Real value of Apple REITs from David Lerner

[bh1973]

I own a number of shares in Apple REITS 7, 8, and 9. So far, these have been
wonderful investment vehicles. They pay out 8% a year. I reinvest some and
take some of this dividend as a cash payment. REITS 7 and 8 dropped from 8%
to 7% last year, but still, I can't complain - I always love opening my
David Lerner statement (the brokerage firm that manages these REITS for
Apple). However, I am concerned about the borrowing that Apple is
undertaking to meet current expenses (dividend payouts). I am also concerned
that the $9 or $11/per share that I paid (and continue to pay as I reinvest
some dividend income) does not reflect real value. They are no publicly
traded and thus not subject to market pricing. (I think I'm explaining this
properly!). Anyway, I heard somewhere that this year, maybe in April?, that
this type of private REIT will be subject to market pricing, some kind of
new SEC rule going into effect? Is that right? If so, I worry that the
market will find that they are overvalued, owners will try to redeem them,
and the REIT could rapidly collapse.

Do I know at all what I'm talking about? I'm really not sure, but all I get
are friendly reassurances from David Lerner that all is well, nothing to
worry about, etc. Might I have something to worry about? Are these share
prices about to become subject to market pricing? Is there some kind of new
rule going into effect?

Thanks for your help, and thanks for putting up this forum!

[REIT Wrecks]

Do I know at all what I'm talking about? I'm really not sure, but all I get
are friendly reassurances from David Lerner that all is well, nothing to
worry about, etc. Might I have something to worry about?

Hi. Yes, you DO know what you're talking about and so should your broker, as the issue directly impacts a significant chunk of David Lerner's business. Yours is also the perfect launch post, as it touches on numerous issues. First, I am not a financial advisor, but I do want to be both clear and comprehensive, so I have a lengthy (but hopefully helpful!) response:

BACKGROUND
I have attached FINRA Notice 09 09 (the link is below). FINRA is an acronym that stands for the Financial Industry Regulatory Authority; FINRA is separate and distinct from the SEC. The SEC is a Federal agency controlled by the government, while FINRA is a so-called self-regulatory organization controlled by its members (including David Lerner). Some FINRA activities, and most FINRA member activities, are governed by the SEC, but not all. The numbering nomenclature in the FINRA notice (09 09) refers to the 9th regulatory notice issued by FINRA in 2009. As you will see when you review it, this notice was issued to the public, including the broker/dealer community and David Lerner, in February 2009.

SUMMARY
The notice addresses two aspects of member dealings in illiquid securities, and it specifically includes Non-Traded REITs by reference. First, it states that par value (essentially the issue price, $10/share) is not an appropriate value to use on customer statements if the data used to determine that value is more than 18 months old. Second, the notice addresses the safety of dividend distributions, and it redirects the burden of evaluating the safety of those distributions toward the broker/dealer. The notice requires the broker/dealer to assess the sustainability of such distributions, taking into consideration (among other things) whether the distributions are composed of returns of investor capital and/or borrowings. The notice states specifically that "paying dividend distributions that are unsustainable over the long term due to cash flow difficulties presents a significant risk to investors' future returns and the long-term viability of the program". [emphasis mine]

IMPACT
Since all Non-Traded REIT valuations appear on customer statements at par (usually $10/share), I interpret this notice to mean that all Non-Traded REITs more than 18 months old must be "marked to market". It also means that all Non-Traded REIT dividends must be subject to analysis by broker/dealers, and sponsors paying dividends in excess of operating cash flow are subject to a higher level of scrutiny. Clearly, unsustainable distributions affect the valuation of the underlying securities. There is no effective date, and FINRA provided absolutely no guidance on the valuation methodology that should be used. In terms of the date of implementation, that leaves significant discretion in the hands of broker/dealers. More importantly, it allows sponsors to use any valuation methodology they please.

HOW IT MAY AFFECT YOU
The notice could be implemented at any time by your broker/dealer, and it does not mean all Non-Traded REIT values will go down. In theory, some could go up. I am aware that David Lerner in particular continues to show a $10 (or $11) per share valuation for Apple REITs on their customer statements. I believe this is because Apple REIT has a redemption policy in place, and David Lerner's contention is that since Apple REIT is always willing to pay you $10/share, then that's what your Apple REIT shares are worth.

However, that just doesn't add up. First, Apple's redemption policy is limited and conditional, and just like Behringer Harvard, Cole, Inland, KBS, Wells, Whitestone and Piedmont, they can suspend it at any time. No competent accountant would ever sign off on a $10 valuation under those conditions. Second, given what has happened in commercial real estate it is simply impossible that the shares, which represent ownership interests in real property, could continue to be worth anything close to $10. Broadly speaking, commercial real estate values are down by at least 30%, depending on property type and location. Hotels, which are Apple REIT's stock-in-trade, are down by at least 60%, broadly speaking.

