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INCOME
If It Smells Like...
by Jeffrey R. Kosnett
If a rose by any other name still smells sweet, then a skunk by any other name still smells. Although they have been re-dubbed "direct investment programs" or "direct participation programs," real estate limited partnerships are still the same critters that resulted in massive losses for investors in the 1980s. And yet real estate LPs are experiencing a renaissance. Also booming are sales of their close cousins, relatively new financial inventions called private real estate investment trusts. These nontradable vehicles are set up like regular REITs for tax purposes but look much like LPs in other key respects: They come with high fees and are difficult to unload.
Sales of all LPs peaked at $10.7 billion in 1987, then dwindled to less than $1 billion in 1999. But last year, with real estate prices surging around the country, back they came, to the tune of $7.6 billion in sales. Property LPs and private REITs accounted for 97% of last year's sales.
It's not hard to explain the renewed interest in esoteric property investments. Real estate is hot, and brokers love to push high-commission products. "Glossy packaging and high up-front commissions" are major factors in surging sales, says Lewis Altfest, a financial planner in New York City.
The main attraction of LPs in the '80s was the huge up-front write-offs they afforded investors. But changes in the tax code enacted in 1986 ended that game. Given the absence of tax benefits, it's hard to discern the appeal of partnerships. The major benefit of an LP is that, unlike a corporation, it pays no income tax, so it can pass all the income it generates to investors. In theory, you also get a cut of the proceeds when any of the venture's properties is sold or the deal is liquidated.
Modest requirements
So-called public partnerships generally come in units of $1,000 or $2,000. Private REITs are generally sold in units of $10 but also require initial minimums of $1,000 or $2,000. To be eligible to invest in either product, you have to meet income and net-worth minimums. The amounts vary by state, but you can often qualify if your annual income is at least $60,000 and you have assets (excluding the value of your residence) of at least $125,000.
The fat fees are punishing. Consider Behringer Harvard Short Term Opportunity Fund I, an LP that says in its prospectus that it plans to invest in any type of commercial property. You pay 7% in sales commissions and a "dealer manager fee" of 2.5%. Another 2.5% fee goes for "organization and offering expenses," still another 2.5% for "acquisition and advisory fees," and 1.2% for acquisition expenses and an initial working capital reserve. That's a haircut of nearly 16% before any money goes to buy property. For some LPs, the figure is more than 20%.
That's not all, folks. Once the partnership raises the money, it moves into the "acquisition and development" phase, during which it searches for properties. In the case of the Behringer LP, the sponsor, or general partner, collects 3% of the price of each property as an advisory fee and 0.5% of the price for "acquisition expenses." Next comes the "operational stage," in which the sponsor takes 4.5% to 6% of revenues annually for property-management and leasing fees, and 0.5% of the total property value for "asset management."
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