Finra Steps Up Probe of Nonlisted REIT Sales Amid Complaints on Disclosure

Photographer: Ryan Anson/Bloomberg

Larry Lipman, 49, of Davis, California, invested in the Behringer Harvard REIT starting in 2005. Close

Larry Lipman, 49, of Davis, California, invested in the Behringer Harvard REIT starting in 2005.

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Photographer: Ryan Anson/Bloomberg

Larry Lipman, 49, of Davis, California, invested in the Behringer Harvard REIT starting in 2005.

The broker’s pitch was appealing: Inland Western Retail Real Estate Trust Inc. would pay steady dividends and the stock price wouldn’t fluctuate with the market. In 2004, Robert and Davida Wendorf invested $100,000.

Last year, the real estate investment trust, which isn’t listed on an exchange, slashed its payout by 70 percent. It had earlier suspended a program under which the Wendorfs could have sold back shares at the same $10 apiece they paid, a key draw for the couple. By the end of 2009, the company had reset the stock price to $6.85.

“You can say I was stupid,” said Robert Wendorf, 69, a retired psychotherapist in San Juan Capistrano, California, who eventually sold Inland Western at a $45,000 loss. “In all honesty you don’t think people sit down and really read all of those papers? Most people do what I did. They trust the guy as he points where to sign.”

Regulators are examining brokers who sell unlisted REITs, which have raised $59 billion since 2000, as investors such as the Wendorfs complain they weren’t properly informed of the risks. The Financial Industry Regulatory Authority has stepped up its scrutiny by opening formal investigations into “marketing, advertising, disclosure, suitability analyses and more,” according to an e-mailed statement.

Finra started the probes after sending letters in March 2009 seeking information from the 10 to 20 most-active brokers in the market, a person with knowledge of the matter said at the time. The initial inquiry was meant to determine whether the firms weighed and disclosed risks to clients, the person said. Herb Perone, a Finra spokesman in Washington, declined to identify the brokerages.

Finra Focus

Finra is likely focusing on “whether the sales were suitable and whether the firms made misleading statements about fees, dividends and liquidity,” said Brian Rubin, a partner in the Washington office of Sutherland Asbill & Brennan LLP, which is representing two broker-dealers being investigated.

Rubin, former deputy chief counsel in the enforcement department at the National Association of Securities Dealers, Finra’s predecessor organization, declined to identify his clients. He said the firms were asked by Finra a few months ago to produce additional documentation and data.

Fees, Conflicts

Nontraded REITs tend to attract unsophisticated investors who don’t understand the extent of the risks, said Michael Knott, a senior analyst at Green Street Advisors Inc., a real estate research firm in Newport Beach, California. These include the lack of share trading; fees that eat into returns; potential conflicts of interest between investors and REIT managers; and dividends that may be paid with cash from new investors or debt rather than operating income.

“I understand how people who lost money in the current downturn could be upset, but all investors lost money,” said Daniel L. Goodwin, chairman and chief executive officer of Inland Real Estate Group of Companies Inc., the Oak Brook, Illinois-based company that sponsored Inland Western.

“The question is, was anything inappropriate done? The standard operating procedure is that the investor is given the prospectus and must sign a statement saying they read the prospectus,” which says in several places that the investment is illiquid, Goodwin said in an interview. “There is no guarantee that you will get your money back.”

Shareholders must also sign a separate list of risks, he said.

Elderly Clients

Investors are filing broker-arbitration claims with Finra after being surprised by share devaluations, dividend cuts and the suspension of buyback programs, said Andrew Stoltmann, a Chicago attorney who has taken on 10 cases in the past six months, including one by the Wendorfs.

“We are seeing a huge concentration of elderly clients’ portfolios jammed into nontraded REITs,” said Stoltmann, who worked as a Merrill Lynch & Co. financial adviser before going to law school. “There are fraudulent representations made that these things are low risk. Some of the brokers are selling these things as an alternative to a certificate of deposit.”

While disclosing risk is necessary, it’s difficult to discuss complicated fee structures with investors “without completely frustrating and confusing them,” said John Rooney, who runs the West Coast operations of Commonwealth Financial Network, an independent broker-dealer in Waltham, Massachusetts.

“Do I think a retail investor has the enthusiasm and capacity to understand them?” he said. “No. That’s why they hire a financial adviser.”

