Getting A Slice Of The Commercial Market

Unusual property plays may look promising, but beware the high fees and lack of liquidity

The boom in commercial real estate has stirred interest in some unconventional plays. Two of them are untraded real estate investment trusts and tenant-in-common deals. Together last year they scooped up around $14 billion worth of assets. The pitches are enticing: Untraded REITs promise stable valuation, while TIC sponsors offer a tax shelter for capital gains. But is either right for you? Fees are high, and it's easier to get in than out. Here's a look at both:

Private REITs' Dividend Draw

Untraded REITs are a lot like the real estate investment trusts that trade on the stock market. Both pool cash to buy commercial properties, pay out at least 90% of their income in dividends, and register with the Securities & Exchange Commission.

Their differences, though, are striking. The price of a share of an untraded REIT -- also called a private REIT, non-traded REIT, public unlisted REIT, and non-publicly traded REIT -- is set by the sponsor, and it doesn't fluctuate. An unlisted REIT that sells for $10 a share in February will be worth $10 a share a year from now. Unlisted REITs last for a set time period, typically 10 to 12 years. Investors then cash out through an initial public offering, a merger, or a liquidation. Dividends are now in the 6% to 7% range, vs. an average 4.7% for public REITs.

Although investor buying has slowed recently, sales of unlisted REITs have gone up elevenfold since the stock market peaked in 2000. And of course, real estate has surged in that period. "The lack of market volatility appeals to older investors," says Robert Lee, a certified financial planner in Fairfax, Va. "They like to see their principal stable and get a 6% to 7% dividend."

Critics charge that the stable principal and steady income have a steep price. Sponsors such as Wells Real Estate Funds, W.P. Carey (WPC ), the Inland Group of Real Estate Cos., and CNL Financial Group levy lots of fees. Typically, only 84 cents to 90 cents of every $1 gets invested. The fees go to the sponsor and to the broker-dealers and personal financial planners selling the REITs. (Commissions are in the 8% to 9% range. In contrast, you can buy public REITs for as little as a $10.99 commission at an online broker.) Says Christopher Meyer, director of the Milstein Center for Real Estate at Columbia Business School: "It's hard to imagine these are a good deal relative to paying for a public REIT with very little transaction costs."

Another drawback is the illiquidity. While getting in for as little as $1,000 is easy, getting out is tough. Redemptions are typically limited to no more than 3% a year of the entire fund. Sponsors can suspend redemptions at any time. In general, the shorter the holding period the higher the surrender charge. For instance, in the Wells REIT 11 offering of 2003, an investor can redeem a limited number of shares after a year of ownership at $9.10 for every $10 invested. Three years later, the formula changes to 95% of the estimated value of shares.

Untraded REITs are successors to the real estate limited partnerships that were popular as tax shelters during the real estate boom of the 1970s and early 1980s. These limited partnerships collapsed in disrepute in the late 1980s and early '90s, thanks to a combination of changing tax laws and a real estate downturn. A major complaint among investors in those partnerships was their inability to get out once losses started mounting. Phillip Cook, a CFP in Torrance, Calif., sold limited partnerships 20 years ago, an experience he recalls with deep regret. One reason he avoids unlisted REITs "like the plague" is their lack of liquidity.


What about overall returns? They're no more certain than those on a publicly traded stock. For one thing, dividend yields are attractive, but they're not guaranteed. More than 117,000 investors, for instance, eventually pooled their cash in the Wells REIT created in 1998. But its dividend was cut to 7% from 7.75% in September, 2003. The overall return of a private REIT depends on the success of the exit strategy, such as an IPO. So far, the track record is good. For instance, W.P. Carey has taken 11 of its funds public, providing investors with an average annual total return of 12%. Inland took Inland Real Estate (IRC ) public in June, 2004, at 10 a share. The fund started in 1994, but most shareholders invested in 1998. They earned an average dividend yield of 9% a year from 1998 through the IPO. Now the shares trade at $15.40, with a 6.2% dividend. Still, a concern in many quarters of the commercial real estate market is that unlisted REIT companies currently are paying top dollar for properties, and those high prices cut into gains when it's time to return money to shareholders.

