Public nonlisted REITs are the subject of persistent questions and scrutiny. And misconceptions abound about the track records of operators and how nonlisted REITs function on a day-to-day basis.
If you listen to the critics, nonlisted REITs are unattractive products. They aren’t transparent enough. There is limited liquidity, meaning once investors have forked over their cash they can’t get it back until the REIT’s liquidity event takes place seven to 10 years later. The firms are suspect because they don’t have enough cash flow to cover dividend payments. Instead, they use debt and cash from new investors to make up for shortfalls. They charge high front-end load and ongoing fees. And the sector has a spotty record when it comes to liquidity events.
To top it off, some broker-dealers have been subject to lawsuits from investors who felt cheated after being steered into nonlisted REITs that didn’t perform as well as advertised. The Financial Industry Regulatory Authority (FINRA) in August even went so far as to reissue an alert cautioning investors to be careful before investing in the sector.
But backers of nonlisted REITs say this is an inaccurate picture. They’re looking to set the record straight. And when you compare the claims with the reality, there’s some merit to the idea that nonlisted REITs have gotten a bad rap.
The truth is that nonlisted REITs aren’t as opaque as detractors claim. The lack of liquidity is a feature—not a bug. Fees associated with nonlisted REITs have fallen and are comparable with other financial products. And the majority of nonlisted REITs that have gone full cycle have performed on par with publicly traded REITs and other real estate investments.
Despite the questions, the industry continues to perform and raise funds. In the first half of 2012, nonlisted REITs raised $5.1 billion, a $500 million rise over the first half of 2011, according to BlueVault Partners, an Austin, Texas–based research firm that specializes in non-traded REITs. Nonlisted REITs acquired $5.8 billion in properties in the first half of the year. That was down from $7.5 billion in the first six months of 2011.
Nonlisted REITs generally have a life cycle of about 10 years—although that is now shortening.
Here’s a look at some of the claims against the sector and some of the leading sponsors’ and analysts’ responses.
Lack of transparency
Nonlisted REITs have come under fire of late for how they report valuations. After the 2008 financial crisis, publicly traded REITs saw their stock prices plummet. But nonlisted REITs reported relatively stable valuations. That practice has come under scrutiny.
Inland Western REIT, which went public this year under the name Retail Properties of America, told investors last fall that its shares were worth $6.95 each. But when it went public, its shares were valued at just $3.20 before a reverse stock split.
But backers say the issue with the REIT had nothing to do with transparency. It was more about market timing. Moreover, nonlisted REITs are held to high standards in terms of documentation. And state regulators also have to sign off on any unlisted REITs based within their boundaries.
“I’ve probably never been involved with a more regulated part of the industry than this one,” says Kevin Hogan, president of the Investment Program Association (IPA), an industry group that advocates for direct investments.
Both FINRA and the Securities Exchange Commission (SEC) already have rules in place outlining in detail the information nonlisted REITs need to provide in disclosures to broker-dealers and investors.
In fact, there’s even some information nonlisted REITs are prevented from reporting that some think would add even greater transparency.
“With institutional investors, we can give a forecast and then quarter-to-quarter and year-to-year we can track our performance versus the forecast,” says Charles Schreiber, CEO and co-founder of KBS Realty Advisors. KBS sponsors nonlisted REITs but also has a track record of working directly with institutions and pension funds. “We can’t do that with nonlisted REITs. It’s a little bit frustrating because we could give the investor a way to track our performance. But agencies like the SEC and FINRA view that as promissory.”
In addition, to improve transparency going forward and help broker-dealers when selling nonlisted REITs, the IPA is developing a designation for financial advisors. It has developed two courses to date and wants to have seven or eight in total in order to create a full designation. Hogan estimates it will take several years to fully build out the courses.
Lack of liquidity
Related to transparency is the question of liquidity. With nonlisted REITs, investors put their money in for the life of the vehicle. Traditionally, nonlisted REITs have had life spans of about a decade. That’s beginning to shorten to four to six years with some newer issues. Regardless, there is a secondary market for nonlisted REIT shares, but it remains small. And cashing out before the end of the life span comes with penalties. So, by and large, once you’re in, you’re in.
But proponents say that this is precisely the point of nonlisted REITs. Nonlisted REITs were designed specifically to be nonliquid assets to help balance investor portfolios. And the assets are meant to be long-term holds so that emotion is taken out of the equation for investors in times of market euphoria or despair.
“Liquidity is an important component of some investments, but it comes at the price of market volatility,” says Jason Mattox, CEO of nonlisted REIT sponsor Behringer Harvard. “Because direct real estate investments are not correlated to the same forces as those that impact the equity markets, they can effectively reduce a portfolio’s exposure to market volatility.”
And the lack of liquidity comes with a reward: higher dividends.
