REAL ESTATE INVESTMENT TRUSTS

Steven HallReal Estate Capital Investors, Ltd.January, 2009 (last updated July, 2010)

ATTRIBUTES AND REQUIREMENT OF REITS

A REIT (“Real Estate Investment Trust”) is an entity organized for federal income tax purposes, and is a corporation that owns and manages a portfolio of real estate properties and mortgages. A REIT is a “pass-through entity,” and does not usually pay corporate federal or state income tax - it passes the responsibility of paying these taxes onto its shareholders. In order to maintain REIT status on an on-going basis, it must operate in conformity with the strict requirements for REIT qualification under the Internal Revenue Code.

Because of a REIT’s generally tax-free status at the corporate level, dividends paid to shareholders are typically taxed at ordinary income rates. However, for individual investors, the most important requirement related to maintaining REIT status is the obligation to distribute at least 90% of taxable income to shareholders. This gives shareholders a legal claim to at least 90% of the REIT’s taxable earnings.

Under the Tax Code, “REIT Taxable Income” excludes net capital gains and certain non-cash income. As a result, a REIT generally may choose to retain all or part of its long-term capital gains and as much as 10% of its ordinary income and short-term capital gains. However, a REIT that chooses to retain capital gains or operating income in excess of 10% would be subject to tax on the undistributed amounts at regular corporate tax rates. Accordingly, REITs generally distribute at least 90% of all taxable income, regardless of its composition.

Since most REIT bylaws require majority shareholder approval to “de-REIT”, REITs that meet these tests will continue to be required to distribute at least 90% of taxable earnings to shareholders. This claim on earnings is central to successful high-yield REIT investing, and any REIT that is in danger of losing “REIT status” will quickly lose its appeal as an investment.

REITs Must Comply With Income and Asset Tests

The ability to maintain REIT status is also often directly related to the credit quality of the portfolio, as the majority of the REIT’s income and assets must also be derived from “real estate sources.” To the extent that a REIT portfolio deteriorates, income and assets from real estate sources will decline as “real estate” assets are written down in value and income from “real estate sources” diminishes. This situation has become common during the recent economic downturn, as occupancy levels and net operating incomes have been stressed. In constrained capital markets environments, such as what occurred during 2008, REITs were often unable to raise funds to replace these “real estate” assets and could no longer meet the REIT asset and income thresholds. Accordingly, some REITS failed to any longer meet the requirements for REIT qualification.

Specifically, at least 75% of the REIT’s gross income must be from real estate-related sources, such as rents from real estate or interest on loans from mortgages on real estate. An additional 20% of the REIT’s gross income can include passive forms of income, such as dividends and interest from non-real estate sources (like bank deposit interest). Consequently, no more than 5% of a REIT’s income can come

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from non-qualifying sources, such as income from management fees or other non-real estate business income. In addition, at least 75% of a REIT’s assets must consist of real estate assets such as real property or loans secured by real property. To the extent that income and/or assets related to “real estate sources” fall below the above thresholds, the REIT will be disqualified.

REIT Taxable Earnings vs. Operating Earnings

REIT taxable income is adjusted by deducting any net operating loss carry forwards that have been utilized, after offsetting any net realized capital gains with capital loss carry forwards. This may create opportunities for some REITs to shield themselves from the 90% distribution requirement, since taxable earnings could therefore be less than actual operating earnings.

Other REIT Requirements

In addition to the requirements noted above, REITs must also:

Be structured as a corporation, trust, or association; Be managed by a board of directors or trustees; Have transferable shares or transferable certificates of interest; Otherwise be taxable as a domestic corporation; Not be a financial institution or an insurance company; Be jointly owned by 100 persons or more; Have no more than 50% of the shares be held by five or fewer individuals during the last half of

each taxable year (5/50 rule).

Up-REIT and Hybrid Structures

Existing real estate partnerships (portfolios of properties) can be rolled up into the REIT, creating an operating partnership (“OP”), which should qualify as a non-taxable event. The result would be a new REIT that would own this OP (upREIT Structure). Properties are generally contributed from the existing partnerships at their “appreciated value,” in exchange for operating partnership units, which could in-turn be converted into REIT shares (and share in dividends on a pari-passu basis with the shares).

Going forward, new acquisitions into the OP would either roll-up their partnerships into the OP, avoiding taxable events, or have new investors invest directly into the REIT. Properly established, this structure would avoid taxes on the existing real estate, create a vehicle for future real estate that is already owned to be rolled into the REIT, and give the REIT structure for future investors and/or investments.