David Lerner & Apple continue to show $10 valuations your customer statement for two reasons: to keep you in the dark, and to keep you from selling.

MY OPINION
You should run for the hills, as fast as you can. Your best option is to try to get David Lerner or Apple or both to buy the shares back from you at $10 per share, and threaten legal action if they won't. Another option would be to sell your shares to one of a number of brokers that make a secondary market in these shares (see How to Sell Non-Traded REITs), but I think they will likely offer even less than the true value of the shares. This is because many of them either hold them to maturity and/or try to resell them at a profit, both dicey propositions involving a ton of risk. Hence, you get a big haircut.

Also, although Apple's leverage ratios are quite low, the Apple REIT VIII 10Q indicates that Apple REIT VIII is paying dividends significantly in excess of cash flow from operations. That is not surprising at all, since Apple management has not appreciably reduced their payout rate, even though the industry's Rev/PAR numbers (a commonly used income metric in the hotel business) have plunged. You should ask David Lerner to tell you how Apple REIT has managed to maintain those 7-8% distributions given that industry Rev/PARs are down by something like 50%. It just isn't possible, or even believable.

The reason they were able to maintain that 8% dividend is that they borrowed heavily to subsidize it. The Apple REIT VIII 2009 third quarter 10Q shows that they drew down (i.e., borrowed) $39 million from a line of credit priced at LIBOR +175, and that line of credit must be paid back in November 2010 - or somehow refinanced. I would be surprised if that credit line could be refinanced in November 2010 at any price, never mind LIBOR plus 175. Based on the 10Q, some of your distributions are also being paid using proceeds from new and existing investors buying more stock through the DRIP. This is nothing more than a ponzi scheme - nothing more, nothing less (see Industry Addresses Non-Traded REIT Ponzi Scheme Allegations).

My understanding is that the Apple REIT charter allows all of this nonsense, and if that's true it's all perfectly legal, but it is obviously far from prudent and not in the best interests of shareholders. The only other explanation for drawing down that line of credit is that their hotel properties are not producing cash flow sufficient to pay expenses, and they are paying their mortgages and/or operating expenses by borrowing even more. This is even worse, as it makes the value of your shares worth even less. The question I would ask your friendly broker at David Lerner is this: why didn't you explain all of this to me when I decided to reinvest??

In terms of the valuations on your statement going forward, FINRA provided no guidance to broker/dealers or sponsors on valuation methodology. This is intentional. It is significant, in my view, that the notice never uses the term "mark to market". Mark to market is a term of art used by the SEC and the Financial Accounting Standards Board (or "FASB", these are the folks that bring us GAAP, or Generally Accepted Accounting Principals). Had the notice used this term, valuation would be a relatively straightforward procedure of applying SFAS 157, which is the official FASB accounting promulgation on the valuation of investment portfolios.

SFAS 157 is GAAP, and it is the only method by which any reputable organization in the United States would use to value an investment portfolio that is "held for sale". As a consequence, by avoiding the use of this term, and by not requiring the an independent third party valuation, my guess is that FINRA, in all its self-regulatory wisdom, has purposefully provided a barn door through which many broker/dealers and sponsors will drive a speeding get-away bus. I would not trust valuations whatsoever unless they use SFAS 157. Why use anything other than GAAP? Is this Venezuela??

And yes, you are correct that this is all going to be a big problem when it all blows up. One month after issuing Notice 09 09, FINRA issued a so-called "sweep letter" to the broker dealer community. The letter requested more information on member firms' sales practices with regard to Non-Traded REITS, including, among other things, information on commission payouts, sales promotions and bonuses, copies of sales literature and procedures for determining "suitability". My suspicion is that determining suitability at David Lerner (and other firms) primarily involved the following series of questions: (1) does the investor have money, (2) will he/she ask any tough questions and (3) will they then manage to see through our double talk? The "sweep letter" looks to me like an attempt by FINRA to show that they are on top of their members, and they will probably produce a slaughtered lamb or two after it's all over. My belief is that they are indeed "on top" of their members, and it is very, very consensual. So far, all of this regulatory noise does nothing for investors.

As for David Lerner, I would triple check anything your broker tells you about these investments. That firm is massively conflicted. They are paid by Apple REIT to sell Apple REIT shares, not to look out for your best interests.

Cheers, REIT Wrecks

[bh1973]

Hi,

Thank you for this very informative response to my question. I did call my broker at David Lerner, whom I do think is a nice, ethical guy, but might not be fully informed as to the real value of the Apple shares he's hawking. He told me, among other things, that since Apple has a redemption program (92% of value before 3 years, 100% after three years), it is not subject to the revaluation requirement of FINRA. Whether or not this is really the case I'm not sure. He also told me that none of the Apple REITs currently outstanding are leveraged more than 15% (2 at 5%, one at 15%).

