Sick of Being at the Market's Mercy?

Private real estate trusts and partnerships may be smart plays for the long term

Real estate is hot; the stock market's not. Besides owning a home and perhaps a vacation property, what other ways are there to play the boom? Real estate investment trusts (REITs), which own diversified portfolios of properties, don't get you entirely free of the stock market. Most REIT shares trade on stock exchanges, so they are subject to the stock market's whims.

Perhaps you should consider real estate limited partnerships (RELPs) and private REITs. Like public REITs, both investment vehicles own diversified portfolios of real estate and pay out most of their rental income in the form of dividends. Like a mutual fund, these products also issue shares, but their value changes only once or twice a year, when the real estate in the portfolio is appraised. That appraisal value, unlike with publicly traded REITs, is the share price.

RELPs, the older of the two, have a checkered history. They were popular in the 1970s and early '80s, when real estate boomed and the partnerships were designed to deliver big up-front tax write-offs rather than sound real estate investments. Then, in 1986, Congress ended the generous tax benefits and therefore the market for RELPs. Without new investment dollars, prices of existing properties collapsed, too.

Only a few partnership operators from that era remain in business. Among them are Wells Real Estate Funds, W.P. Carey, CNL Real Estate Advisors, and Inland Real Estate. Business for those survivors has picked up sharply during the past few years. New money invested in private REITs and RELPs grew about 60% in 2001, to $1.6 billion, and has been increasing at a rate of 10% a month in 2002--to $1.8 billion of new money through July. About 90% of that has gone to these four firms. The partnerships are sold mainly through independent financial planners who receive commissions of up to 10% for each sale, though brokerage firms A.G. Edwards and UBS PaineWebber are selling private REITs through their brokers.

Today's RELPs and private REITs, while sheltering some of their income from taxes, are designed mainly to deliver income and capital appreciation. "Most of these products offer a current yield of 6% to 8%," says Robert A. Stanger, publisher of The Stanger Report, a real estate partnership newsletter. "That's very attractive when Treasury bills are yielding 1.6%." The reliability of those dividends is also appealing. "We've paid 624 dividends in our 30-year history and have never missed a single one," says William Polk Carey, chairman and CEO of New York-based W.P. Carey. "And 85% of those payouts have been increases." Only 2% of those payouts have been decreases.

Carey's firm operates a RELP called W.P. Carey (WPC) that it took public in 1998 after nearly two decades as a private partnership. In its private years, Carey provided an 11.5% average annualized total return, which includes reinvestment of dividends. As a publicly traded company, it has returned 12.8% per year to investors. Carey says he took the partnership public to create a liquid market for investors who wanted to cash out. With private RELPs, those who want to sell usually can only do so by accepting a price that's often at a steep discount to the underlying real estate value.

Carey still runs five private REITs. Only one, Corporate Property Associates 15 (CPA:15), is open to new investors. It yields 6.1%, though that should increase when the remaining cash is put to work. This REIT invests in single-tenant corporate facilities, typically office buildings, warehouses, and manufacturing plants. Most recently, the REIT acquired seven Midwestern plants leased by Tower Automotive, a global manufacturer of auto parts. In the past, the firm has leased property to Best Buy, Federal Express, and PETsMART.

The private REIT offers more liquidity than a standard RELP, but, of course, not as much as a public company. Carey has designed CPA:15 so that a small portion of the REIT's income is set aside to cover redemptions. After they've held ownership for one year, investors have an opportunity to cash out four times a year.

What sellers get is the 90% of the underlying value of their property. (After three years of ownership, they get 93%.) Such redemptions are subject to the approval of the fund's board of directors, which may restrict them if too many people are rushing for the exits at once. Wells Real Estate Funds also offers a private REIT. Wells Real Estate Investment Trust, which currently yields 7.8%, allows investors to redeem shares once per quarter, and they get 100% of the appraised value of their holdings. As with Carey, the directors can put redemptions on hold.