Upfront Costs

Nonlisted REITs, like their better-known publicly traded counterparts, are designed to allow retail investors to buy stakes in large commercial buildings they couldn’t otherwise afford. They are managed by a founding sponsor, which earns fees for services such as overseeing properties and making acquisitions.

The REITS raise money for purchases by selling shares through brokers, who collect commissions of 6 percent to 7 percent. The charges, along with other upfront costs, take 10 percent to 15 percent of the investor’s outlay.

Shares are sold at $10 apiece, an arbitrary price that doesn’t change unless the REIT determines they should be revalued. Companies generally offer to repurchase a limited amount of stock at a specified price, usually after a one-year holding period. Otherwise, investors can exit only when the REIT lists its shares, sells or merges, or if they can find a buyer privately.

Dividend Yields

Investors like that share prices aren’t whipsawed by the market and dividends can exceed those on money-market funds, bank CDs and public REITs. The average payout rate for unlisted REITs was 6.5 percent as of the fourth quarter, compared with 4.5 percent for public trusts, according to Blue Vault Partners LLC, an Atlanta-based researcher that sells data to financial advisers, brokers and sponsors.

Nontraded REITs were among the most active buyers in the commercial real estate market last year. Five of the top 10 REIT operators ranked by acquisitions were unlisted, including Inland Real Estate Group, which was second at $863 million, according to researcher Real Capital Analytics Inc. of New York. The biggest purchaser was a publicly traded REIT, Kimco Realty Corp. of New Hyde Park, New York, with $910 million.

Dividend Cuts

Inland Western and Behringer Harvard REIT I Inc. were among unlisted REITs that responded to lower occupancy rates, falling rents and tight credit by reducing dividends. Eleven firms, including Cole Credit Property Trust II Inc., Hines Real Estate Investment Trust Inc. and Wells Real Estate Investment Trust II Inc., suspended or limited redemptions this year and last, Blue Vault said. Some investors were rattled by offers from third- party firms such as CMG Partners LLC in Seattle to buy nonlisted REIT shares for as little $2 each.

“It has probably opened the eyes of people who hold current investments,” Knott, the Green Street analyst, said of the impact of the real estate crisis.

In November, the board of the pension fund for municipal employees in West Warwick, Rhode Island, voted to put $3 million, or about 10 percent of assets, into shares of Cole Credit Property Trust III, which raised an industry-best $969 million last year.

“We have rarely, if ever, seen a potential investment that is more inappropriate for an institution than this one,” U.K.- based P-Solve Asset Solutions, the adviser to the Town of West Warwick Pension Board since 2006, wrote in an Oct. 5 memorandum.

‘Lots of Money’

The adviser, which resigned after the purchase was approved, said fees of about 13 percent were “astronomical” and investors’ interests weren’t fully aligned with Cole’s because the REIT manager is paid for each property transaction.

“Cole make lots of money whether or not investors do well,” according to the memo.

Paul P. Caianiello Sr., a member of the West Warwick pension board and a retired government auditor, said an investment with a steady income was appealing after the fund lost 14.5 percent in the year ended last June.

“We wanted to diversify,” Caianiello said.

The board on May 10 accepted an offer from Cole to return the investment after the town began an investigation.

Nontraded REITs should be part of a diversified portfolio and are closer to a direct investment in the real estate than buying public shares, said Rick Lavin, executive vice president and general counsel for Phoenix-based Cole Real Estate Investments, which manages the Cole trust.

Cole Is Baffled

Lavin said questions about conflicts arising from the role of outside managers were “baffling,” comparing the arrangement to that of a mutual fund, which has an external adviser whose compensation is determined by an independent board. Costs to shareholders of setting up an unlisted company and ongoing management expenses are probably similar to those at public REITs, he said.

Returns on nonlisted real estate investment trusts are harder to analyze than on publicly traded REITs, according to Chris Germain, president of Piping Rock Partners in San Francisco and publisher of REITWrecks, a blog that writes about the securities.

They are a “financial jack-in-the-box” because investors don’t know how much they’re worth until the company decides to list or sell its assets, said Germain. The stable share price and regular dividends lull investors into a sense of safety, he said.

