The private placement REIT market is much larger than the registered traded and registered non-traded REIT market. While private placement REITs are more opaque and illiquid than registered, non-traded REITs, let alone registered and traded REITs, the level of sophistication of the investors who purchase them is thought to be quite high.
Traded and non-traded REITs are subject to the Securities Act of 1933 and the Exchange Act of 1934 and must register or find an exemption. Private placement REITS use exemptions to avoid registration but still need to file with both the SEC and applicable state regulators. Traded REITs can be bought or sold through a brokerage firm. Investors can typically sell their shares after a holding period of a year.
Private placement REITs are generally sold through exempt private offerings under Rule 506 of the SEC’s Regulation D or pursuant to new Regulation "A+" or as a SCOR/504 offering. For oversea investors, Regulation S applies.
REITs typically operate with: a) a sponsor, b) an advisor, c) a property manager, and d) a dealer manager. None of the contracting parties may be the same entity as the REIT, but they may be and often are wholly-owned affiliates.
A REIT’s sponsor is the company that organizes and controls the properties in the portfolio. The property manager is responsible for the leasing and maintenance of the property. Sponsors and their advisers make investment decisions such as purchasing, developing, and selling properties in addition to managing day-to-day operations. Dealer managers, if any, market and sell the shares.
The overlapping roles of key individuals in a REIT’s business can lead to conflicts of interest. While NASAA has published guidelines restricting the ability of the sponsor and advisors to sell properties to, offer financing to, or jointly invest with the REIT, these guidelines are easily avoided by the creation of special purpose entities. The same management team may conduct all these transactions by contracting with third-party entities, which entities they control.
One example of this is reflected by publicly available information regarding Behringer Harvard Opportunity REIT 1. “Advisor: Behringer Harvard Opportunity Advisors Sponsor: Behringer Harvard Holdings, LLC (100% owner of affiliate) Dealer manager: Behringer Securities LP Limited partner: BHO Partners Operating partnership: Behringer Harvard Opportunity
Property manager: HPT Management Services Affiliate: Behringer Harvard Partners (99.9% owner of advisor, dealer manager and property manager).”
Behringer notes in a filing that, “We may acquire properties...with affiliated entities, including Behringer Development, a wholly owned subsidiary of Behringer Harvard Partners, which is a wholly owned subsidiary of Behringer Harvard Holdings, and BHDLLC, which is a wholly owned subsidiary of Behringer Harvard Holdings.”
Public records show that Inland American REIT and a number of other REITs have uses similar structures to enable managers to conduct transactions with various controlled entities and affiliates.
Advisors and managers can be paid up to 15% of the proceeds raised as “organization and offering expenses.” Based on SEC filings, property managers often receive up to 3% of the gross revenue from the properties they manage. Affiliates may receive a commission of up to 3% of the price for any property sold to the REIT.
External advisors can receive acquisition and asset management fees. REIT advisers are often wholly owned subsidiaries or affiliates of the sponsor. Dealer mangers or agents who sell shares are also very frequently controlled by the sponsor. Some REITs have created repurchase programs through which investors can sell their shares to other investors or to brokers at a reduced price after a holding period of one year.
While no public market exists for non-traded REIT shares, some private markets have created listings for these funds. Non-traded REITs tend to trade on the secondary market at a discount to reported share price, in addition to any loss of value being priced in by the market.
FINRA Rule 2340 governs how non-traded REITs are allowed to report their estimated per share values. It requires that the per share value be calculated using data no more than 18 months old. Rule 2340 requires non-traded REITs to use current estimated share values (as opposed to ‘par values’ or initial offering prices) in their customers’ account statements 18 months after the initial share offering.
REITs that have large debt burdens may find it difficult to maintain high dividend payments, and investors need to be aware that the debt loads incurred by REITs to support their dividend and commission levels is a significant drag on future earnings. One measure of dividends paid from operating cash flow is the dividend coverage ratio. For REITs, dividend coverage is measured by dividing funds from operations (FFO) by total dividends paid. This ratio reflects the percent of dividend payments that came from sources related to the REIT’s real estate earnings, as opposed to debt.
A REIT that has a dividend coverage ratio of less than 100% is paying higher dividends than it is generating in earnings and must support those dividends through increased debt, liquidation of assets, or additional investor contributions. Many dividend payments for non-traded REITs take the form of dividend reinvestment programs (‘DRIPs’). Cash dividends paid by some REITs exceed operating income. Of the 42 non-traded REITs tracked by the Direct Investment Spectrum in 2012, only fifteen reported complete dividend coverage in the second quarter.
Return on equity (ROE) is a ratio of net income to shareholder’s equity, and represents the income generated from a particular amount of equity investment. Net profit margin is net income as a percentage of total revenue, which reflects the profitability of the firm from sales.