A currently-popular hybrid approach is to have a partnership on top, which owns a series of REITs underneath, to allow the potential sale of certain parts of a portfolio and not the whole. A lot of funds are doing single asset REITS to facilitate the eventual sale, via a sale of REIT shares, and thus avoid FIRPTA for the foreign investors. This would be like our current structure, where we avoid FIRPTA by liquidating a company upon sale of the assets with the corporation. Of course, the 100 shareholder requirement and all other REIT requirements for each “single-asset REIT” would still apply.

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PUBLIC REIT OVERVIEW

In a public REIT, which is traded on the major exchanges, investors can readily get in and out of their shares effortlessly with low transactional costs. Public REITs also must comply with the financial reporting and governance requirements under the Sarbanes-Oxley Act and the Securities and Exchange Commission (“SEC”). Legal and accounting fees for small public companies that report quarterly to the SEC often run upwards of $1 million per year. Although it is decidedly more costly to comply with the required disclosures and SEC filings, many investors prefer the public REIT structure to its alternatives, as discussed below, due to the increased financial transparency and mandated governance requirements which add a significant amount of security, credibility, and confidence to the investment.

“PRIVATE PLACEMENT” REITs

As discussed here, a “private placement REIT” is defined as a non-traded private REIT with a relatively small pool of sophisticated domestic and/or international investors. These REITs may not be advertised or sold through a “public prospectus” offering. Instead, they are sold through a private placement memorandum, usually to accredited individual investors or institutional investors. By selling shares privately to only accredited investors, this form of REIT can utilize an exemption from registration under the Securities Act of 1933 and save their sponsor from quarterly filings with the SEC. While private placement REITs incur legal and accounting fees to report to their shareholders, they can do so typically for a fraction of the cost their public (both traded and non-traded) counterparts must pay.

Generally speaking this type of REIT structure is advantageous for the following types of investors: Foreign investors which are resident in a jurisdiction which has an advantageous treaty (low

withholding rate on dividends); Foreign investors trying to avoid FIRPTA* treatment (domestically controlled REITS); Tax exempt domestic investors (e.g. pension funds) wishing to invest in real estate, but also

wanting to avoid UBTI (unrelated business taxable income).

* Foreign Investment in Real Property Tax Act

Besides the general REIT rules discussed previously and which still apply, there are additional considerations for the private placement REIT structure:

Real estate purchased for the REIT must be held for a minimum of 4 years (safe harbor requirement) to ensure that the sale of property is not considered "dealer property." If property sold by a REIT is deemed to be dealer property then the federal tax rate is increased to 100%;

Need 100 investors - Most “private placement” REITS use a third-party service provider that does nothing but find qualified investors, and makes sure that at least the required 100 shareholders are maintained. These “100 investors” would receive preferred stock automatically paid at a fixed rate of interest annually and automatically, to avoid any preferential dividend problems;

Assets initially “contributed” into the REIT (Up-REIT) generally are required to be held 10 years from the date of contribution. Any property sold prior will be subject to a corporate level tax, and gain that was deferred by the contributing partner will also be triggered;

No more than 50% of REIT shares can be owned by five or fewer investors (a pension fund is considered many investors);

If at least 50% of the REIT is owned by domestic investors, then the REIT is not subject to FIRPTA;

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Once the REIT exceeds 500 investors it is subject to regular SEC reporting requirements; Detailed records must be maintained on a quarterly and annual basis to protect the REIT status.

NON-TRADED PUBLIC REITS

Non-traded public REITs have some similarities to their “traded” counterparts. Both pool cash to buy commercial properties, pay out at least 90% of their income in dividends, and register with the Securities and Exchange Commission. However, other than not being traded on public exchanges, non-traded public REITs have unique characteristics worth understanding in detail.

Non-traded public REITs follow a four-stage lifecycle: raising capital; acquiring properties; portfolio management; and a liquidity event. Their typical entire lifecycle is 7 to 10 years, with monthly or quarterly dividend distributions paid throughout the lifetime typically after some initial investment period.

Investment objectives for the non-traded public REIT are clearly stated in the investment prospectus, a legal document the sponsor uses, and must register with the SEC, to describe the shares they are offering to the REIT investors. It will commonly provide material information such as a description of the sponsor’s history, investment strategy, fee levels, biographies of officers and directors, risks associated with the offering, and any other material information.

Non-traded public REITs typically raise money for up to two years before they start buying assets. After that they can, and often do, register to raise more money. Shares of non-traded public REITs are typically sold to “retail” investors via the prospectus through SEC registered broker/dealer networks. These investors pay an upfront commission of normally 7% to their broker/dealer, and a dealer/manager fee of up to 3% to the sponsor. In addition, sponsors charge fees for individual property acquisition fees of up to 2.75%, property financing fees of up to 1%, disposition fees of up to 1%, and asset management fees of up to 1% per annum, plus expense reimbursements.

