Industries Banking/Finance

Apple REITs under scrutiny

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Print this page by Tim Loughran

Glade M. Knight told an audience in Williamsburg last fall that his company, Richmond-based Apple REIT Cos., works hard to “structure something that is better for a shareholder.” But some disgruntled investors claim they got less than they bargained for in buying shares in his Apple real estate investment trusts (REITs).  After a disciplinary complaint against the sole brokerage selling Apple REIT shares gained national attention, they sued the broker, Knight and others connected to the REITs, alleging the investors were misled about the true value and risk of their investments.

In response to three lawsuits, Apple REIT Cos. issued a statement saying, “We believe that these claims against us and our officers and directors are without merit, and we intend to defend against them vigorously.” Although the company has a longtime business relationship with the broker, David Lerner Associates, Apple REIT Cos. said the firms are not affiliated. Knight and other senior company executives declined to be interviewed for this story.

The controversy has focused a media spotlight on the firm and its special niche, nontraded, or unlisted, real estate investment trusts.

Knight is the founder, chairman and CEO of Apple REIT Cos., which has issued nearly $6.8 billion in securities to about 122,600 customers, according to the Financial Industry Regulatory Authority (FINRA), an independent securities industry regulator.

But many people across Virginia also know Knight as a church leader, gentleman rancher and philanthropist.

In Chesterfield County, Knight served for 10 years as president of the 4,000-member local district, or stake, of the Church of Jesus Christ of Latter-day Saints. In Buckingham County, the executive, who was raised in rural northwest Utah, is the owner of the 500-acre Slate River Ranch, where he breeds and rides champion cutting horses. In Buena Vista, he’s the board chairman at Southern Virginia University, a small liberal-arts college that he and a group of fellow Mormons rescued from insolvency in 1996.

In downtown Richmond, Knight is a trustee and patron of the First Freedom Center, a nonprofit organization that honors the 1786 passage of the Virginia Statute for Religious Freedom — the law that served as a model for the First Amendment to the U.S. Constitution. His company is scheduled to build two Marriott Hotels on a corner lot the center owns in Richmond’s Shockoe Slip district where the temporary state Capitol stood in 1786. The project will house an exhibition space and learning center celebrating religious diversity in the United States. It will provide the center with “more than sufficient” annual rental income to fund its education activities, says Randolph M. Bell, the center’s president.

Early success

At November’s “Reinventing Real Estate” conference at the College of William & Mary, Knight told an audience that he began building a real estate business after being discharged from the U.S. Army at Fort Lee in the early 1970s. He failed his first attempt at the Virginia real estate exam but persevered because he saw many opportunities in real estate investment. Taking advantage of generous tax shelter laws, Knight encouraged his investors to borrow money they invested in real estate properties and later pocket $2 worth of tax relief for every dollar they invested.

When Congress ended the last of those tax shelter benefits in 1986, Knight began looking for new opportunities. He discovered real estate investment trusts, an investment that reduces corporate taxes by distributing 90 percent of its taxable income to investors in the form of dividends.

In 1989, Knight formed a Richmond company that would eventually become Cornerstone Realty Income Trust. Seeking to expand his business, he approached Syosset, N.Y.-based David Lerner Associates in 1992 in an effort to reach thousands of potential investors. His plan was to use 100 percent cash offers to buy investment properties for less money. A few years later, Cornerstone listed its stock on the New York Stock Exchange.

By 1999, while still running Cornerstone, Knight formed the first of eight Apple REIT companies.

(In 2005, Cornerstone Realty was acquired by Birmingham, Ala.-based Colonial Properties Trust, which manages apartment communities in 10 states, including Virginia. Knight resigned from its board of directors in April after almost six years of service.)

“...Being able to think a little differently, work a little bit harder and structure something that is better for a shareholder has been able to take us through the ups and downs of the real estate cycle,” Knight said at the conference. “The model we developed as we reinvented ourselves — no one else is doing it that I’m aware of to the extent that we’re doing it.”

Nontraded REITs

The business model used by Apple is called a nontraded REIT. The shares are registered with the Securities and Exchange Commission (SEC) but are not traded on any exchange. In Apple’s case, David Lerner Associates (DLA) is the sole underwriter and broker for all Apple shares and earns a combined 10 percent of all offerings. That arrangement has produced 60 to 70 percent of the New York brokerage’s total business since 1996, according to FINRA. 

DLA suggests Apple REITs and municipal bonds to moderately conservative investors as part of the firm’s “middle ground of investing” strategy which shuns the volatility of stocks and focuses on investments that offer steady dividends. Most Apple REITs continue to pay monthly distributions that equal an annual return of 7 to 8 percent (Apple REIT Eight recently dropped its rate from 7 to 5 percent). Investors get their initial investment back when the company becomes publicly traded, merges with another company or is sold.

Apple REIT Cos. currently has five real estate investment trusts, all of which are invested in Marriott and Hilton hotel properties. Four of them (Apple REITs Six, Seven, Eight and Nine) are closed to new investors. Two earlier REITs, Apple Hospitality Two and Apple Hospitality Five, were sold to other companies in 2007. (Apple Two had merged with the firm’s original REIT, Apple Suites.)

Publicity and lawsuits

In late May FINRA filed a complaint against DLA, citing its sales of the $2 billion Apple REIT Ten, a disciplinary action that, if proved before a hearing panel, could result in fines, censure, suspension or a disgorgement of profits.

