From the June 2005 issue of Investment Advisor • Subscribe!

June 1, 2005

Your New Partners?

Today's limited partnerships are unlike the legacy LPs, and often involve untraded REITs

Even as interest rates continue to rise and some experts predict that the next economic downturn is on its way, many eager investors are still putting their money to work in tight financial markets, searching for yield wherever they can. Asset classes that had been overlooked in recent times have been showing up again on investors' radar screens, and some, like the limited partnership (LP), which had pretty much fallen by the wayside, are being reinvented and revamped, such that they are once again figuring in the menus of available investment options for some clients.

While the traditional LP structures of the late 1970s and 1980s still exist (albeit in greatly reduced numbers), trading in small volumes in a quiet secondary market, many investors today are setting their sights on a new kind of LP product: The untraded real estate investment trust, or REIT, is a structure that market players describe as essentially a new avatar of the LP of yore. It has overshadowed such traditional LP sectors as energy and equipment leasing, as well as other sectors, such as cable television, that had their day in the sun, too.

For all intents and purposes, the untraded REIT has completely replaced the old-fashioned real estate LP of the 1980s, and the products have raised about $20 billion in the past three years, experts say. Those who are familiar with the structure say it makes for a good investment option, not least because an untraded REIT pays high dividends and offers investors initial yields on their equity contributions ranging anywhere from 6% to 8%. These investments can be particularly attractive to the baby boomer generation, since their focus is more on income than total returns.

From 2003 onward, there has been a spate of untraded REIT deals, many of which were put together by such well-known players in the partnership business as W.P Carey, Inland Real Estate, and Wells Real Estate. The untraded REIT--which, unlike its public REIT counterpart, does not trade on an exchange--offers investors the chance to buy into an asset class that is more typically associated with larger, institutional real estate players. Investors can reap the benefits of investing in real estate without having to deal with the hassles of property management.

These untraded REITs provide attractive returns and opportunities for even the most ordinary of investors to put their money into the fixed asset that is real estate. Beyond that, these structures are also popular because they are very different from the LPs of the 1980s, which largely served as tax shelters for wealthy investors. Those LPS often were structured without economic foresight, were unfairly skewed toward the benefit of the general partner (GP), and commanded exorbitantly high front-end fees from investors.

Greater Accountability

Today's REITs, by contrast, require GPs to be a lot more accountable than they were in the past, and while they do not trade publicly at inception, many untraded REITs have in their mandate a provision to either list on an exchange in a given period of time, or liquidate entirely. Those mandates mark a clear change from the structures of the 1980s, and represent attempts to address both the historic lack of secondary market trading in the LP asset class, and to make these investments more attractive to a broader range of investors, particularly the income-oriented.

The increased volume of investments in non-traded REITs has also enabled deal sponsors to reduce both sponsorship fees and brokerage commissions--another huge change from the 1980s, and a big incentive to investors. Despite all the positive changes that have taken place, many people still wonder whether untraded REITs will last as a viable and attractive investment option within the panoply of investment choices available today, or if they will unwind in the same manner as their LP predecessors of the 1980s, and simply disappear from view.

Thus far, it is too early to tell, say experts like Jack Hollander, chairman of the Investment Program Association (IPA), the national trade association representing the interests of investors in non-traded investment programs including partnerships, non-traded REITs, and limited liability companies. The cycle of new LP-style deals is really only just beginning, he says, but it is nevertheless clear that people are keener on untraded REITs than any other kind of LP deal, and want to see them go through a full cycle in order to fully assess their worth as durable investment options.

"The more people see these things perform, the greater the chance they have to appeal to a broader base of investors," Hollander says.

The appeal, though, is already evident, experts say. According to data from Fiserv Investment Support Services, a company formed from the union of the four largest trust companies in the nation, approximately 91,000 investors held 61,000 LP positions at the end of 2003, representing $2.5 billion, or 17%, of Fiserv's total holdings (the firm does not distinguish between SEC-registered LPs and exchange-traded structures). While at the end of 2004 the number of positions decreased to 53,000 and the number of LP owners declined drastically to 3,619, the value of LP assets in trust increased to $3 billion, which once again represented 17% of Fiserv's total holdings.

"Because we are still holding the same percentage value, and because there has been an increase in dollar terms of the assets we hold in trust, we can see that there is still an interest in LPs, even though the number of holders has dropped off," says Carol Gillet, VP of client relations for Fiserv. "While some clients are getting out of LPs, others are replacing the older ones that have little or no value with newer, more viable LPs."

Not Your Father's LPs

Undoubtedly the renewed interest level in LPs, in particular non-traded REITs, represents a sea change from the 1990s, when limited partnerships of every kind were well off the radar screen of most investors. Indeed, even before the soaring popularity of glitzy technology stocks completely overshadowed the potential appeal of other investment options, LPs were a tainted asset class that rapidly went out of style after the tax code was changed in 1986, and after many highly leveraged deals, set up purely for investors to write off as losses against their income, completely soured.