Reassessing Share Price

Unlike their public counterparts, unlisted REITs have a finite life, usually not longer than 10 years, after which they are supposed to distribute proceeds of their investments. Most nontraded REITs haven’t fully paid off shareholders or been acquired, Blue Vault said.

Finra told firms in February 2009 that they must reassess share prices within 18 months of closing to new shareholders. A handful of companies, including Inland Western and Behringer Harvard Opportunity REIT I Inc., lowered the value of their shares. A few, including two W.P. Carey & Co.-managed firms that have portfolios that predate the boom, increased them.

“These shares are being sold at a price that does not reflect the value of the properties or the quality of the portfolio,” Germain said.

Fantasy Value

Behringer Harvard REIT I, which raised $2.9 billion from its 2003 launch through the end of its final offering period in December 2008, reduced its share value as of May 17 to $4.25 and cut its annualized dividend rate to 1 percent, according to a regulatory filing. Larry Lipman, a 49-year-old resident of Davis, California, who bought $100,000 of the trust starting in 2005, said the revaluation was “crushing.”

Lipman said he would never have bought the shares if his financial adviser had explained that the companies weren’t listed. “Shareholder value of a private fund is based on fantasy,” he said.

“We do not have knowledge as to an individual investor’s communication with his financial adviser,” Jason Mattox, chief administrative officer at Addison, Texas-based Behringer Harvard said in an e-mailed statement.

“While unfortunate, we believe modifications to the redemption programs associated with our illiquid real estate investment programs have benefited all shareholders and have been appropriate given the depth of the recession, its impact on the commercial real estate marketplace and the many critical uses for capital,” he said.

Funding Dividends

Unlisted REIT dividends are sometimes funded by returning shareholders’ money rather than cash flow from operations, Knott said. The practice is common for new issues because they make the payments even as they’re buying their first properties and incurring acquisition costs.

The dividends are “gimmicky and can have a Ponzi flavor because payouts are discretionary,” Knott wrote in a Jan. 29 report. “It is easy to ‘overpay’ the dividend to sport a higher yield.” Knott did not identify particular REITs.

The median payout ratio for nontraded REITs in 2009 was 136 percent, meaning the companies’ distributions exceeded their funds from operations, a measure of cash flow used by REITs, according to Blue Vault. Of the 36 REITs that paid distributions in 2009, 12 could not be included in the calculation because FFO was negative. Five companies earned more than they paid out, according to the consultant.

Inland Western Changes

The average payout ratio for publicly traded REITs in 2009 was 64 percent, according to data compiled by the National Association of Real Estate Investment Trusts, which is largely made up of listed companies.

Inland Western, facing $1 billion of maturing debt last year, cut its dividend and said in a Dec. 1 shareholder letter that cash flow would no longer be directed entirely to distributions and would also be used to pay down debt. Inland Western became a separate self-managed company in late 2007.

“Others have kept their dividends up there and are subsidizing them by using offering proceeds,” Inland Real Estate Group’s Goodwin said. “Ultimately, the net worth of the company goes down and the value of the stock goes down if you do that.”

Inland Real Estate doesn’t take fees for arranging acquisitions, as other REIT sponsors do, and its latest trust won’t use offering proceeds to pay dividends, Goodwin said.

Some REITs are getting into trouble because falling property values have resulted in greater leverage ratios, said Mark Swenson, president of CMG Partners, the Seattle real estate firm that started contacting unlisted REIT investors to buy their shares about 18 months ago as companies began cutting dividends and curtailing redemption programs.

Response Rate

The company gets responses from about 1 percent of shareholders who need to sell because of a divorce, a death or illness, he said. Swenson, who is offering $2 a share for Inland Western, said companies are reluctant to reset their shares to more realistic values.

“On the one hand they need those numbers to come down to reality,” he said. “On the other hand, they have a massive fundraising machine and those things are in conflict with one another.”

The Wendorfs six weeks ago unloaded their Inland Western shares in a private sale and collected about $55,000 after fees for an investment that would have been worth about $134,000 including reinvested dividends in the first quarter of 2009.

The couple filed a Finra arbitration claim in September against their broker-dealer for putting them in about $575,000 investments they now say are inappropriate. Robert Wendorf said they lost about $250,000 in the technology bubble and asked the broker to put them in conservative investments.

To contact the reporter on this story: Prashant Gopal in New York at pgopal2@bloomberg.net.

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