Anyway, I decided to stop reinvesting my shares and will be taking the cash payout until I decide what to do. I've been invested in Apple VII for 2 1/2 years, so I might pull out right at 3 years. I only got into Apple IX in late 2008. It, though, seems to be the healthiest of them all since it's made most of its real estate purchases in 2008-2009 (and hopefully at steep discounts). A former David Lerner broker told me he thinks that the existing Apple REITs might end up merging, with the healthier ones bailing out the weaker ones.

I'm going to take a wait-see on these for now. I could pull everything out right now and probably break even despite the 8% hit. Also, if Apple plans to keep these REITs for several more years, they might ride out the worst and emerge in halfway decent shape, although I suppose if Glad Knight wants he could liquidate whenever he wants for whatever price he wants - it's not his money, after all.

Thanks again for your answer!

[crabsofsteel]

Wow, I had no idea you had addressed this topic. A friend of mine has been touting David Lerner and encouraged me to take a look at Apple REIT IX. I looked at the prospectus and saw that they had paid in excess of $200K per key for their properties. I also looked at the David Lerner website and saw that they were hawking CMOs to retail investors. No retail investor can value a CMO without at a minimum a subscription to Bloomberg ($1,500/month) which they are unlikely to have. I filed a complaint with FINRA about DL selling inappropriate investments and got a phone call several months later; they did nothing as DL is still hawking CMOs. I am really pleased to see the guts of the Apple REITs laid bare here; thank you RW.

[larry785258]

Investors who reinvest their dividends through the company are doing so at inflated prices. I don't know of a REIT that isn't selling for much less than the DRIP (Dividend Reinvestment Program) price in the secondary market. Investors are reinvesting in Wells II at around $9.75
when it can be purchased for around $7.00 in the secondary market. My suggestion is to accumulated your dividends and call my company REILTCO LLC at 602-721-4730 or one of my competitors and you will always buy shares for much less than the DRIP price. I personally don't understand why a company is allowed to sell new shares covered by the dividends at a price above the secondary market. For all of you who are not reinvesting, it is wonderful for you that your REIT can sell new shares at inflated prices - for every fool who reinvests at inflated prices, your equity increases.

You asked about the new SEC ruling. As I understand it (I am not an SEC attorney), companies must show a real value for their shares eighteen months after they complete the offering. The problem is that the SEC didn't define how to determine the real value. Is it the net worth of the REIT divided by the shares; is it what the investors would receive if the REIT sold all its properties - paid commissions and exit fees to the manager; I like to think that value is what another informed investor would pay for your investment. They certainly won't use my definition.

One of the important reasons that planners sold these products originally is that the poor investor had no idea what he owned nor its value. The planner sold the product and the investor saw that it was worth $10.00 on his statement when the facts were quite different. For every $1 invested, the investor owned about $.85 of equity - that was until the market dropped. The planner loved seeing $10.00 on their client's stantements. By the SEC requiring at least some change, this is a step in the right direction.

I don't know who manages this site but please comment of my remarks. The manager and any other reader is welcome to call me and challenge me if they wish or ask other questions. Larry 602-721-4730

[REIT Wrecks]

Investors who reinvest their dividends through the company are doing so at inflated prices. I don't know of a REIT that isn't selling for much less than the DRIP (Dividend Reinvestment Program) price in the secondary market. Investors are reinvesting in Wells II at around $9.75
when it can be purchased for around $7.00 in the secondary market.

Larry, thanks for posting - you'll get no arguments from me. Investors are getting trampled, first on the front end, when $.15 of every dollar is siphoned off too fees and commissions, and then again - if they're foolish enough to reinvest through the DRIP - when they're sold shares for sometimes twice what they're actually worth.

Buying in the secondary market at more realistic prices is definitely better, but people should remember that the lack of liquidity is still a big issue no matter what you pay.

[jakrus007]