Diversifying into commercial real estate is a smart strategy for many investors. But a better alternative to untraded REITs exists: public ones. Over the past five years (ended Dec. 31), they had an average annual total return of 19.1%, vs. 2.7% for the Standard & Poor's 500-stock index. Of course, there's no assurance that the sector will remain hot, but if the public market tanks, so will the private. At least with public REITs, investors can cash out with a click of the mouse.

By Christopher Farrell

A Capital-Gains Gambit

You're in a panic. You sold some commercial property for a few million bucks, and you're facing a big capital-gains tax bill. You can avoid the bite -- or defer it, to be exact -- if you roll over the money into another property. But the law requires you to pick out the replacement asset within 45 days and close on it within 180 days. The clock is ticking.

In this time crunch, a solution for many investors may be a form of ownership derived from English common law called a tenancy in common, or TIC. A TIC allows up to 35 investors to jointly own real estate such as an office building, shopping center, or apartment complex. Unlike a real estate investment trust or a limited partnership, a TIC is structured so that participants are direct owners of real estate, allowing them to qualify for a tax-free "like-kind" exchange under Internal Revenue Service section 1031. If you stick with like-kind properties until your death, your heirs will avoid much if not all of the capital-gains tax.

TICs let investors get a piece of expensive, high-quality properties with creditworthy tenants that would otherwise be out of their reach. Most properties that are TIC-ified cost $30 million or more. Last year Santa Ana (Calif.)-based Triple Net Properties, the biggest TIC sponsor, bought a 30-story office building in downtown Chicago for $174 million. TICs have grown from almost nothing since a 2002 statement by the IRS clarified their status. Last year TIC sponsors sold $7.3 billion worth of properties to investors, according to Omni Brokerage of Salt Lake City.

Look out, though. Property prices can be high because some buyers, in their rush to beat the IRS deadline and preserve their capital gains, don't shop around. And TIC sponsors, eager to acquire properties to resell, can spend too much for assets. "There are certainly some TIC sponsors out there who are very good and very responsible, but there's also some massive amounts of overpaying," says Brian Ward, chief executive of Orion Residential, a multifamily housing buyer in Seattle, who says he has been outbid by TIC sponsors on several deals.

The risk, of course, is that the building eventually will be sold for less than the mortgage, wiping out your equity. Some established players are concerned: "The number of sponsors who have popped up because they have dollar signs in their eyes, but they don't have a lot of experience...that scares me," says Patricia DelRosso, president of Inland Real Estate Exchange in Oakbrook, Ill., and president-elect of the Tenant-in-Common Assn., a trade organization.


Fees aren't cheap. In a typical deal, sponsors charge a property-acquisition fee of 2% to 6% of the equity they put into the deal. Sales commissions are 5% to 8% of equity collected, and there can be a 2% to 3% fee for organization and marketing expenses, not to mention the ordinary annual property management fees, which run from 2% to 6% of net rental income.

The governance of these investment vehicles is clumsy. Decisions on such matters as selecting major tenants require unanimous votes. The only solution to an impasse is for one side to buy out the other. And it can be hard to find a qualified buyer if you need to sell your interest.

Most TICs are open only to "accredited" investors, which generally means those who have $1 million or more in net wealth or annual income of $200,000 or more for the past two years. Investors who aren't doing a 1031 exchange should think doubly hard about whether a TIC is right for them, because they're paying a premium for a 1031-qualifying property but won't be able to use the tax break.

The best advice is to plan so you're not rushed into a TIC to beat the IRS deadline. A TIC can be a good choice. Just be sure you know what makes it tick.

By Peter Coy

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