Inland American Real Estate Trust Inc. is the kind of property company that gives some investors bad dreams. It raised $7.9 billion to buy assets it now can’t or won’t sell. The value of its holdings has plunged 60%. It has cut its dividend by three-quarters.

“It’s a zombie,” says Allan Roth, one of 170,000 shareholders of the nontraded real-estate investment trust. Instead of returning money to shareholders, the REIT is plowing proceeds from the few properties it has sold into new purchases or reducing debt, complains the financial adviser from Colorado Springs, Colo.

Nontraded REITs became popular among individual investors over the past five years with a simple proposition: buy portfolios of properties, pay annual dividends of 6% or more, then liquidate the assets and return investors’ original capital and then some. Instead of being traded on stock exchanges like traditional REITs, the funds are sold by brokers directly to investors.

Annual fundraising by nontraded REITs more than tripled between 2009 and 2013 to a record $20 billion. At the same time, funds began to return capital to investors on a faster timetable, often two to four years instead of six or eight that had been typical in the industry.

But some nontraded REITs grew so fast that they became difficult to unwind. Others overpaid for their properties and since the crash of the commercial property market have had trouble selling assets at a price that would make investors happy. Such funds became zombies.

Thomas P. McGuinness, chief executive of Oak Brook, Ill.-based Inland, said the company is trying to satisfy all of its stakeholders. While some investors want to be repaid now, management believes it’s wiser to acquire more property in hopes of selling later at a better price.

“Each asset class has an optimum timing in terms of when you create the best value,” he said. In the future, if the company has meaningful asset sales, “that could include returning money to shareholders.”

Fundraising by nontraded REITs has now cooled. The funds pulled in about $15 billion in 2014, down by a quarter from 2013, in part because the funds returned just $12.9 billion of investors’ original capital last year, down from $17.2 billion in the previous year.

Of the 85 U.S. nontraded REITs at the end of February, 41 had closed fundraising but hadn’t returned capital to investors, up from 39 at the end of 2014, according to investment bank Robert A. Stanger & Co. Of those, at least 10 have let three and a half years or more go by without fully liquidating.

The funds held a combined $57.1 billion in equity outstanding, according to Stanger. That was down from the record $61.6 billion at the end of 2013, but the funds were returning capital to investors more quickly in 2013, according to Stanger, so the problem wasn’t as severe.

Nontraded REITs are designed to return cash to investors two ways: through dividend payments and at the end of the fund’s life cycle through what are known as liquidity events, typically a sale or listing of the REIT on a public stock exchange. There is only a limited secondary market for nontraded REIT shares, giving small investors few options beyond simply waiting.

ENLARGE

Skiers congregate at the base of a run at Sunday River ski resort in Maine. The property is owned by CNL Lifestyle Properties, a real estate investment trust that has seen its shares fall roughly 50% from their offering price. PHOTO: ASSOCIATED PRESS

“Most REITs, once they stop raising money, have an 18- to 24-month window in which they’re looking to have a liquidity event,” and many don’t make it, said Dirk Aulabaugh, a managing director of real-estate research firm Green Street Advisors.

One such case is CNL Lifestyle Properties Inc., an owner of some prominent ski resorts, including Sunday River and Sugarloaf in Maine. The firm raised $2.9 billion from investors between 2004 and 2011.

CNL’s fundraising prospectus sets a deadline of Dec. 31, 2015, to return investors’ capital, but it is unlikely the company will be able to return most shareholders’ full investment. After being battered by the real-estate downturn, the fund reported its shares were worth $5.20 at the end of last year, down 24% from a year previous and nearly 50% from their offering price of $10.

CNL said in a written statement it is operating the fund on a longer timeline than most nontraded REITs, and pointed out that it has sold or agreed to sell about $1 billion in assets over the last year.

Inland’s experience has been particularly rough. It raised a record $7.9 billion between 2005 and 2009, selling shares at $10 apiece, and did the bulk of its buying before the commercial real estate market turned south. The real-estate bust battered the value of its holdings, forcing the REIT in 2011 to cut the price of its shares to $7.22 apiece. In May 2012, it announced the Securities and Exchange Commission was investigating its management fees and other issues.The investigation is ongoing, an Inland American spokesman said.

Inland isn’t planning to liquidate anytime soon. Mr. McGuinness said its strategy is to expand its portfolio of student housing through development and acquisition, and to refine its shopping-center holdings to focus on its most profitable markets. He said the company has expanded its credit line and is using the proceeds from some recent asset sales to pay down debt and fund the expansion rather than return money to shareholders.

“We have a lot of shareholders, Mr. McGuinness said. ”We’re trying to balance the desire to have a current yield and still have a base in student-housing and retail assets.”

Inland American executives point out that the fund has taken some steps to provide shareholders some more flexibility. Most recently, the REIT spun off 46 hotels into a new publicly traded company, Xenia Hotels & Resorts Inc., while issuing shareholders one Xenia share for every eight shares of Inland American they owned. That gave investors a liquid public stock. But the split also prompted Inland American to cut its dividend. Even with the Xenia’s dividend, distributions to shareholders are about half what they were before the spinoff.

Inland says it plans to use $480 million of the $1.1 billion in proceeds from a separate sale of hotels last year to expand its portfolio of student housing and pay down debt. That has angered some investors, who want Inland American to cash them out.

Kenneth Mills, a retired human resources manager in Marlton, N.J., invested $10,000 of his retirement savings in Inland American in 2006. Now, with the quarterly dividend cut and his investment worth roughly $6,400, he is frustrated. In recent months he has sent letters to Inland American’s management team requesting they liquidate the fund and return his money. The company sent him a letter explaining that this wasn’t possible, he says. Inland American declined to comment on its conversations with individual shareholders.

“It was a rotten investment,” said Mr. Mills. “I don’t think they’re making any effort to accommodate the shareholders.”

http://www.wsj.com/articles/latest-fear-for-property-investors-zombie-reits-1427221093