Tricks plumped up REIT distributions, according to suit

An eye-opening analysis of the “distributions” of nontraded REITs sold exclusively by David Lerner Associates Inc. shows that the REITs' property investments largely underperformed the level required to pay promised dividends to investors. Indeed, the analysis claims that the real estate investment trusts consistently borrowed from a line of credit and used distributions that investors were recycling back into the REITs to meet the targeted dividend payout. The examination of the REITs sold by David Lerner Associates brokers, known as Apple REITs, is included in an amended complaint of a prospective class action filed by investors last week in U.S. District Court in Newark, N.J.

MISMATCH CLAIMED

The original class action was filed in June, weeks after the Financial Industry Regulatory Authority Inc. sued David Lerner Associates, a broker-dealer based in Syosset, N.Y., for misleading investors. The firm allegedly provided misleading performance figures for Apple REITs and implied that future investments could be expected to achieve similar results, according to Finra. According to the amended class action complaint, the distribution paid to investors didn't match the level of income generated from the various Apple REITs, which invested primarily in Marriott and Hilton extended-stay hotels. Brokers at David Lerner Associates allegedly told clients that the Apple REITs were safe, conservative investments that would protect their savings from the volatility of the stock market. Investors were promised steady, annualized returns in the neighborhood of 7% to 8%, according to the suit. According to the complaint, David Lerner Associates represented that distributions would be made based on cash flow. Offering documents, however, stated that paying distributions from other sources could happen only in “certain circumstances” and “from time to time.” For example, Apple REIT Eight paid $238.2 million in distributions to investors from 2007 to 2010, with just $82.3 million — or 34% — coming from cash from the REIT's operations, according to the complaint. Likewise, Apple REIT Nine from 2008 to 2010 paid $188.5 million in distributions, with $42.2 million — or 22% — derived from cash from operations. David Lerner Associates and other defendants “paid distributions without regard to profitability, even as they acquired properties at prices they knew could not conceivably justify the level of distributions they were paying,” the complaint alleges. Paying for a nontraded REIT's distribution with cash from operations has become one of the most closely watched measuring points for a REIT product, industry executives have said recently. “David Lerner Associates vehemently denies all allegations. It would be inappropriate to comment further because this is pending litigation,” Joseph C. Pickard, senior vice president and general counsel, said in a statement. “We studied the David Lerner REITs in great detail and have consulted with REIT and hotel experts, and laid out a case in great detail for the court and David Lerner Apple REIT shareholders,” said Jake Zamansky, a plaintiff's attorney. “It's a stark and startling presentation of this very dubious investment.” All told, investors bought $5.7 billion in five separate Apple offerings from David Lerner Associates brokers from 2004 to 2011, according to the class action complaint, with the REITs valued at $11 a share. The most damning allegation in the lawsuit, which is waiting for approval of class action status, is that David Lerner Associates negligently misrepresented to investors the value of the Apple REITs as $11 a share, Mr. Zamansky said.

LERNER LONE B-D SELLER

“That was not accurate, and the financial operations of borrowing and financing through new purchasers were never disclosed,” he said. Lead plaintiffs include Stanley and Debra Kronberg of Mahwah, N.J., who invested $420,000 in various Apple REITs. David Lerner Associates, which is the lead defendant the lawsuit, didn't create or manage the REITs, but no other broker-dealer sold the product. The Apple REITs are controlled and managed by Glade Knight, a real estate investor based in Richmond, Va., who is also named in the lawsuit. David Lerner Associates and its brokers have received $341.5 million in commissions and expenses from the sale of Apple REITs Eight, Nine and Ten, according to the complaint. The firm and brokers receive a 7.5% commission from each Apple REIT share it sells, along with a 2.5% marketing expense, according to the complaint. On client brokerage account statements, David Lerner Associates no longer lists the Apple REIT shares at $11 a unit but now describes them as “not priced,” according to the class action complaint. Email Bruce Kelly at bkelly@investmentnews.com