In the following guest post, Sarah Abrams, Head of Claims Baleen Specialty, a division of Bowhead Specialty, takes a look at the D&O underwriting issues associated with Real Estate Investment Trusts (REITs), in the context of a pending securities class action lawsuit involving a cannabis-focused REIT. I would like to thank Sarah for allowing me to publish her article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Sarah’s article.
********************
Plaintiff shareholders in Innovative Industrial Properties, Inc. (IIPR), a publicly traded cannabis-focused real estate investment trust (REIT), recently appealed the dismissal of their proposed securities class action and argued to the 3rd Circuit Court of Appeals that the REIT misrepresented its financial health and failed to conduct due diligence on a tenant (King’s Garden) who had been accused of embezzlement. The allegations made against IIPR by shareholders are interesting, given that IIPR specifies that its investment portfolio focuses on the acquisition, ownership, and management of industrial properties leased to state-licensed cannabis and cannabis is still banned under federal law, creating challenges for legally banking revenue. Even so, IIPR is publicly traded on the NYSE and, to date, is still issuing dividends.
Before discussing the alleged facts in the underlying IIPR securities case, to understand the unique risks that REITs present to D&O underwriters, the following reviews the creation of REITs as an investment vehicle as well as REIT performance, applicable Securities and Exchange Act regulations, and case examples alleging fraud against REITs. Because REITs remain a common investment vehicle for shareholders to earn returns (primarily dividends), hedge against inflation, and diversify a portfolio, D&O insurers of REITs should take note of the risk nuances.
Congress established REITs in 1960 by way of Public Law 86-779, sometimes called the Cigar Excise Tax Extension of 1960, which was enacted to allow all investors to invest in large-scale, diversified portfolios of income-producing real estate through the purchase and sale of securities. The industry expanded significantly in the late 1960s and early 1970s from the increased use of REITs in land development and construction deals. The Tax Reform Act of 1976 authorized REITs to be established as corporations in addition to business trusts.
Basically, REITs provide a way for individuals to invest in real estate without directly owning property by pooling money from investors and using it to purchase and manage income-producing real estate, such as apartment buildings, shopping centers, office buildings, warehouses, through the issuance of publicly traded shares. Investors in REITs receive income, typically in the form of dividends, generated from the properties. A 2020 Federal Reserve Board Survey of Consumer Finances (SCF) estimated nearly 144.7 million Americans—or roughly 44 percent of American households—invest in REIT stocks. The top 3 REIT investments to buy in 2025 included REITs specializing in logistics, wireless communications and broadcast towers, and healthcare facilities. That is a large amount of retail investors and potential shareholder plaintiffs for a securities class action.
The National Association of Real Estate Investment Trusts (Nareit) has been keeping track of historical return data for the REIT sector since 1972. It has developed several indexes to track REIT returns, led by the FTSE Nareit All Equity REITs Index. REITs have outperformed the S&P 500 over the past 20-, 25-, 30-, 40-, and 52-year periods. Stocks have delivered higher returns in recent years, with the S&P 500 beating REITs over the previous 1-, 5-, and 10-year periods. While posting a positive return of 8.8% during 2024, REITs underperformed the broader market for the year, lagging all of the major indices, including the S&P 500 (25.0%), the DJIA (15.0%), and the NASDAQ (29.6%).
While the economy held steady and inflation stabilized, uninspiring earnings growth and relatively constricted transaction markets have limited potential upside. Also, expectations for the Federal Reserve to cut interest rates in 2025 have not yet panned out, which may hurt REIT performance. Interest rates affect REITS because REITs, as a portfolio of real estate, REITs usually carry a lot of debt. Lower interest rates tend to reduce interest expenses, improve profitability, and increase the present value of future cash flows (via lower discount rates). Over the past several years, REITs have faced rising interest rates, which increased their borrowing costs and put pressure on their profitability.
Given the recent comparative decrease in performance, including depression of REIT share value and lower dividend payments, shareholders may look to regulatory filings for leadership misrepresentation regarding growth and profitability. Notably, publicly traded REITs must register their securities under the Securities Act, typically with a Form S-11. The S-11 must include detailed disclosures about investment strategy, risk factors, management, property types, financial statements, corporate governance, and related-party transactions. Once listed, REITs are required to file 10-K, 10-Q, and 8-K reports and comply with stock-exchange corporate governance rules (e.g., independent directors, audit committees).
With an appreciation of the history and recent performance of REITs, as well as filing requirements, examples of potential securities class actions stemming from required disclosures may provide helpful background to how securities cases against REITs are built. As D&O underwriters are aware, regulatory missteps and securities litigation increase expense spend from a public company’s policy.
For example, in the underlying complaint filed against IIPR and its executives, the REIT shareholders alleged that IIPR failed to disclose that the REIT’s focus was to be a cannabis company lender rather than a REIT, misrepresented financial values of various properties in public filings, and ignored information about Kings Garden’s criminal acts. After short seller and market researcher Blue Orca Capital brought the foregoing to light and, among other things, highlighted IIPR’s largest tenant being in default and the co-founders of IIPR’s second largest tenant, Kings Garden, being accused of fraud, IIPR’s share price fell 7.5%.
Whether the 3rd Circuit will be sympathetic with shareholders of a cannabis-focused REIT or instead agree with the New Jersey District Court’s finding that the shareholders failed to show how the REIT and its executives knew their statements about the efficacy of IIPR’s due diligence were false when they were made, remains to be seen. Still, even outside of the semi-legalized drug industry, financial fraud allegations against REITs have been particularly troubling.
D&O underwriters may remember another notable REIT case involving fraud that was prosecuted from the mid-2010s involving American Realty Capital Properties, Inc. (ARCP, now VEREIT). Shareholders of ARCP alleged that senior executives, CEO Nicholas Schorsch and CFO Brian Block, manipulated its core non-GAAP metric, Adjusted Funds From Operations (AFFO), to falsely inflate reported earnings and maintain artificially high stock and bond prices. ARCP allegedly paid fees to entities controlled by Schorsch and Block, who enriched themselves at the expense of investors. The fraud unraveled in late 2014 when ARCP announced that its 2013 and Q1–Q2 2014 financials were unreliable and needed restatement, resulting in a significant stock drop when the inflated AFFO was disclosed.
Thus, in anticipation of an interest rate cut that positively impacts REIT returns and attracts new investors, D&O underwriters of REITs may want to take a closer look at the REIT portfolio of properties and executive oversight to avoid a policy that goes up in smoke.
The views expressed in this article are exclusively those of the author, and all of the content in this article has been created solely in the author’s individual capacity. This article is not affiliated with her company, colleagues, or clients. The information contained in this article is provided for informational purposes only, and should not be construed as legal advice on any subject matter.