Morningstar Advisor - February/March 2012 - (Page 67)

initial operating cash flow to meet and sustain investors’ annual dividend expectations. This may require the REIT to use cash reserves, investor capital, bank lines of credit, asset sales, and sales of additional shares to pay the dividend. Essentially, investors in nonlisted REITs may be receiving a return of capital instead of a return on capital. In comparison, the average listed REIT, according to the National Association of Real Estate Investment Trusts, has an FFO dividend payout ratio of 70%, which means the operating cash flow sufficiently covers current dividends and can cushion against a future economic downturn or allow for a potential dividend increase. 5. The “have to” investor The dividend obligations, and the rate at which investors are pouring money into these offerings, put significant pressure on the nonlisted REIT and its advisor to invest the blind pool’s money as quickly as possible, regardless of the current market conditions. This type of scenario does not lend itself to the best or most appropriate investment decision-making process. Furthermore, it does not allow for proper risk management throughout different market cycles. Consider that, between 2005 and 2008, nonlisted REITs raised and invested $33.3 billion (45.2% of the total assets raised since year-end 1999). This period is widely considered the peak in commercial real estate valuations. 6. Acquisition-only marketing machines Most nonlisted REITs focus on acquisitions, rather than development, and spend significant resources on marketing, sales, and distribution. Morningstar favors proven REIT business models and managers with a diversified real estate skill set, which includes acquisition, development, redevelopment, and property-management experience. These skills allow the REIT to exploit growth opportunities and manage risk and cash flows throughout real estate and economic cycles. Many of these characteristics and skills are lacking within many nonlisted REIT business models, potentially increasing risk and limiting growth. 7. Potential conflicts of interest A REIT can choose to be managed internally or externally. Most listed REITs are internally advised, while most nonlisted REITs are, at least initially, advised by an “outside” advisor that is affiliated with the REIT sponsor. Just like internal management, outside advisors operate and supervise REIT activities, including administration, acquisition, and disposal of assets; portfolio management; property management; and shareholder services. Most often, outside advisors are owned, controlled, and managed by the principals and board of the REIT. This may create potential conflicts if the advisory fee and incentives aren’t structured properly. 8. Lack of transparency Nonlisted REITs are SEC-registered public entities and are, therefore, subject to minimum reporting requirements, such as filing quarterly and annual financial documents. We live in a relative world, however. Nonlisted REITs report far less useful or relevant data as compared with their listed counterparts. For example, most listed REITs host quarterly conference calls, property tours, and management visits for investors and analysts. Additionally, the majority of listed REITs provide information packages to supplement required filings. These disclosures outline, in detail, pertinent information related to real estate operations, property-level specifics, and corporate capital structure. This transparency provides the necessary tools for investors to make intelligent and informed investment decisions. Conversely, nonlisted REITs rarely disclose more than is required by the SEC. 9. Volatility—more than meets the eye One of the benefits touted by nonlisted REITs is that the shares do not swing with the stock market, as shares are not listed on a major exchange and because the underlying investments are not marked-to-market frequently. It would be naive to think, however, that underlying nonlisted REIT portfolios and business models are not affected, both positively and negatively, by many of the same factors that contribute to stock market volatility. In fact, the 2007–09 economic downturn resulted in significant declines for nonlisted REITs. Sudden dividend reductions and unit-price markdowns took many investors by surprise. More disclosures combined with a regular mark-to-market and an independent valuation process would have certainly exposed this increased volatility and risk profile. At the very least, better communication may have limited the panic felt by investors. 10. Limited access to capital and illiquidity Nonlisted REITs gain access to capital primarily through retail investors during specific offering periods and under announced terms. These limitations may result in a nonlisted REITs’ inability to raise capital when needed, for refinancing or capital-structure purposes, for example. This illiquidity may result in the undesirable scenario of having to sell assets at an inopportune time. The illiquidity extends to nonlisted REIT investors, who have limited options to cash out. What the Future May Hold Morningstar does not believe a significant investment in nonlisted REITs makes sense for most investors. There are still too many drawbacks and unresolved issues. Listed REITs are the most appropriate option, from the standpoint of both the alignment of shareholder interests and long-term risk/return potential. That said, a better nonlisted REIT product is possible—the segment is in transition, with efforts under way to improve investor suitability, transparency, standardization, fee structure, and incentive programs. FINRA and the Dodd-Frank reforms are driving much of this change, but a few nonlisted REIT sponsors have begun to address concerns. There is a real first-mover opportunity for both sponsors and the broker/dealer in this regard, making a better REIT product a win-win for investors, sponsors, and broker/dealers alike. K Philip J. Martin is director of REIT research with Morningstar. MorningstarAdvisor.com 67 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

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