by Edward Pekarek, Esq. and David Haimi
Do you want a safe "middle of the road" investment that isn't affected by ups and downs on Wall Street? Do you want 7-8% dividends? Do you want the peace of mind that comes from putting your hard-earned cash in a proven investment featuring years and years and years of stable stock prices and returns? Then you need to invest in non-traded REITs right now! Variations of this "too good to be true" sales pitch have been the sales siren for many of the non-traded Real Estate Investment Trusts sold domestically to thousands of elder investors seeking steady income in an unprecedented low interest rate environment. FINRA has focused enforcement efforts on deceptive sales of these illiquid shares, charging Long Island-based brokerage David Lerner Associates (DLA) (CRD #5397), and its namesake CEO (CRD #307120), in a highly publicized 2011 enforcement action with misconduct related to its sales of allegedly unsuitable "Apple" (no, not that Apple) non-traded REIT shares. Last week, a FINRA arbitrator awarded equitable rescission relief to a pair of Apple REIT shareholders who can now tender the stock and be refunded their original investment. Not surprisingly, a DLA lawyer told the Wall Street Journal that the FINRA member headquartered in Syosset, NY "disagrees with the decision." A number of class actions are pending presently.
A half-century of REITs
REITs date back to the passage of the Real Estate Investment Trust Act, as part of the Cigar Excise Tax Extension of 1960, and have a long history of allowing individuals to purchase a piece of large real estate speculation. REITs collect pools of money from investors and then use the pooled capital to buy real property as assets. Over time, REITs have evolved into three main types: equity, mortgage, and hybrid, and can be either private or publicly held concerns. The non-traded equity REIT variety is distinct because the stock is not traded or quoted on any securities exchange, but these issuers are registered with the Securities Exchange Commission ("SEC"), and subject to SEC (as well as state and SRO) regulation. For a company to qualify as a REIT, and receive an exemption from corporate income tax, it must adhere to sections 856 and 857 of the Internal Revenue Code. The major requisite of these provisions, and what is a major selling point of REITs, generally, is that the issuer must distribute at least 90% of its annual income to its (100 or more) shareholders to qualify for the tax exemption. The seemingly assured large dividends are often used to lure would-be investors.
Questionable to the core?
Non-traded REITs have received substantial negative attention lately, due largely to the FINRA enforcement action and class action complaints against Apple REITs Six through Ten and their sole underwriter, DLA. Roughly 60-70% of DLA's business is comprised of non-traded REIT sales. These Apple REITs, along with other non-traded REITs, are alleged to have lured unsophisticated investors with misrepresented share values and deceptive dividends seemingly sourced from income, but often derived from shareholder capital and extensive debt. Forbes columnist Brad Thomas, established a blueprint for non-traded REIT reform in two April 2012 columns.
Recipe for REIT reform
Mr. Thomas, in Dividend REITs As Reliable As Jack Nicklaus And Tiger Woods, discusses the success of publicly traded REITs, especially eight specific public REITs, comparing them to the success of the famous golfers Jack Nicklaus and Tiger Woods. Mr. Thomas contributes the success of these REITs to their ability to maintain "consistency (including increased dividends during the great recession) and sound risk-control - the mark of greatness." He goes on to state that "[w]ithout fail (sound risk-control), these eight equity REITs are all distinguished by consistency in dividends paid and increased quarterly." Mr. Thomas then concludes his column with investment icon Ben Graham's maxim, "...[w]e think that a record of continuous dividend payments for the last twenty years is an important plus factor in a company's quality rating."
While consistent dividends might be an indicator of a sound REIT in the public securities market, investors in non-traded REITs do not have the benefit of being able to rely on the "efficient-market hypothesis" as there is no regular price discovery for these illiquid securities. Non-trade REITs, as the name suggests, lack a secondary market which often results in significant informational asymmetries between insiders and investors, with no public trading to adjust the imbalance. One of the biggest issues with Apple REITs has been their alleged masking of losses through large scale leveraging and reinvestment of capital, so as to keep dividends constant and create the illusion of operational success.
