More on Non-Traded REITs
I mentioned at the end of the last post that I'd have more to write on Behringer Harvard Multifamily REIT I (BHMF). I think it is important that broker / dealers and investors read its 10-K. It's complicated, but will give you a good picture of what the REIT owns. It may surprise some broker / dealers to know that the REIT's strategy has been to acquire apartment complexes via development, and more specifically through mezzanine loans to apartment developers. The mezzanine loans are junior to construction loans and the mezzanine loans will convert to equity when the developments are complete. Many of the REIT's recent acquisitions have been newly constructed apartment complexes (or properties originally build as condos that are now being rented as apartment communities) that need to be leased.
I don't have a problem with BHMF's investment strategy. It's a perfectly fine, legitimate method of acquiring real estate. Broker / dealers need to understand that BHMF is not simply buying cash flowing garden style apartment complexes. BHFM's investment strategy will not allow it to pay distributions from operating cash in the near term because its properties are either under construction or in lease up. Given the strategy, the negative Funds From Operation is not shocking or even unexpected, but it's eye-opening when you see that the REIT paid a 7% distribution to investors. I don't have a guess when operations will fully cover the REIT's distribution, but I wouldn't expect it to cover in 2010. Note that the BHMF had actual rental revenue in the fourth quarter.
Investors need to be compensated for the extra risk of development and acquiring properites in their lease-up phase. This is simple investment risk/reward, where a risky investment should pay a higher return than a less risky investment. Obviously, an investment that develops its properties should generate a higher return to its investors than an investment that acquires existing properties with established, stable income.
Sponsors of non-traded REITs get pulled by competing forces. Broker/dealers want high distributions, but they want those distributions to be stable, low-risk and covered from operations immediately. BHMF raised more than $40 million a month for the first two months of 2010. I wonder how much this REIT would raise if it told broker/dealers it would only pay distributions generated from operating cash? I don't think it would be $40 million a month. You can't single out BHMF for "buying" its equity capital with the 7% distribution, because it is not alone in this practice, far from it.
Broker / dealers should analyze specific acquisitions made by their approved non-traded REITs that are in capital raising mode. This eliminates the influence of excess cash waiting to be invested, and determines whether acquisitions are accretive to the REITs' expected or current distributions. (A specific property's cash return to a REIT, based on the REIT's investment in the property, should generate sufficient cash to support a REIT's distribution.) If a REIT is acquiring non-accretive properites, broker / dealers better ask why, because REITs that are acquiring properties that are not accretive to their current distributions will eventually have to cut their distributions. Broker / dealers should not feign surprise when distribution rates get cut.