The optics aren’t good and too often neither is the return on investment. The problem is there might not be a good alternative.

That’s the situation for older nontraded real estate investment trusts. Going back about four years, a popular strategy for nontraded REITs facing a liquidity event was to merge with affiliated REITs, meaning one or more REITs under the same management umbrella. It has not been the optimal solution and, on the surface, it appears to be a bit of self-dealing.

The bogeyman for this type of liquidity event has been the NorthStar mergers. In 2018, two nontraded REITs with the same management parent, NorthStar Real Estate Income Trust and NorthStar Real Estate Income II, merged with Colony Northstar Credit Real Estate, with the latter as the surviving entity. According to a report by Blue Vault, early investors in NorthStar Realty Income realized an internal rate of return of 4.71 percent, while late investors saw an IRR of 1.99 percent. Early investors in NorthStar Real Estate Income II realized an IRR of –0.43 percent, while late investor IRR was –19.21 percent. In the end, the capital loss as a percentage of initial offering price for both nontraded REITs was –28 percent.

There have been similar mergers with even worse results. In 2017, American Finance Trust (originally American Realty Capital Trust V) merged with American Realty Capital – Retail Centers of America. The following year, the combined REIT went public with a listing on NASDAQ under the ticker AFIN. Again, according to Blue Vault, capital loss as of percentage of IPO was –44 percent for American Finance Trust and –37 percent for American Realty Capital – Retail Centers of America.

The NorthStar and AFIN listings went poorly, observes Aaron Rosen, a senior vice president and co-portfolio manager with Pinhook Capital. “Combining those entities was supposed to be beneficial to investors in regard to a final entity that got listed. That didn’t happen and it rarely seems to be the case that anything beneficial does.”

Investors in nontraded REITs generally expect after a five- to 10-year holding period that their investment would have what is called a liquidity event, which is essentially a cash-out. The three most common of these “events” are a conversion of the nontraded REIT to a publically traded REIT with a listing on a stock exchange. A second solution is the sale of the nontraded REIT’s portfolio to a larger, often institutional, buyer. Finally, a third strategy is to merge the nontraded REIT to a similar entity to create a larger holder of real estate investments.

“As an investor, I don’t know if the type of event matters as much as to whether I’m getting the most value for my investment; that’s what I care about primarily,” says Charles Reiling, president of Coastal Investment Advisors. “Whichever method is going to realize the largest gain for investors is the preferred method.”

That seems to be the concern. Are investors getting the best results possible?

The problem, some observers claim, is that there has been a disconnect between management of nontraded REITs and the shareholders. This all has to do with objectives. The shareholders want to make money on their investment, but management wants to make money on the management of the investment. As Rosen says, “the most frequent disconnect is around alignment of interests. Management is often incentivized to maximize management fees going forward. That is the profit line and revenue for being in the business. Putting all the assets [various nontraded REITs] together into one larger REIT usually keeps management in the seat where it has the most amount of revenue going forward. If management doesn’t sell assets, it gets to keep managing and collecting fees. That’s a big part of what is going on here.”

In Rosen’s view it would behoove the sponsor and REIT board of directors to look more closely at selling off the entire portfolio or pieces of the portfolio to maximize value for investors.

That, however, is not as easy as it would seem. It’s arduous and sometimes expensive to organize a portfolio sale, and in today’s market, except for specific sectors such as self-storage, it is difficult to find a buyer offering an incentive for a big portfolio.

“When the entire market is trading at a discount, few buyers are willing to offer that premium,” says Laura Sexton, senior director of program management for AI Insight.

The attractiveness of a portfolio depends on asset class, quality of the portfolio and what buyers in the market are seeking. For a large portfolio, investors are limited, mostly to publicly-traded REITs or a large institution.

“Valuation of the portfolio is a key component,” says Kevin Vonnahme, an associate with Mick Law P.C. “The nontraded REIT may not be able to get the valuation it is looking for to give an adequate return to investors.”

