Real Estate - OCTOBER 13, 2014

Nontraded REITs are a hot property

by Brad Berton

As investors look to diversify their portfolios and capture higher yields in today’s low-yield environment, many have turned to nontraded real estate investment trusts (REITs). The space is certainly booming these days, with the nearly $20 billion in share offerings in the past year almost doubling 2012’s count, according to deal tracker Robert A. Stanger & Co. And, as many shareholders continue reinvesting proceeds into newly formed nontraded REITs as existing trusts execute generally lucrative “liquidity event” exit strategies, offerings may well push past the $20 billion mark this year.

In addition to profitable exits of REIT portfolios assembled when property values were lower three to five years ago, ongoing structural adjustments are likewise attracting more investment in the nontraded sector. Forward-thinking REIT sponsors are offering investors greater transparency with respect to share valuations and fee structures, and in some cases also improving liquidity by allowing more redemption opportunities before liquidity events.

Likewise boosting interest in the space is its expanded variety of investment advisory offering structures — as RIAs in some cases can charge annual fees, rather than the sector’s traditional (and controversial) large up-front loads.

But advisers should counsel caution as additional high-net-worth investors look to join mostly older and passive investors who continue reinvesting exit proceeds into new nontraded REIT offerings in pursuit of the sector’s attractive 6 percent-plus dividend yields. Indeed any frank discussion should touch on the possibility that cap rates and leverage costs will be higher when REITs currently (or soon to be) in asset-accumulation periods approach their liquidity events five or more years out.

While some recent liquidity events have cashed out investors far more successfully than others, the average IRR of late has been close to double-digits — with many in the mid- and high-teens or better. Again, however, those attractive yields in part reflect the strong valuation recovery seen in recent years — a trend unlikely to be maintained over the balance of the decade.

The corresponding risk that shares of today’s newly formed REITs could ultimately end up valued below offering prices (dividend income aside) illustrates some of the key differences between nontraded REITs and their publicly traded brethren.

One critical distinction is that sponsors of nontraded REITs (which often manage the REITs externally) typically raise capital while starting to assemble a blind pool of income-generating properties — rather than offering an existing stabilized portfolio and internal management operation, as is generally the case with publicly traded REITs.

For investors in nontraded REITs that means promised dividend distributions during the early investment period are funded with investor capital rather than portfolio-generated cash flows. This is eventually followed by the sector’s monumental liquidity events entailing dispositions of entire portfolios (via mergers, public offerings and asset-by-asset liquidations).

And while both publicly traded and nontraded REITs must distribute at least 90 percent of their cash flow in order to avoid taxation at the corporate level, another important difference is that there is no established marketplace for nontraded REIT shares, and limited opportunity to redeem them with the issuer. So investors must realize and accept the illiquidity of this vehicle.

In the prevailing environment, “advisers need to put a lot of thought and effort into identifying REITs able to deploy capital efficiently, structure debt properly, and pursue properties and strategies that appear best-positioned for growth in coming years,” saysveteran registered representative Eric Johnson with Centaurus Financial, based in La Jolla, Calif.

Johnson, who has placed substantial client capital into nontraded REITs and meets regularly with officials from these sponsor firms, alsoemphasizes, “Diversification and client suitability are paramount, in addition to the due diligence.”And he tends to favor REITs formed by teams with proven expertise in some of the property categories that should continue benefiting from strong tenant demand going forward. These sectors include apartments, senior housing, healthcare, grocery-anchored retail and perhaps even more specialized assets such as data centers.

Given the hundreds of billions of dollars in commercial mortgage debt scheduled for maturity over the coming half-decade or so, Johnson likewise foresees opportunities for formations of nontraded mortgage REITs in addition to the 70-some active equity REITs in the sector.

Predictably amid such heavy capital inflows, the nontraded REIT space has attracted regulatory scrutiny — and sponsors have responded with products featuring improved valuation and fee transparency, and more liberal liquidity features. Some are recalculating net asset values (NAV) per share at regular intervals — or at least before the typical required valuation disclosure 18 months after a capital raise.

Some NAV-minded trusts are also being structured to allow for more liberal share redemptions — with up to 20 percent of shares redeemable annually on a first-come, first-served basis, compared with the traditional 5 percent.One implication here is that portfolios require more liquid assets to fund redemptions in case investor requests approach the maximum.

And, again, some sponsors are also structuring new trusts to offer broker-dealers share-class options allowing for either up-front loads or annual advisory fees, or combinations of both.Many are generally taking pains to be more transparent with respect to fees and commissions paid by investors, along with how sponsors, managers and advisers are compensated.

The improved transparency and liquidity have helped attract greater investor interest in the sector, and also have allowed for greater access to debt markets. Average leverage in the sector is now slightly above 50 percent, on par with public REITs that have the additional benefit of issuing publicly traded debt instruments, according to calculations by senior industry analyst James Mathieu with SNL Financial.

Brad Berton is a freelance writer based in Portland, Ore.

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