In Non-Traded REITs: The Evolution Of A Repeatable Income Alternative, Mr. Thomas builds on his previous description of what makes a public REIT exceptional, and identifies some non-traded REIT standouts. Mr. Thomas' work singles out American Realty Capital for its industry best practices of "shorter life cycles, fully covered distributions, elimination of both internalization fees and follow-on offerings, along with lower fees and pay-for-performance management compensation." These practices, along with consistent dividends sourced from Funds from Operations ("FFO"), make up the majority of the recipe for a non-traded REIT to be considered an appropriate investment as a portion of a qualified investor's portfolio.
The shorter non-traded REIT "life cycle" refers to transitioning to the publicly traded market, where price discovery tends to better reflect the true financial condition of an issuer. Mr. Thomas maintains that the REITs that make an expedient transition, typically gain value and achieve great investor confidence with the enhanced transparency offered by publicly traded shares. "Fully covered distributions" means dividends paid from FFO, not from leveraged assets that can and often do lead to a debt spiral. The last of his proposed ingredients is reduction of excessive upfront fees associated with non-traded REITs, which often depress share value by 10-15% immediately upon purchase. Along with substantially lower purchase fees, in Mr. Thomas' view, non-traded REIT managers should only be paid for transparent operational revenue success, as oppose to a murky fixed management fees and a host of other opaque charges for things such as general operations and property transactions. Mr. Thomas sees this list of best practices, along with genuine transparency, as a necessary "evolution" of the non-traded REIT sector.
Transparency, short-term life cycle, no excess fees, and consistent distributions from FFO, all sounds like a fantastic wish list, but these features are not beyond the realm of possibility, particularly as market and regulatory forces appear to be insisting these firms reform or perish. If over-valuation of shares and over-leveraging of assets to pay dividends are the means by which investors are duped into buying illiquid shares, non-traded REITs must remake themselves to be smarter, leaner, and more short-term oriented, or the market will rightfully attach a permanent stigma to the sector. What is meant here by "short-term orientation" is that the overall goal of the non-traded REITs should be to develop or acquire high-quality performing assets, and enter the public securities market as expediently as possible. This is different from the pyramid type non-traded REIT model, where debt and offering proceeds are used to fund future distributions, instead of FFO. If a non-traded REIT faces the prospect of open market trading (and the related price discovery) in 3 years or less, or asset liquidation to pay back shareholders, there would be a greater level of investor confidence for non-traded REITs. More so, if a non-traded REIT successfully transitions to the public market in a reasonably short time period, subsequent offerings of similar ilk will enjoy improved investor confidence.
Darwin or Dodo?
In today's economic climate, with large scale fraud and investor abuse souring the public's perception of Wall Street, the non-traded REITs currently holding some $84 billion in assets, will wither on the vine absent meaningful legislative, regulatory and/or internal reform, as market forces will cause the beleaguered sector to go the way of the Dodo bird. The reform ingredients identified above, combined with short-term oriented business models that lead to publicly held shares, could result in the transformed and legitimized non-traded REIT sector Mr. Thomas envisions. If these changes do not occur in short order, already eroded investor confidence will continue to wane, and the sector may someday soon face extinction with an ice age of investor rejection.
Mr. Pekarek is a Visiting Professor of Law and Supervising Attorney at Pace Law School, who also serves as Assistant Director for the non-profit Pace Investor Rights Clinic of John Jay Legal Services, Inc. He is a former Marketing Manager for Developers Diversified Realty Corp., a publicly traded REIT (DDR: NYSE).
Mr. Haimi is a 2012 Pace Law School graduate and student-intern for the non-profit Pace Investor Rights Clinic, as well as Managing Editor of the Pace Environmental Law Review and a member of the national championship team of the 2011 FINRA/St. John's Securities Dispute Resolution Triathlon. Mr. Haimi is also the recipient of the 2012 Adolph Homburger Humanitarian Award, and is the managing member of Direct Title, LLC, a Boston-based title examination firm.