Once funds are raised, assets are typically purchased quickly to get income flowing to shareholders. Some non-traded public REITS will pay distributions from equity or other cash reserves until which time as the acquired properties can afford to make the distributions. Also, these REITs on average offer dividend yields on initial investments that are significantly higher than those available on average from publicly traded equity REITs - a premium viewed as necessary due to the illiquidity of the investments.

The financial strength of the sponsor company, quality of its management team, investment strategy, sector, and geographic diversification are important factors that informed investors and their financial advisors must explore before choosing to invest in a non-traded public REIT. There have been recent and well-documented examples of poor performance and governance within this sector. However, well-run and governed non-traded public REITs seek to protect investor principa,l and can provide steady distributions and eventual capital appreciation.

The share price of a non-traded public REIT is set by the REIT’s Board of Directors and usually reflects the underlying value of the REIT’s assets, as determined by periodic asset valuations. The shares of a non-traded public REIT usually lack the liquidity of a publicly traded REIT, making it difficult for shareholders to redeem the shares or sell to a third party. However, most non-traded public REIT sponsors do offer limited share repurchase programs to address the unanticipated emergency liquidity needs of their shareholders.

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A non-traded public REIT may decide to list with an exchange at some point in order to achieve liquidity for its shareholders. Alternatively, it may merge with a public company and give its shareholders tradable shares in exchange for their original non-traded shares. Either scenario enables this type of REIT to offer liquidity without actually liquidating its real estate or mortgage portfolio.

The market for non-traded public REITs has come back in 2010 following declines during the depths of the recent recession. In 2007 non-traded REITs raised nearly $11.5 billion in investor equity, followed by $9.7 billion in 2008. The equity raise for 2009 declined to just over $6 billion. However, it is expected to rebound to approximately $8 billion in 2010. In addition, the market is getting crowded. According to Bank of Montreal, there were 44 non-traded REITs operating as of September 2008. As of the end of 2009, there were another $19 billion in non-traded REITs in registration, and nearly $2 billion in still more registrations had been announced as of early 2010. A current list of public non-traded REITs is provided in the Appendix.

The costs of setting up and governing a non-traded public REIT can be substantial both in terms of time and money. If it has 500 or more investors (which is typical), the REIT must comply with SEC reporting requirements.

SEC and State Reporting Requirements for Non-Traded Public REITs

Non-traded public REITs are required to report earnings and other events to the Securities and Exchange Commission, which regulates them like their traded brethren. Additionally, they must comply with Sarbanes-Oxley accounting regulations. The North American Securities Administrators Association (NASAA) adds a layer of state-level regulation not imposed on traded REITs.

SEC reporting requirements include quarterly reports on transaction and balance sheet activity and regular SEC filings for all material events. In addition, the sponsor’s prospectus and ongoing transactional activity must be reviewed by securities officials at the state level. Conflicts of interest are extensively discussed and disclosed in each company’s prospectus filed with the SEC, which must be read and signed off on by the individual investor. Finally, non-traded public REITs are controlled by an independent board of directors that guides the actions of the REIT management team.

Recently, the SEC communicated an effort to make public non-traded REITs prospectuses more concise, informative and useful to investors. Under the new approach, investors will receive a base prospectus that incorporates previously filed information by reference and a quarterly "operating supplement" that provides an update of portfolio data and operating performance. This is in contrast to the historical practice of distributing amendments describing both probable and completed acquisitions, which resulted in a multi-layer disclosure document that presented detailed information on a property-by-property basis in several different sections, but did not present unified information about the REIT's portfolio as a whole. The expansion of existing disclosure of business and financial information is intended to provide a "snapshot" of portfolio data, acquisition activity and overall operating performance.

SEC specific reporting requirements for non-traded public REITS are detailed and complex. A sponsor should obtain advice from both lawyers and accountants experienced with the process, and should also be prepared to staff an internal regulatory compliance and investor relations department. In general, SEC ongoing disclosure requirements are as follows:

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General portfolio operating information, including the number of properties, 10% tenants, occupancy rates, lease expirations, and average effective annual rents per square foot;

Diversification of the portfolio by geographic region and property type, such as office, apartment, industrial and shopping centers;

Discussion of acquisition activity during the most recently completed fiscal quarter, including total costs, occupancy, and property type and yields on such acquisitions based on capitalization rates determined using forward or historical financial measures such as net operating income;

Distributions paid during the most recent period, and the cash flow from operations or funds from operations (FFO) available to source such distributions;

Selected other financial information like that required by Item 301 of Regulation S-K; Discussion of overall company financial performance with period-to-period comparisons, which

could include disclosure of performance metrics such as FFO per share; Discussion of overall portfolio performance, which could include disclosure of performance

metrics such as same location NOI; For each type of fee disclosed in the base prospectus, disclosure regarding both the amounts of

any fees paid as well as any amounts accrued but unpaid; The amount of securities sold to date in connection with the offering, the amount remaining to

be offered, whether the registrant has broken escrow, if applicable, and the offering termination date.Form 8-KThe form required by the SEC when a publicly held company incurs any event that

might affect its financial situation or the share value of its stock.

