Google the term “unlisted REIT” and you might get a little frightened. Between articles like “Unlisted REITs Face Investment Challenges” and “Nonlisted REIT Losses May Be Recoverable” and websites asking if you lost money to REIT fraud or if you need an attorney to help with REIT losses, you may want to run and hide.

Indeed, these big players in the apartment business have had their problems. Richmond, Va.–based Grubb & Ellis Apartment REIT faced litigation challenges last year, and Addison, Texas–based Behringer Harvard dealt with a barrage of issues in January, with a technical default in Dallas in its Opportunity Fund I, disgruntled investors, and the loss of broker–dealers and key executives, according to Investment News.

This doesn’t exactly surprise many observers. “The nontraded-REIT space is a very difficult and questionable business model, with the up-front loads and the difficulty that probably exists in terms of generating a decent return,” says Dave Bragg, director of REIT research at market research firm Zelman & Associates. “I think the broader [unlisted] industry is troubled. I’m not surprised that there’s more and more negative press.”

Unlisted REITs contend they can weather the storm, but a number of industry watchers wonder whether they can really make their returns as cap rates shrink.

A Different Animal

With turbulence in the stock market and sustained low interest rates, many investors, desperately seeking yield, have come around to unlisted REITs in the past few years. While these ­REITs share many similarities with public REITs, they aren’t listed on the securities exchange, making them illiquid for periods of eight years or more. Selling these products earlier than that can “be high risk and erode total return,” according to the Financial Industry Regulatory Authority (FINRA), an independent regulator for all securities firms doing business in the United States. Unlike public REITs, whose distributions are typically derived solely from earnings, unlisted REITs can be paid out of borrowed funds or out of a return of investor principal. With questions about where investors’ dollars go, the Securities and Exchange Commission (SEC) monitors the industry.

The problem, explains Tony Chereso, president of Edina, Minn.–based FactRight, a firm that provides third-party due diligence related to alternative investment products, is that with cap rates pushing so low in the multifamily sector, it’s harder for unlisted REITs to pay out their promised returns without dipping into other pots of capital if they have an open-ended fund. (A closed fund can’t pay out with new capital.)

“There are very few programs that are close to, or are, covering distributions from cash-flow investments,” Chereso says. “If they’re buying at a 5 or sub-5 cap rate, and they’re paying a 6 percent dividend and a 10 percent load, it doesn’t work. Where is the money coming from? If you have an open program and you’re still raising capital and deploying that capital going forward in an accretive fashion, you’re using new investors or leveraging up in order to have cash to pay dividends.”

Robert S. Aisner, president and CEO of Behringer Harvard Holdings, parent company of Behringer Harvard, explains that distribution coverage evolves over a REIT’s life cycle as assets are acquired and begin to generate operating income, and that investors understand that reality. “With an unlisted REIT, it’s generally understood that distributions must be paid to investors before assets are acquired, and therefore, before operating income covers distributions. Distributions at that phase are largely a return of the investor’s capital,” Aisner says.

Chereso thinks the solution is for unlisted REITs to be a little less ambitious in their return projections. “When [unlisted REITs] acquire the first asset, they should calculate what they can generate after the fees,” he says. “Whatever it is, that’s what they should be paying out.”

The Chase for Yield

If unlisted REITs don’t change their yield requirements, they need to find a way to boost returns. Jeff Hawks, a principal in the Denver office of brokerage firm ARA, says he’s seeing unlisted REITs securing five-year interest-only debt at low rates, sometimes around 3 percent, to score good returns.

There are other methods, as well. “Some unlisted REITs are putting preferred equity into deals to try to get yield up even higher,” Hawks says. “Some have come to Denver ­and, with sponsors/partners, have placed preferred equity or participating debt in order to achieve an above-market return.”

As for Behringer Harvard’s Multifamily REIT I fund, diversification seems to be the top item on the menu, as it builds a long-term platform that could possibly even go public. The REIT added a management arm and entered into a new co-investment partnership with the National Pension Fund of the Republic of ­Korea Government, managed by Chicago-based Heitman. The Korean pension fund acquired minority interests in 15 communities (4,100 units), a little more than one-third of the REIT’s portfolio in terms of units, in late 2011.

Otherwise, Behringer Harvard’s Multifamily REIT I has certainly slowed down on the multifamily acquisition front. Throughout the recession, the firm was one of the industry’s most active and aggressive acquirers, a beacon of opportunistic investment. In 2010, for example, the company spent about $855 million on apartment purchases, but last year, it wasn’t even among the top 10 most-active buyers. As the acquisition market for institutional-grade assets in major metros continues to grow overheated, the company is transforming into a more vertically integrated business model.

“We’re very deliberate about our investment style, and with cap rates compressing, we’ve deployed capital in other areas,” says Mark Alfieri, COO of Behringer Harvard Multifamily REIT I. “We’ve done some mezzanine investing and invested in new development, so we’ve really transitioned from a predominantly acquisition focus to more development and finance.”

In fact, the company recently broke ground on its first in-house development project, in Addison, Texas. The firm has also closed on a few land sites in Austin, Texas; Atlanta; and Costa Mesa, Calif., that should break ground in the next 12 months.

“We’re looking to have about five developments under way between now and the end of the year,” says Alfieri. “We’re still looking at acquisitions, too, and we’re very interested in portfolio opportunities. Debt maturities this year and next are at cyclical highs, and there’s still a lot of overleveraging out there, so I think we’ll have some acquisition opportunities.”