The complaint caught the attention of prominent newspapers (The New York Times and The Wall Street Journal, to name two), which published follow-up articles questioning the valuation criteria of properties owned by nontraded real estate investment trusts like Apple REITs. The disciplinary action also attracted the interest of a large number of law firms that specialize in shareholder lawsuits, some of which began running ads on the Web that would pop up when the names “David Lerner” or “Apple REITs” were searched.

By late June, Knight, several Apple REIT executives and board members, DLA and several of its senior executives had become defendants in three separate lawsuits filed by four plaintiffs in federal courts in New York and New Jersey.

In a statement published in The Wall Street Journal, Joseph C. Pickard, DLA’s senior vice president and general counsel, called the suits frivolous, adding the allegations are “baseless and rife with falsehoods, distortions and misleading statements…we look forward to the opportunity to be vindicated in a court of law.”

FINRA allegations

The lawsuits build upon allegations contained in FINRA’s complaint, which, while directed against DLA, is also highly critical of some Apple REIT practices. FINRA does not regulate REITs. They come under the control of the SEC.

FINRA said DLA failed to comply with the industry’s stringent due-diligence standards in selling shares to investors in the $2 billion Apple REIT Ten, which launched in January — an offering that at press time had attracted more than $400 million in fresh investment, according to Alan Chodosh, DLA’s chief financial officer.

In the complaint, FINRA alleges DLA sold Apple REIT Ten shares “targeting unsophisticated and elderly customers” to buy illiquid securities. In marketing Apple REIT Ten shares, according to FINRA, DLA cited the distributions of previous Apple REIT companies on its website while failing to note that many of the distribution rates had dropped and distributions had exceeded funds from operations at Apple REITs Six through Nine in recent years. Citing information available in public filings, FINRA said, for example, that distributions totaled $118.1 million last year at Apple REIT Nine, while its funds from operations totaled only $60.2 million.

In its complaint, FINRA said DLA did not make it clear to customers in sales presentations that distributions might be paid from sources other than the income generated by hotel properties. Those other sources include loans and capital the company would collect from new investors.  “In other words, to maintain an artificially high return on investment, the Apple REITs made a return of investment with the monthly dividend,” FINRA said, adding that using loans and returning capital in this way reduces the value of the REIT and decreases its ability to maintain future distribution levels.

FINRA noted that shares in Apple REITs Six through Nine had been valued at $11 a share since their initial offerings despite recent market fluctuations in commercial real estate, net income declines, increased leverage through loans and the return of capital to investors through distributions. The $11 valuation was the price used by the REITs in periodically redeeming investors’ existing shares or selling them new shares under a dividend reinvestment program.

“The $11 per share valuation Apple REITs Six through Nine adopted is currently inaccurate and has been inaccurate in the past,” the complaint said.

Maintaining a constant share price is an old practice of nontraded REITs that most other companies in the field have dropped, according to FINRA. After a California firm made a tender offer of $3 a share for shares of Apple REITs Seven and Eight in June, the Apple REITs said in a filing that the shares had a book value of $7.57 each.

Investor forms

Pickard denies FINRA’s allegations that DLA targeted elderly investors. “We do not target any particular demographic,” he says. The decision of any investor to buy investments like Apple REITs is “very much a case-by-case, individual-by-individual decision,” he adds.

The brokerage also produced two documents, a suitability profile and an “investor acknowledgement of risk” form, which it says each Apple REIT Ten investor is required to sign. The acknowledgement of risk form points out that REIT distributions “may be sourced from offering proceeds and/or borrowings” and that while the value of each share will be listed on monthly account statements at $11, “the true value of my Apple REIT 10 investment may be higher or lower.”

The Apple REIT Ten prospectus also lists more than 30 potential risk factors, including the illiquidity of its shares and the possible use of investor capital and borrowed funds for distributions.

While Apple REIT Cos. has stressed that it is not affiliated with DLA, plaintiff attorneys contend the firm must share responsibility for any alleged misrepresentation by the broker. 
“It would be different if David Lerner was one of many different brokers that sold Apple REIT investments,” says Jacob Zamansky, a plaintiff’s lawyer in lawsuit filed in New Jersey. “But David Lerner has always been the sole, exclusive representative of Apple REITs ... So it’s our contention that Glade Knight and Apple [REIT Cos.] knew everything David Lerner was telling potential customers ... They are all equally responsible.”

The burden for plaintiffs

Regent University Law School professor Haskell Murray, a former securities litigator at Weil, Gotshal & Manges in New York, says that for these lawsuits to succeed, the plaintiffs must prove that:
• investment counselors intentionally made false or misleading statements in face-to-face sales meetings with clients;
• sales presentations either contradicted or ignored key warnings in the Apple REIT offering prospectus;
• these alleged misrepresentations caused investors to buy shares in Apple REIT funds they otherwise would not purchase;
• and that these Apple REIT shares cost them money.

“I’d guess that 90 percent of these types of lawsuits settle before they ever get to trial,” Haskell says. “The first step will be a ‘motion to dismiss’ from the defense. If the judge denies that motion, then the defendants usually get very serious about settling out of court.”

Managing Editor Paula Squires contributed to this story.

Apple REIT Prospectus
FINRA complaint against David Lerner Associates
David Lerner Associates Inc’s Suitability Report
Apple REIT 10 Investment Acknowledgement of Risk