Guide to Real Estate Investment Trusts

Author: Douglas Slain

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.
According to IRS public records, over 1,300 REITs filed tax returns in 2012 while only
200 or so of those were publicly traded. The remaining 1,100 or so were either
registered but non-traded or were private placement REITs, which are neither traded nor
registered.
Traded and non-traded but registered REITs are subject to the Securities Act of 1933
and the Exchange Act of 1934 and must register. 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 SECs Regulation D or pursuant to new Regulation "A +" or SCOR/504
offerings, or, for oversea investors, pursuant to Regulation S.
REITs typically operate with: a) a sponsor, b) an advisor, c) a property manager, and d)
a dealer manager. None of contracting parties may be the same entity as the REIT, but
they may be and often are wholly-owned affiliates.
A REITs 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 REITs 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 several special purpose entities. The
same management team may conduct all these transactions by contracting with thirdparty 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 OP I, LP
Property manager: HPT Management Services Affiliate: Behringer Harvard Partners
(99.9% owner of advisor, dealer manager and property manager).
Behringer also 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 use
similar structures to enable managers to conduct transactions with various controlled
entities and affiliations.
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. Further, 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. Often REIT
advisers are 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; 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 the degree to which dividends are paid from operating cash flows 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 REITs 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 debt,
liquidation of assets, or additional investor contributions. Many dividend payments for
non-traded REITs take the form of dividend reinvestment programs (DRIPs); the 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 shareholders 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 REITs 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 companys 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 publics 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 as 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.
Private Placement Advisors LLC is a group of JOBS Act experts who draft and
file disclosure and offering documents for review by regulators and investors.
We write and produce pitch decks and assist clients in investor
presentations. Managing partner Douglas Slain, a Stanford Law graduate
with big firm experience, authored the 10-volume Private Placement
Handbook Series.