapolis from Equity Office Properties Trust for $174 million. And fundraising is running ahead of last year's rate. By mid-May, Wells raised $670 million. It's goal is to raise and deploy $2.5 billion by the end of this year.

Wells is the beneficiary of a trend that favors all REITs. Real estate is still seen as a safer bet than stocks, so plenty of new investors have rushed into the REIT sphere. Unlisted REITs such as Wells have aggressively targeted investors who are still wary of putting money into stocks, even those of REITs. To such an investor, all REITs may seem the same. A closer look at the REIT model, however, reveals that the fundamental differences between listed and unlisted REITs are substantial.

Listed REITs are priced daily on an exchange, allowing shareholders to gauge the value of their shares anytime. Not so with unlisted REITs, which commonly issue shares at a set amount. Then there is the thorny liquidity issue — cashing out of an unlisted REIT investment such as Wells isn't that easy. There is always a market for exchange-listed shares.

Why investor dollars are flocking to unlisted rather than traded REITs is a matter of debate. Is it purely marketing that's driving this expansion? Are shares of these REITs sold rather than bought? Marketing is indeed vital to the fund-raising efforts of unlisted REITs, and industry watchers cite Wells' aggressive marketing.

The Wells Machine

Wells says it is attracting money because its investments are safe and less volatile. The company says it reduces risk by diversifying its portfolio both geographically and by type of tenant. In addition, leases are staggered so that a series of expirations won't decimate occupancy all at once.

There are now more than 65,000 investors in the Wells REIT, with the average stake around $25,000 per investor. The minimum initial investment in the Wells REIT is $1,000.

Most of the properties that Wells buys are single-tenant assets. This is a sound tactic assuming that the tenants' credit never gets sticky. But if a tenant does have problems it can empty the building.

Wells claims that in exchange for this stable pool of tenants, investors should be willing to pay a premium.

Wells gets it in the form of a 16% front-end fee from investors. So for every dollar invested in the REIT, only 84 cents go into the investment.

One selling point that Wells drives home to investors is that there is virtually no risk of default. Wells structures all-cash deals, so there are no lenders to take over a property if a sudden vacancy hike hits the portfolio.

David Steinwedell, Wells' chief investment officer, says that investors are willing to pay hefty fees for a piece of his REIT because it is insulated from the gut-wrenching swings of the public market and owns its buildings free and clear. “Our investors really like a load combined with a no-debt scenario,” says Steinwedell.

Last September, however Wells cut its dividend to 7% from 7.75%. The cut came at a time when Wells was raising money faster than properties could be acquired. Wells was forced to pay out more cash than it was generating to cover its 7.75% dividend. Jeffries of Partnership Spectrum adds that Wells' $40.8 million worth of dividend payouts during the first half of 2002 exceeded its adjusted funds from operations (FFO) for those six months by $4.8 million.

Founder Leo Wells III attributed the dividend cut to a slew of corporate accounting scandals such as Enron and WorldCom, which prompted his REIT to raise its credit standards for tenants. Wells has said publicly that he preferred to cut the REIT's dividend back as a way to make quality, prudent acquisitions involving high-credit tenants, rather than race to buy properties as a way to keep up with the funds rolling in.

It doesn't appear that Wells slowed down at all following the dividend cut, though. For the month of September 2002, the REIT acquired more than $275 million worth of real estate.

Under the Wells REIT's articles of incorporation, the REIT must sell its assets and return the net proceeds to shareholders if shares have not been listed on a national securities exchange or over-the-counter market by Jan. 30, 2008.

List or Liquidate

These so-called “list or liquidate” provisions are common to unlisted REITs. While W.P. Carey has taken 10 public programs from start to liquidation and Inland has liquidated a total of four, Wells and CNL have yet to liquidate any of their public programs. In W.P Carey's case, the firm took its first nine REITs public as a limited liability corporation five years ago. Investors generated a total yield of nearly 12% on this conversion.

Wells, like other unlisted REITs, offers limited redemption rights to shareholders seeking liquidity before the stated “list or liquidate” deadline. Steinwedell says Wells only offers “hardship” redemption opportunities to shareholders who need to liquidate because of an emergency.

“It's a long-term investment with Wells. The investor knows that he gets a really good dividend, but it's not that liquid,” says Steinwedell.

Redemption rights commonly require that shares be owned for a minimum period of time, with the redemption price based upon a pre-set formula.

Inland Retail REIT shareholders are allowed to sell shares back to the company at $9.50 per share this year, $9.75 per share next year and $10 per share from 2005 though 2007. One share of Inland Retail REIT costs $10.

The Infamous RELP

Wells Real Estate Funds grew out of the mid-1980s limited partnership era, and the firm still sponsors several real estate limited partnerships (RELPs). One REIT watcher views the flood of capital into the unlisted sector as eerily reminiscent of the limited partnership days of the 1980s. Unlike the many RELPs that collapsed, Wells was able to keep its partnerships alive through the 1990s, largely due to its low-leverage focus.

“By and large, these private REITs are really just real estate limited partnerships in a REIT wrapper,” says Barry Vinocur, chief executive of Rainmaker Media Group, publisher of both “Realty Stock Review” and “Property Magazine.”

RELPs have a decidedly checkered past. During the 1980s, RELPs were created to deliver huge up-front tax write-offs — but many were hardly solid real estate investments. Then, in 1986, Congress put an end to the generous tax benefits. Investors stopped flooding RELPs with capital, and property prices subsequently collapsed.

“The whole structure of these limited partnerships was flawed. There was really no liquidity there,” says Ralph Block, chief REIT portfolio manager at San Francisco-based Bay Isle Financial Corp. and author of the book “Investing In REITs.”

Still, the mid-to-late 1980s real estate market was far different than it is today. Overbuilding and irresponsible lending ruled the day back then. Yet a handful of RELP operators survived through the next decade and emerged as REITs.

20/20 Hindsight

The real estate limited partnership debacle of the 1980s soured many investors on the real estate business. As Vinocur of “Realty Trust Review” points out, many people still unfairly regard all real estate executives as unsavory based on what transpired back then.

“This industry worked very hard to get itself out of the hole it dug for itself in the 1980s,” says John Kramer, president of Kensington Investment Group, a San Francisco-based real estate investment advisor. “We feel that a high-profile syndicator blow-up could set us back.”

Wells, which had no RELP failures back then, says it won't be the one to give unlisted REITs a bad name — if that happens. In the meantime, Wells will continue to do what it does best: raise money — and shop.

Nestle USA

Glendale, Calif.
Seller: Douglas Emmett
Vacancy Rate: 0%
Sale Price: $157 million
Total SF: 505,115 sq. ft.
Acquired: December 2002

AON Center

Chicago, Ill.
Seller: Blackstone Group
Vacancy Rate: 7%
Sale Price: $465 million
Total SF: 2.7 million sq. ft.
Acquired: May 2003

Independence Square I & II

Washington, D.C.
Sale Price: $345 million
Seller: Boston Properties
Total SF: 948,000 sq. ft.
Vacancy Rate: 0.2%
Acquired: November 2002