Stephane Fitch Contributor
I write about small business owners' investing fails, lessons & wins
Pious and affable, Leo Wells has them flocking to his dimly lit real estate complex. Where's the exit door?
Leo F. Wells has become one of the hottest names in real estate. His real estate investment trust is amassing an amazing amount of fresh capital: In 2003's first half he sold $1 billion of stock, amounting to nearly half what public REITs raised, and he's targeting another $1.5 billion by year's end. Like a latter-day Harry Helmsley, he is using the money for a buying binge of first-class office properties. In May his REIT bought Chicago's 83-story Aon Center, the third-tallest building in the U.S.
Wells' five-year-old investment pool is in the vanguard of a new trend, "private REITs," whose shares aren't traded on exchanges. Although Wells files publicly with the Securities & Exchange Commission, you must buy and redeem the stock directly from the REIT. This private-REIT bunch is madly peddling shares. W.P. Carey, the grandfather of these creatures, right now is offering $1.8 billion in stock.
Are these good investments? Not really (see table). Private REITs keep their share prices frozen, meaning there's no possibility of appreciation. If, for instance, you buy a hotel-REIT share from Apple Suites Realty at $10, this company will give you $10 back. Private REITs are pretty liberal with the fees siphoned off for insiders. And there is scant prospect of a hostile tender offer to rescue the shareholders of a mismanaged private REIT.
As the largest private real estate trust, $3.3 billion (assets) Wells REIT does things on a grand scale. The company owns 18 million square feet of prime office buildings that are 98% occupied, mostly by corporations with investment-grade credit ratings. Wells REIT pays an annualized 7% dividend yield, in line with those of public office REITs. Free of long-term debt, Leo Wells says that he has plenty of margin for error. He boasts, "If 50% of my properties go bankrupt, I can still give you a 3% yield."
A cherubic fellow with an easy Southern charm, Wells, 59, combines a salesman's bonhomie with a religious conviction that he is doing good for his 100,000 investors. The company creed is "to glorify God and care for people." Meetings at headquarters in suburban Atlanta often begin with a prayer. Professions of atheism, casual dress at work and drinking are verboten. So are beards and moustaches. Last year Wells settled a lawsuit with Gregory Genovese, a broker for Wells until 1999, when he alleged he was fired for failing to shave.
Like many financial products, this one needs heavy marketing to succeed. "Private REIT shares are sold, not bought," says Jon A. Fosheim, cofounder of real estate research firm Green Street Advisors. Mirroring its peers, Wells REIT depends on an army of salesfolk--39 affiliated brokers and 3,000 independent reps--whom Wells' executives pump up at annual conferences.
These rah-rah sessions have drawn the scrutiny of the National Association of Securities Dealers, which has decided to institute disciplinary action against Leo Wells for violating rules on gift-giving by paying for reps' travel to the conferences. Wells won't comment on that.
Amid all the sales palaver, Wells' REIT's weaknesses get downplayed:
Stagnant stock. Wells' REIT's big pitch is that no investor has lost money with the trust. True, if you ignore opportunity cost. The share price has been fixed at $10 since 1998. Since then the four most widely held publicly traded office REITs have averaged 5.4% yearly in price gains. Add in their dividends and the return was 11.5%, outpacing Wells' 7% dividend-only return.
If you want to redeem your Wells shares, you may have to stand in line. The REIT has committed to cash out (at the full $10) up to 3% of its shares every year. So far redemption orders have been modest and last year's $21 million of cash-outs came to only 1.75% of the stock then outstanding. But if there were a rush for the exits--say, after a big cut in the dividend--the redemptions would be first come, first served, and it might take a long, long time to unwind a position.
If you want liquidity, try a conventional REIT. AMB Property , a public REIT of roughly the same asset size as Wells' REIT, trades on the New York Stock Exchange and turns over 35% in a single month.
With a private REIT you are not permitted to sell your shares to anyone else but Wells REIT. If you want to transfer your Wells shares to someone else in particular, you must arrange the deal through Wells itself.
Next comes the dilution problem, partly resulting from a frozen stock price and willy-nilly sales of new shares. Look at a common earnings metric for REITs called funds from operations (earnings plus depreciation). Investors have seen the Wells FFO dip from 83 cents per share in 2000 to 70 cents today.
All the fresh capital is being plowed into ever more expensive real estate. From the REIT's mid-1998 founding until the end of 1999, Wells paid $110 million to buy 1.25 million square feet of office space, or $88 a foot. With the boom years over, though, office building prices paradoxically went up: People shunted their money from the ailing stock market into property, a strategy that dropping interest rates aided. Last year Wells spent $1.7 billion for 5.7 million square feet, $188 a foot.
Weak earnings. Wells has long insisted that any shareholder who bought his stock in late 1999 was well served by his efforts to expand the REIT, because its vastly larger tenant roll lowers the risk that one or two tenants could go bankrupt and force a dividend cut. "I'm passionate about the surety of my dividend," says Wells.
Nonsense. The safety of Wells' dividend has deteriorated alarmingly. Last year's 73-cent dividend was not covered by FFO, so Wells had to borrow $8 million short term to cover it. For 2003's first period (the second one isn't out yet) the FFO was 19 cents a share, up a penny from the year earlier and barely enough to cover the 17.5-cent quarterly dividend Wells has retreated to.
What's happening: Recession-time rents on new properties aren't keeping up with these buildings' rising costs. And although Wells has long crowed over his tenants' stellar status, it turns out that some were deadbeats. Two of them were Enron-tainted Arthur Andersen, whose accounting business propelled it into oblivion, and auto parts maker EYBL CarTex, which went bankrupt. "The quality of tenant credit in this country was sliding rather rapidly," he admits.
Most big office REITs pay out only 70% to 80% of their FFO. Some of the balance goes to cover the cost of replacing roofs and elevators and the like, a cost Wells largely avoids by signing tenants to triple net leases in which they cover operating costs.
But some of a REIT's funds from operation must be set aside to update space when leases roll over, and Wells does face that burden.
High fees. To ensure that tenants maintain property, Wells says, inspectors need to visit them quarterly. The REIT buys that service from a company owned by Leo Wells, called Wells Management, to which it pays a fee of 4.5% of the rent roll. Real estate pros find that way high: For a triple net lease, 1.5% is more like it.
Then there's an entity called Wells Real Estate Funds, which gets a 2.5% cut on the purchase price for advice on which properties to buy.
Then come lush fees on all the new capital. Some $400 million--16% of the equity capital Wells is raising this year. By Green Street Advisors' reckoning, that's four times what publicly traded REITs incur when they make follow-on offerings. A third of the boodle goes to Wells' own sales organization, Wells Investment Securities, or its advisory firm, Wells Real Estate Funds.
How does Wells justify these fees? Wells says he spares no expense to give his investors maximum service. He quotes Bob Dylan, saying: "'You gotta serve somebody.' We serve the investor."
Interesting. Leo Wells owns 100% of these affiliated firms, but he has just a tiny $15,000 stake in his supposedly wonderful REIT.
Stephane Fitch
I took the biggest risk of my life in 2011. I quit my beloved job as an award-winning Forbes bureau chief, financial writer and occasional TV blatherer to join the ranks...