Total asset turnover reflects a REIT’s efficiency – how much revenue it generates from each $1 of assets. The product of these two ratios is the return on assets, or how much income is generated by each $1 of investment. The last component in ROE is the leverage ratio. Since total assets are the sum of a company’s total debt and equity, if, for example, this ratio is 1.5, it follows that 50% of shareholders’ equity reflects leveraged borrowing.
The posted share price of a non-traded REIT is commonly kept at its initial offering price regardless of changes in the underlying real estate portfolio, creating problems.
With up to 15% in commissions and other transaction fees and commissions to be earned, the sponsor needs discipline in face of a significant incentive to sell as many shares as possible--which is not the same thing as returning value to shareholders in the REIT.
Many of the potential deficiencies and conflicts of interest in non-traded REITs were brought to the public’s attention as a result of a FINRA complaint against David Lerner Associates, Inc. (DLA), the dealer-manager for the Apple REITs.
The complaint, filed on May 27, 2011, alleges that the dealer manager David Lerner Associates (DLA) “should have been aware of valuation irregularities and other improprieties” in the Apple REITs. The complaint details the market fluctuations, deteriorating financial performance, and increased leverage of the Apple REITs. FINRA argued that by maintaining only average distribution information on its website DLA was misleading investors.
Common problems of REITs are: 1) illiquidity; 2) high fees and conflicts of interests with diminished shareholder value, and 3) reliance on leverage to fund current dividend payments.
Some REITs have paid a substantial portion of their dividends out of the proceeds from issuing debt rather than from earnings; others have failed to update share valuations to reflect decreasing net asset values of their portfolios.
Is a REIT for you?
In order to qualify as a REIT, an entity must meet a number of organizational, operational, distribution, and compliance requirements.
A REIT must be formed in one of the 50 states or District of Columbia as an entity taxable for Federal purposes as a corporation. It must be governed by directors or trustees. Its shares must be transferable.
A REIT that distributes 100% of its taxable income will have no Federal income tax liability. Although state tax laws relating to REIT vary, most states with an income-based tax regime follow the federal law and permit a REIT "dividends paid deductions. Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 different shareholders (the "100 Shareholder Test"), and 5 or fewer individuals cannot own more than 50% of the value of the REIT's stock during the last half of its taxable year (the "5/50 Test").
A number of "look through" rules apply when determining whether the REIT meets the 5/50 test. In an attempt to ensure compliance with these tests, most REITs include percentage ownership limitations in their organizational documents. Most REITs do not permit any one shareholder to own more than at most 9.9% of a REIT's stock without a waiver by the REIT's board of directors.
The REIT must satisfy two annual income tests and a number of quarterly asset tests that are designed to ensure that the majority of the REIT's income and assets are derived from real estate sources.
Annually, at least 75% of the REIT's gross income must be from real estate-related income such as rents from real property and interest on obligations secured by mortgages on real property.
Additionally, 95% of the REIT's gross income can also include other passive forms of income such as dividends and interest from non-real estate sources (like bank deposit interest). No more than 5% of a REIT's income can be from non-qualifying sources such as from service fees or a non-real estate business.
A REIT can own up to 100% of the stock of a "taxable REIT subsidiary" ("TRS"), a corporation with which a REIT makes a joint election that can earn such income. Quarterly, at least 75% of a REIT's assets must consist of real estate assets such as real property or loans secured by real property.
Although a REIT can own up to 100% of a TRS, a REIT cannot own, directly or indirectly, more than 10% of the voting securities of any corporation other than another REIT, TRS, or qualified REIT subsidiary ("QRS"), a wholly-owned subsidiary of the REIT whose assets and income are considered owned by the REIT for tax purposes.
A REIT cannot own stock in a corporation other than another REIT, or a TRS or a QRS, the value of whose stock can comprise not more than 5% of a REIT's assets. Finally, the value of the stock of all of a REIT's TRSs cannot comprise more than 25% of the value of the REIT's assets.
In order to qualify as a REIT, the REIT must distribute at least 90% of the sum of its taxable income. To the extent that the REIT retains income, it must pay tax on such income just like any other corporation.
In order to qualify as a REIT, a company must make a REIT election. The REIT election is made by filing an income tax return on Form 1120-REIT. Because this form is not due until, at the earliest, March 15th following the end of the REIT's last tax year, the REIT does not make its election until after the end of its first year (or part-year) as a REIT. If it desires to qualify as a REIT for that year, it must meet the various REIT tests during that year, with the exception of the 100 Shareholder Test and the 5/50 Test, both of which must be met beginning with the REIT's second taxable year.
Finally, the REIT annually must mail letters to its shareholders of record requesting details of beneficial ownership of shares. Significant monetary penalties will apply to a REIT that fails to mail these letters on a timely basis.
Our Exempt Offerings Library includes books and audiobooks on crowdfunding, exempt offerings, and other topics.
Our monthly reporting service, Exempt Offerings Reporter, summarizes recent developments in the world of Blue Sky law and regulation.