In contrast, RELPs usually offer no redemptions. Investors don't get their money out until the partnership liquidates or goes public, which typically doesn't happen for 10 to 15 years. In a liquidation, investors should get their initial investment back plus a percentage--typically 80% to 90%--of any appreciation in property value. (The sponsors, who are the general partners, usually keep 10% to 20% of the appreciation.)

Most RELP managers will not liquidate unless they know they can do so profitably. Otherwise, they prefer to hold the properties until the real estate market rebounds. Investors who want out prior to that can sell their partnership units at exchanges such as the American Partnership Board, but they may be fortunate to get 75% of the value of the partnership, says Stanger.

It's no wonder, then, that private REITs are becoming more popular than the partnerships. "We're raising more than $100 million a month in new investor money in the REIT product," says Leo Wells, president of Wells Real Estate. Private REITs are also easier to convert into public companies because their tax structure is less complicated than partnerships, and Wall Street is more welcoming of REITs in general. Wells's REITs must, according to its prospectus, either list their shares on an exchange by 2008 or liquidate.

If you have a long time horizon, though, there are advantages to a RELP over a private REIT. For one, RELPs tend to have higher yields. Wells's older partnerships, closed to new investors, currently pay out yields in excess of 9%. That's higher than the 6.6% paid currently by public REITs. His latest RELP, Wells Real Estate Fund XIII, which is open, pays 6.6%. Wells says that's because it still hasn't invested all of its cash. When fully invested, he says, it's expected to yield about 8.5%.

The reason Wells's RELPs have higher yields than public REITs is their unusual financial structure. The RELP has two classes of investments, cash-preferred and tax-preferred. This allows some investors to choose to receive income, while others get the depreciation write-off from the properties (table). Both REITs and RELPs offer investors tax benefits by passing on the depreciation costs of their property to shareholders as a tax write-off. As a result, about 30% of the income that an average REIT, public or private, distributes is non-taxable. With a RELP, the depreciation write-off counts as a passive loss of income while the shareholder owns the RELP, which cannot be used to reduce ordinary income. Once the investor sells his shares or the RELP liquidates, the loss becomes an ordinary loss.

Wells's clients who hold their units in retirement accounts can't make use of write-offs. They just want income. "The advantages of this two-share-class partnership is that you can have a disproportionate allocation of income and tax losses," says Wells. "I give all of the income without the depreciation losses to the 80% of my clients in tax-protected accounts. Meanwhile, all of the tax benefits go to the remaining clients, who want a tax benefit." That shift amplifies the yield delivered to cash-preferred accounts by about two percentage points, Wells says. Tax-preferred investors benefit through bigger write-offs.

Another way to boost yield is through leverage--borrowing money to purchase properties and increase the dividends. Both public and private REITs and RELPs do this to varying degrees, and there are risks. Just as leverage can amplify gains, it can exacerbate losses. If a major tenant goes bankrupt, landlords need to scramble to make the interest payments on the debt. For this reason, Wells uses no leverage. W.P. Carey, on the other hand, often borrows as much as 60% of the value of a property. But the firm uses "nonrecourse debt," which allows the lender to claim only the property of a bankrupt company as collateral, leaving the assets of the REIT untouched.

RELPs and private REITs charge high commissions and fees. To get into Wells Real Estate Fund XIII, you have to pay a 7% broker commission if you pony up the minimum $1,000 investment. The rate drops to 5% for investors putting in at least $250,000 and 3% for those who go over $1 million. As is often the case, the fees are negotiable at the discretion of the broker.

And those charges only get you in the door. Wells takes an additional 7% from each dollar raised to cover acquisition expenses involved in buying properties. W.P. Carey's brokerage commissions and acquisition costs for CPA:15 total about 13%--not much better. Despite these costs, the partnerships are designed so that the yield you receive is based on your entire investment, not just the net investment after fees. But every RELP or private REIT is unique as far as commission, liquidity, and dividend policy go, so read the fine print carefully. The last thing you want is to get locked into an unsuitable investment.

That said, these products can be a good choice for long-term investors--think at least 10 years. They're also attractive if you like the idea of owning something whose value doesn't bounce up and down every day.

By Lewis Braham

Before it's here, it's on the Bloomberg Terminal.