Written by the stodgy antiquarians at American Heritage, my father's dictionary defines the word "dividend" as "a share of profits received by a stockholder or a policy holder in a mutual insurance society." Since many non-traded REITs habitually pay dividends using money from new investors and borrowings- not profits- whose dictionary must they be using?
Paying dividends using offering proceeds and/or borrowings is deceitful and lazy, never mind financially illiterate, and it puts overall shareholder returns in great jeopardy. It's deceitful because investors are told their money is beng invested in real estate, but it's not being invested in real estate. It's lazy because it allows sponsors to fake the whole thing, just like a man named Madoff.
Rather than doing the hard work of creating a portfolio that will support reliable dividends and capital appreciation over time, sponsors simply buy themselves a free pass using shareholders' cash to pay dividends. Non-traded REIT sponsors all know this is deceitful and lazy, but they pay dividends with offering proceeds anyway. Why? Because it helps them achieve their true objective, which is the sale of still more shares. In addition to being deceitful and lazy, the practice of paying dividends out of offering proceeds is also completely poisonous, and it should be illegal.
For a real life "cradle to grave" illustration of just how poisonous this is, look no further than Behringer Harvard, a non-traded REIT sponsor based in the financial capital of Addison, Texas. This company is in the midst of producing a string of real life REIT Wrecks, including Behringer Harvard REIT I ("BHRI"). BHRI began life in October 2003, at which time Behringer Harvard management immediately began paying dividends out of offering proceeds. Since that time, Behringer Harvard REIT I has never covered its dividend with real operating cash flow. Furthermore, in all but one year, the majority of the "dividend" came simply from returning shareholders' own money. In fact, As of December 31, 2009, BHRI had paid dividends that totaled more than three times its reported Funds From Operations from 2003 through 2009. Overall, 89% of the dividend constituted a return of capital:
What happened? Among other things, Behringer Harvard consistently used investor proceeds to pay dividends, rather than invest the money in income producing real estate. Unfortunately, the same results that Behringer Harvard manufactured with BHRI are now being produced at its sister REIT, Behringer Harvard Multi-Family REIT I (BHMFI). This REIT is literally a disaster in waiting, chock full of 2006-2007 vintage development deals, mezzanine debt and stuctured equity. It is simply not suitable for unsophisticated retail investors, but it's sold to them anyway. Furthermore, in 2008, Behringer Harvard Multi-Family REIT I did not even come close to covering its 6.5% dividend (according to the 10-K, it was only 58% covered by FFO), yet management somehow decided it would be wise to raise the dividend to 7.0%.
How did this REIT fare in 2009? That depends on your perspective. If you're a shareholder, you're in big trouble. The portfolio produced FFO of negative $700,000, yet management somehow decided to declare dividends totaling $22.7 million. If you're the sponsor, on the other hand, things are looking great: the ill-advised dividend increase helped BHMFI raise $400 million more in equity than the year before!
Whether the SEC continues to tolerate this nonsense is an open question. My educated guess is that they may not tolerate it much longer. All I can say is that it's about time. As [url=http://www.forbes.com/forbes/2005/0509/078.html]Forbes wrote critically in 2005[/url], the practice of "paying dividends with sawdust and promises is rampant among private REITs." Ironically, Forbes used Behringer Harvard REIT I, among others, as an example of this poisonous behavior. The results of paying dividends with sawdust and promises are now in, and it seems pretty obvious that this practice needs to end.