See 8-K.

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APPENDIX

NON TRADED REIT DIRECTORY

Last Update: July 27, 2010 REIT NAME OFFERING YIELD CURRENT YIELD REDEMPTION POLICY

American Realty Capital New York Recovery REIT

In Registration In Registration In Registration

American Capital Realty Trust 6.5% 6.7% DRIP proceedsApple REIT Six 8% 8.2% 5% of shares outstandingApple REIT Seven 8% 7% 3% of shares outstandingApple REIT Eight 8% 7% 3% of shares outstandingApple REIT Nine 8% 8% 3% of shares outstandingBehringer Harvard REIT I 6.5% 1.0% Not Even if You’re DeadBehringer Harvard Multi-Family REIT I

7% 7% DRIP Proceeds plus 1% of operating cash flow

Behringer Harvard Opportunity REIT I

6.5% 3.25% Suspended

Bluerock Realty In Registration In Registration In RegistrationClarion Properties Trust In Registration In Registration In RegistrationCM REIT In Registration In Registration In RegistrationCNL Lifestyle Properties 6.15% 6.25% 5% of shares outstandingCNL Macquarie Global Growth Trust

In Registration In Registration In Registration

CNL Macquarie Global Income Trust

In Registration In Registration In Registration

Cole REIT II 7% 6.25% Suspended

Cole REIT III 6.5% 6.75% <DRIP proceeds or 5% of shares outstanding

Cornerstone Core Properties REIT

5% 4.8% <DRIP proceeds or 5% of shares outstanding

Cornerstone Healthcare Plus REIT (f/k/a Cornerstone Growth & Income REIT)

5.60 7.60 5% of shares outstanding

Desert Capital 9% Suspended SuspendedDividend Capital Total Realty Trust

6% 6% <DRIP proceeds or 5% of shares outstanding

GC Net Lease REIT 6.75% 6.75% 5% of shares outstandingGrubb & Ellis Apartment REIT 7% 6% SuspendedGrubb & Ellis Healthcare REIT II 6.5% 6.5% 5% of shares outstandingHartman REIT Short Term XX Offering Stage Offering Stage <DRIP proceeds plus 1% of cash flow

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or 5% of shares outstandingHealthcare Trust of America (f/k/a Grubb & Ellis Healthcare REIT)

7% 6% 5% of shares outstanding

Hines REIT 6% 6% SuspendedHines Global REIT 6.9% 6.9% 5% of shares outstandingIncome Property Trust of Americas

In Registration In Registration In Registration

Industrial Income Trust 6.5% 6.5% 5% of shares outstandingInland American 6% 5% Suspended

Inland Diversified 6% 6% 3% of shares outstandingInland Western 7% 1.75% SuspendedKBS REIT I 7% 5.25% SuspendedKBS REIT II 6.5% 6.5% 5% of shares outstandingKBS REIT III In Registration In Registration In RegistrationKBS Legacy Apartment Properties

In Registration In Registration In Registration

KBS Strategic Opportunity REIT Effective 11/9/09

Effective 11/9/09

Effective 11/9/09

Lightstone Value Plus REIT 7% 4% SuspendedLightstone Value Plus REIT II 6.5% 6.5% 2% of shares outstandingMoody National REIT I Offering Stage Offering Stage Offering StageNorthEnd Income Properties Trust

In Registration In Registration In Registration

Northstar REIT In Registration In Registration In RegistrationPacific Office Properties In Registration In Registration In RegistrationPaladin REIT 6% 6% 10% of shares outstandingPiedmont REIT (formerly Wells REIT)

6% 5% Suspended

Prime Group Realty Trust 6% 0% SuspendedPrime Realty Income Trust In Registration In Registration In RegistrationShopoff Properties Trust None None NoneStrategic Storage Trust 7% 7% 5% of shares outstanding

TNP Strategic Retail Trust 6.75% 6.75% <DRIP proceeds or 5% of shares outstanding

W.P. Carey CPA 14 6.32% 7.94% SuspendedW.P. Carey CPA 15 6% 7.20% SuspendedW.P. Carey CPA 16 6% 6.62% 5% of shares outstandingW.P. Carey CPA 17 6.29% 6.34% 5% of shares outstanding

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Wells REIT II 6% 6% SuspendedWells Timberland REIT 0% 0% SuspendedWhitestone REIT 7% 4% Suspended

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