"You saw a crazy period of fundraising between 1982 and 1986, and then everything ground to a halt when the real estate market went into the tank," recalls Spencer Jeffries, editor of Direct Investments Spectrum (a monthly newsletter that covers direct investment programs), who has been a keen observer of the limited partnership market for the past 20 years. "There were so many bad deals that went out and bought real estate at the top of the market that when it cratered, deals that had taken on a lot of debt just collapsed. As the recession wore on into the 1990s and real estate continued to suffer, people just lost interest in these deals."

While a secondary market for LPs did evolve and, to a certain extent, flourish in the late 1980s and into the 1990s, thereby allowing those who wanted to rid themselves of their limited partnership holdings to do so, the volume of trades has steadily declined through the years (Investment Advisor has continued to track these trades through the secondary markets, however, even as trading volume dropped. Monthly trades and average prices for legacy limited partnerships sold on the secondary markets are available online at www.investmentadvisor.com.)

"If you look at a whole year's activity in our market today, it is probably equivalent to a few minutes of trading on the New York Stock Exchange," says Paul Frain, principal at Frain Asset Management, one of the few remaining firms that trades LPs.

Laurie Miller, principal and trader for Alliance Partnership Service, agrees. "Compared to other asset classes, the demand for LPs is very low," she says. "It is really amazing how in the whole of the U.S., so few buyers come into this market."

But while it might be amazing that the market for a once-popular asset class is now a thin shell of itself, Frain, Miller, and others are not surprised by the slow pace of market activity. The bad taste left by the deals of the 1980s still lingers in many investors' mouths, Frain says, and many brokers and investment advisors are leery of recommending LPs and untraded REITs to their clients.

Whither Real Estate?

Yet many of the old deals of the 1980s have now been liquidated, Miller says, and even though trading in the secondary market is muted, there is hope for the LP asset class in general as the new REITs continue to gain a foothold in the financial marketplace, and deals syndicated by such longtime sponsors as CNL Securities Corp. and Boston Capital find their way into the secondary market. New sponsors are also joining the list of those putting together deals, she says, so as fresh product increases, trading in the secondary market, as well as overall market efficiency, should also increase.

But can these deals really endear themselves to investors, given their dubious past, and can they ever hope to compete directly against other investment vehicles such as mutual funds that invest in assets such as stocks or bonds?

According to Jeffries, everything hinges on the direction of the real estate market. Just like in the 1980s, a colossal amount of capital has been thrown into real estate ventures over the past couple of years as a result of lower interest rates, and the real estate market has been bid up to extremely high levels.

"In the 1980s, the rug was pulled out from under the real estate market when it was completely built up," Jeffries says. "Real estate prices are as high now as they were then, so the success of these [untraded REIT] deals will depend upon whether there's a soft or a hard landing once things slow down."

That said, Jeffries points out that what really caused the unwinding of the older REIT structures were the changes in the tax code, which essentially took away the kinds of tax benefits that had been created solely to encourage the building of real estate, thereby causing the sector to completely crumble. Today's REITs, by contrast, are not incentivized by tax rules and function independently of them, he says, so the sole criteria that will determine their success or failure will be the quality of the real estate investments they have made.

The continued broader appeal of untraded REITs and other forms of LPs also depends upon educating advisors about the changes that have come about in the marketplace, Hollander says.

"There is still a stigma associated with the partnership product, but people need to know that this is a different generation [of products], where the best interests of the investors, not the sponsors, are a priority, and get comfortable with that," he says.

One important factor to note is the quality of real estate that is being purchased by many untraded REITs. While the deal-makers of the 1980s rushed out and bought properties at random to hold for anywhere from three to seven years, the deals that have been put together over the past couple of years are much more defined and well thought out, Hollander says, and are structured with economics as the main driver. Real estate is purchased at price levels that make sense for the investors in these deals.

Also of note, a number of unrated REIT deals are being put together by sponsors that have been in the partnership business since the 1980s, and have somehow managed to survive all the negativity associated with partnerships, even as other players went out of business. Many of the companies in the untraded REIT business have been around for ages, and though they spent numerous years struggling to raise money, they have stuck it out. Their proven track record in the industry, as well as their ability to absorb the changes that were necessary to make a new generation of LP products attractive to investors, demonstrates their commitment to the business, Hollander says.

This development, he believes, provides an important perspective to the limited partnership and REIT businesses today, and is one that advisors of all stripes need to be aware of.

Savita Iyer is a freelance journalist who writes on a variety of business and financial topics. She can be reached at siyerwriter@yahoo.com.

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