Nontraded Real-Estate Trusts Shed Shady Past, Boast Returns

By Thomas Kostigen From MarketWatch

Those ugly nontraded real estate investment trusts born out of the limited-partnership industry may finally be looking pretty. But who knows for how long.

On average the typical investor of these REITS has received a full return of capital plus a combined gain of 64% over five years, according to the Stanger Report, which tracks the industry.

"Until now, gauging the investment performance of the 'new generation' of publicly registered, nontraded REITS has been somewhat of a guessing game," the report notes.

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Nontraded REITS are direct investments typically designed to garner income. They're usually partnerships where investors team to purchase an income-producing property. Sometimes the individual partnership units are sold on a secondary market, and then become "traded REIT secondary offerings." But, akin to time shares, these units are bought and sold between private parties.

In any event, valuing privately traded REIT investments has been difficult because few have gone through a full cycle of liquidation where investors buy a property, receive dividends (hopefully) and then sell the property.

The Stanger Report analyzed nontraded REITS begun since 1998, representing $11 billion, or 40%, of the nontraded REIT market.

"True, most of these programs benefit from the tailwind of declining capitalization rates and increasing real estate valuation parameters during their holding periods," it notes. "But most also operated through a period of soft real estate fundamentals following 9-11 and the tech bubble implosion. No program lost money. Internal rates of return among individual programs ranged from a high of 16.6% to a low of 7.3% without dividend reinvestment, and 18.1% to 7.4% with dividend reinvestment."

This is a far cry from the 1980s when direct real estate partnership investments such as these ravaged Wall Street and private investors, and became infamous through shady deal making at then brokerage Prudential-Bache.

The Tax Reform Act of 1986 crushed the industry because it took away many of the tax incentives associated with partnership investing at the time (by limiting deductions for passive losses).

Slowly, however, the direct partnership industry has climbed back with better deals for investors ripe for higher dividend income, better prices on liquidations and a better commercial real estate climate overall. And what has always been the bane of their existence, may now be their grace: the liquidity issue.

Tangible benefits

With the stock market dousing prices and real estate making headlines, publicly traded stock, especially in the real estate sector, is getting batted around. But the trading effect has much less of an impact on owners of tangible property. They rely on private market values. Moreover, the income derived from many of these nontraded REITS comes from tenant leases, which also aren't so much correlated with market behavior.

To be sure, if the real estate market itself tanks, there will be an effect on the sales (liquidation) price of the REITs underlying property, or properties. This could set this performance analysis on its ear. So far, so good, however.

Distributions for these partnership programs has ranged between 6% and 7% per year, accounting for one-third of investors' total return. Sales-price gains have been robust, accounting for the remaining two-thirds of the 12.5% to 13.6% average return these investments have garnered.

With the average life span of nontraded REIT program being between five and 10 years, many of these partnerships are nearing maturity. Nontraded REITS have raised more than $30 billion since 2002 compared with $17 billion in traded equity REIT IPOs, and $43 billion in traded REIT secondary offerings.

This means a raft of properties have been or are about to be sold. Depending upon at what price and when these partnerships liquidate, they could stand to make a tidy profit off the run-up in real estate prices.

And even if the real estate market continues to turn south, prices are still far about what they were five and 10 years ago. So these investors may end up sacrificing some profit, but not likely taking a loss.

Meanwhile, investors in publicly traded stock tied to the real estate sector are subject to daily swings and the sensitivity to news. This could pull their investments down, leaving them without the ground that nontraded REIT investors have to stand on.

Illiquidity is usually thought of as a bad thing in the investing world. But when markets get hammered, it isn't always that way.

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