This reply goes out to the person who wrote "my opinion" I invested $150,000 in Apple 9, 3years and 3 months ago. I have to say, you scared the hell out of me. Lerner redeems share quarterly only, so Feb. 2010, I had a meeting with my broker at my home. I told him I wanted to pull out my $150,000. He wasn't happy but he said I would have to fill out a redemption form and at or about April 15th., I will get my shares. Up to that point, I have been getting my 8% or $1000 a month without fail. The three month wait was brutal. Based on what others said in this blog but especially what you said, sent me into a panic. I was sure I was only gonna get 7 or 8 dollars on the share and not the $11 as promised. That means I would lose about $42,000. When I saw my accountant around April 1st. to do my taxes, who is also my cousin, I told him about the Lerner nightmare. He told me his cousin works for Lerner who I didn't know. He gave me his number so I called him. Well he put my mind at rest. He said David Lerner has NEVER EVER FAILED TO REDEEM SHARES TO INVESTORS AT 100% OF THE SHARE PRICE, THAT INVESTORS HAD BEEN PROMISED FROM APPLE 1 TO APPLE 9. He also said the reason why my broker wasn't happy was, if every one did what I did at one time, yes then these reits would go bankrupt also he said this is not a three year CD. He said you should be in this for the long haul so you can reap the reward when they sell the properties. Two weeks later I got my entire $150,000. So Mr. "my opinion", I was wondering if it was jealousy why you wrote such a critical opinion of David Lerners Apple reits. I don't get it. If this company gets big commissions from our money, who cares, It's not coming out of our principal and we are still getting a solid 7 or 8% return and about half of that tax free. That's like getting 10% from a CD. Try getting that from a bank today! When you say, "This is because many of them either hold them to maturity and/or initiate proxies to gain control of the REIT at fair value, both dicey propositions involving a ton of risk. Hence, you get a big haircut". So when you say, you get a big haircut, so that means when others have redeemed shares since 1994 they got screwed but not one person has. So where are you getting your misleading information from? Then you say "You should ask David Lerner to tell you how Apple REIT has managed to maintain those 7-8% distributions given that industry Rev/PARs are down by something like 50%. It just isn't possible, or even believable". Yet everyone has received there 7 or 8%. So why would you say it's not possible? See, their's a difference between what you think will happen and what does actually happen. Your the reason why people panic and the whole deck of cards collapses. Now i'm not saying this can't happen in the future but it didn't happen after the collapse of the economy after 9/11 or during the housing bubble collapse. That means, there's a good chance it won't happen unless we really do go into another depression. If that happens all bets are off anyway. Anyway, I got all my money back so those of you who are uneasy, learn from my mistake and don't listen to idiots who think they know more than the real facts. Did you ever think maybe you invested with a rock solid company. I know trust is hard these days because of the Bernie Madoff's of the world but he had red flags going back 10 years. The only red flags you can find with David Lerner are dopes like this on blogs like these, fortune tellers, if you will, spreading terrible rumors of things that have not happened. Maybe they hope the worst happens, this way they can say, see how smart I am! I will now take my money and put it in a 5 year CD at 3.3%. After taxes, that's about 2.75% How am I doing? Better or worse???

[REIT Wrecks]

How am I doing? Better or worse???

I don't know jakrus, you need to ask your financial advisor at David Lerner. I can tell you this: In the first quarter of 2010, Apple REIT 9 paid distributions of $22.8 million, but they reported net cash generated from operations of only $4.0 million. This means, somehow, they paid you 570% more than they earned.

How do you think you're doing?

[crabsofsteel]

as an aside there's an article in today's NY Post about David Lerner Associates selling munis at a 4 point markup.

[DrREIT]

To JackRus007....consider yourself lucky you got out. It is a ponzi scheme. You mention that Lerner reps told you that Apple never fails to meet a redemption request. So what? is the broker going to tell you he sold you a pig with wings? Wait until enough perople redeem and then see what happens. You have to understand this business....the private REIT model (i.e. the Wells model) preys on simple retail investors. Promising them a stabe 7% yeild, while at the same time giving brokers a huge comission, plus overpaying for the assets themselves, and then taking additional fees to, in some cases, manage the assets, get project mgmt fees, transaction fees, etc. The load on one of these deals is probably 20%, so the commerical property(ies) purchased have to accrete 120% just to break even.

These investments have been called roach motels ("you can check in but you never check out). You mention that these investments alway pay the dividend and pay the redemtptions....so it must be legit, right? Wrong....the financial calculus does not work, especially when revpar is down 30% over the last 24 months and on top of that, you have all these onerous fees....something is wrong and without full transparent disclosure, you will never know. many of these companies have tried to go public and they cant, becuase the market will price them at $2.00 per share, not $10. (Whitestone). For all you they are operating on fumes, hoping that no more redemptions come in...also they can suspend redemptions and if enough perople do what you did, that's what will happen. Look at other REITs, some prices droped 90% from the 2007 highs....what makes you think the Apple prtfolio is any different?

How do you think Leo Wells got so rich? certainly not by taking the same risks as his investors. But as long as these companies can manage the dividend and the redmeptions, they can mask how far underwater they are....if the market reaches a culinating point, you will see it all unwind, then the entire comapny will be sold for pennies on the dollar and the lawsuits will fly, as grandma Betty will lose her nest egg. But these companies have had years to sharpen this exit strategy and they will not lose. But it wont come to that if they can continue to raise new money....Madoff would be proud.