Last year, Carter Validus Critical REIT announced a merger into Carter Validus Mission Critical REIT II. According to press reports, management had to consider two distinct portfolios, data centers and healthcare, and the solutions varied: sale of one distinct portfolio; sale of all portfolios to one buyer; sales of distinct portfolios to separate buyers; or each portfolio going public. Over a two-year period, 2017–2018, the CVCR data centers (a sector much in demand) were sold off, and a year later the remaining portfolios merged.

Let’s look at this second liquidity event option for nontraded REITs, an eventual public offering. The recent record of nontraded REITs going public has not been stellar. As Vonnahme observes, “A lot of liquidity events have not done as well as in the past, and now there is not as much appetite for the IPOs.”

The pot of gold at the end of the rainbow was traditionally a successful listing when, at that moment in time, an investor could make the decision to cash out by selling shares or continue to maintain the investment knowing they can sell shares any time in the future.

“Everyone was looking for an IPO event during the years 2004 to 2005 when we saw a handful of successful nontraded REIT listings,” recalls Dave Laga, CFO and director of due diligence for DPFG Investments. “Recently, nontraded REITs that have listed have not performed as well. One reason has been the high amount of selling by the nontraded investors once liquidity is available.”

That puts stress on the price of a newly listed security when the corresponding buy activity may still be low. The market has not seen values hold-up very well when there has been a listing event.

The IPOs could go one of two ways, with the new company opting for internalized management or to continue on as an externally-managed REIT, but the market has looked unfavorably on the latter, where the external managers are extracting heavy management fees. Secondly, some of the portfolios are too small to go the IPO route (hence a good reason for mergers). While raising a billion dollars sounds great, it is not enough to attract attention with a listing. In fact, $2.5 billion to $3 billion is the lower end of what the public market is going to accept.

How a new listing performs depends partly on the quality of the real estate in the portfolio, the management, and partly on the premium or discount to net asset value. From 2014 until recently, the average public REIT traded at a discount to its NAV, says Sexton. “If the public REIT market is trading at a discount to NAV on average, then for a nontraded REIT there’s a good chance share prices will automatically drop at the onset of the trade. List and there will be an automatic hit based on the average discount.”

Sexton adds, issues around American Realty Capital during 2014–2015 were challenging for nontraded REITs as well. (Allegedly, managers of American Realty Capital Properties extracted millions in fees from the merger of affiliated traded and nontraded REITs. The company paid $60 million in penalties to the SEC and one executive was sentenced for securities fraud.) The market as a whole, including nontraded REITs looking to list and liquidate, took a hit. The industry has since evolved and rebounded, hopefully for the better, but challenges remain for nontraded REITs that raised and deployed capital during the 2014–2015 time period.

How much value does a listing actually carry for investors if the markets discount these REITs by 20 percent to 40 percent post-listing and the associated volatility and market correlations, asks Rosen. “At least some part of those post-listing discounts are public markets pricing in the relative expertise of management, fee structure, and overall portfolio health versus the now-larger universe of publicly traded peers.”

On the surface, the health of the nontraded REIT market appears strong. That market closed out 2019 with more than $11.8 billion raised, the highest fundraising total since 2014, according to data by Robert A. Stanger & Co., which also predicts nontraded REITs will raise more than $15 billion in 2020.

However, here’s the worry in the Stanger data: Lifecycle REITs, where there is a designated holding period (i.e., five to 10 years), have experienced a significant decline in fundraising, off 20 percent in 2019, with the bulk of the new capital shifting to NAV REITs, perpetual entities that look a lot like open-ended real estate funds.

Suppose then that your nontraded REIT’s liquidity event is a conversion to a perpetual life REIT. Not everyone is comfortable with that. As Laga points out, “If you have invested in a finite-life REIT that is supposed to execute a liquidity event within a certain period of time, but later decides to merge into, or convert to, an NAV REIT, that’s problematic as that wasn’t the expectation set with investors at the point of sale.”

While the NAV REIT may provide for redemptions, such redemptions are limited and could always be amended, suspended or even terminated by the REIT’s board. So, by converting a finite-life REIT to a perpetual NAV REIT, the program’s life cycle could be materially extended beyond what was originally expected.

While a merger with associated REITs isn’t the best solution for nontraded REITs, the overriding issue might be, at present, there is no good way out for investors.

Steve Bergsman is a freelance writer based in Mesa, Ariz.