“Nonlisted REITs pay higher dividends than traded REITs and yield much higher returns than bank deposits,” says Daniel Goodwin, chairman and CEO of the Inland Real Estate Group. “So you experience a trade-off. With nonlisted REITs, you’re trading higher yields for liquidity.”
Still, some nonlisted REIT sponsors have taken steps to address liquidity concerns. ARC and Cole Real Estate Investments have launched so-called daily NAV REITs that provide more frequent valuations of the properties within portfolios and the share price of the REIT. And the REITs will retain a percentage of its overall portfolio in liquid assets to allow for investors the option to sell their shares in advance of the REIT’s liquidity event.
So far, demand for the daily NAV REITs has been muted. But other nonlisted REIT sponsors are keeping an eye on how the two REITs perform.
When it comes to dividends, detractors often point out that in the early stages of a nonlisted REIT’s life span the entities often pay out dividends not from cash flow but from capital raised by new investors and/or debt.
This is generally true. But it’s also part of the life cycle of the vehicles. Nonlisted REITs generally have four phases—raising capital, acquisitions, operating, liquidation. In the early phases nonlisted REITs own few assets. But after they’ve finished raising capital and completed their acquisitions, the entities generally are paying out dividends off from income.
“At that point, the ratios start coming into line,” says David Steinwedell, a managing partner with BlueVault Partners. “Because of the way they’re designed they first operate in a deficit, but then they overcome it.”
What happens at the end of a nonlisted REIT’s life span also has raised some red flags.
Liquidity events include: · liquidation through an outright portfolio sale to a third party · listing on a public exchange · merger with an existing public company.
The example of the IPO for Retail Properties of America that occurred earlier this year was widely pointed to by detractors as an example of how dangerous nonlisted REITs can be.
In this case, the REIT originally projected an initial share price of between $10 and $12. By the time the IPO occurred, the target had dropped to $8. But even that was only achieved by a reverse stock split. That put the true value of the investment at between $2.90 and $3.20 per share, according to various estimates.
Investors in the REIT had received dividends in the years prior to the IPO. But at the end of the day, investors were only returned about 80 cents on every dollar they had invested, according to some estimates.
But while the Retail Properties case played out badly, it has been the exception, according to a study conducted by Blue Vault Partners in conjunction with the Real Estate Finance and Investment Center at the University of Texas at Austin McCombs School of Business.
The research analyzed 17 nonlisted REITs that have experienced “full cycle” liquidity events and found that as a group, they offered “respectable” total returns with an average internal rate of return of 10.3 percent. (Another five non-traded REITs are in the midst of executing liquidity events.) In comparison, the NCREIF index (a proxy for pension investments in real estate) delivered 11.7 percent in total returns and the NAREIT total return index for publicly traded REITs also showed an 11.7 percent return.
“The level of return was pretty close to what the benchmarks produced,” Steinwedell says.
The first non-traded REIT full-cycle liquidity event took place in 1997 when Cornerstone Realty Income Trust listed its shares on a national stock exchange. Of the 17 non-traded REITs that have gone full cycle, five were acquired by a third party, five listed on an exchange and seven merged with other companies.
Part of what’s affecting liquidity events today is the product of commercial real estate values still being down from their 2007 peaks. And that’s something that’s affecting all commercial real estate investors, not just nonlisted REITs.
“Market conditions have the overwhelming impact on liquidity events,” says Keith Allaire, a managing director with Robert A. Stanger & Co., a Shrewsbury, N.J.–based investment banking firm that focuses on real estate. “For example, in this economic environment, a non-traded REIT might have underperforming assets because of the recession—the fundamentals might be suffering—lower occupancy and lower rental rates. As a board member, you’re going to say that now is not the time to harvest the value of the portfolio.”
Nonlisted REITs have also been criticized for having high fees, reportedly 15 percent front loads and then additional fees for operating expenses and other items.
But the days of 15 percent fees are over, according to various sponsors.
According to BlueVault, for the 11 non-traded REITs that were launched in 2011, fees dropped 23 percent from the previous average.
Some fees, for example internalization fees, are being eliminated entirely. An internalization fee was charged when a contract between a REIT and its outside adviser expired and the REIT acquired the outside advisor. But several nonlisted REIT sponsors have now eliminated this fee.
At the end of the day, many nonlisted REIT sponsors argue that the industry has been hurt because real estate as a whole has suffered. But, ultimately, the track record for nonlisted REITs is not that different from other commercial real estate investment vehicles.
Goodwin points out that publicly traded REITs are valued at about 70 percent of pre-recession levels. And the figure is the same for nonlisted REITs.
“So, yes, on average values are down,” he says. “But values are down for all of real estate. So there really isn’t a major distinction in performance.”
Jennifer Popovec contributed to this story.