Challenges faced by the nontraded REIT industry over the past market cycle have caused investors and advisers to pause. The structure has so far proven difficult to manage effectively and problematic to transition to the traded markets, not to mention its complexities are tough to understand. Advisers were left explaining and apologizing to clients when liquidity events returned less than their distribution rates in the nontraded REIT and business development company (BDC) markets.
As predicted, capital raise slowed again in 2017, resulting in continued consolidation and changes in the nontraded space. The traditional “lifecycle” nontraded REIT has become less prevalent, as has the nontraded BDC structure. Sponsors have shifted to either a more institutional “perpetual life” structure in the real estate category or a more flexible closed-end interval fund structure. Institutional money managers have replaced the original nontraded REIT sponsors as industry leaders. All are trends many believe are the keys to helping right the nontraded industry ship.
In summary, nontraded REITs posted the following 2017 numbers:
- $4.3 billion raised by 33 programs active during 2017, the lowest in more than a decade
- 40 percent of that total was raised by Blackstone Real Estate Investment Trust, the leading fundraiser in 2017
- 11 programs closed in 2017, and one sponsor (W. P. Carey Inc.) exited the market
- One institutional money manager entered the market in 2017 (Blackstone Group) and two more are offering programs in 2018 (Nuveen and Starwood Capital Group)
- An average distribution rate of 5.46 percent for the industry (5.27 percent for actively fundraising programs, and 5.56 percent for closed programs) for 2017, lower than the 6.17 percent average in 2012
- Average debt ratio of 45.55 percent, unchanged from 2012
Nontraded REIT sales increased modestly in fourth quarter 2017 compared with the third quarter, although the increase was not enough to offset an already slow year. 2017 is now the lowest capital-raise year in more than a decade for the nontraded REIT sector, raising $5.6 billion, about 4 percent less than 2016. Some $4.3 billion was raised through 33 programs that actively raised capital during the year, while the remainder was raised through the roughly 70 closed programs that continue to raise capital through distribution reinvestment programs.
The slow capital-raise year comes in spite of the entrance of the Blackstone Group (Blackstone REIT); the well-known institutional real estate player had a banner year, raising more than $1.7 billion in 2017. Blackstone REIT, a diversified, perpetual life REIT that adjusts its NAV monthly, acquired 115 properties in 2017 for an aggregate cost of $3.6 billion. It is fully covering its distribution from operations and has been able to redeem all shares requested.
Second to Blackstone was Carter Validus Mission Critical REIT II, a traditional lifecycle REIT that invests in two specialty sectors, hospitals and data centers. Carter Validus raised $418 million (one-quarter of the Blackstone total), acquired 16 properties for slightly more than $600 million, and paid its distribution through a combination of cash flow from operations and distribution reinvestment program proceeds. Notably absent from the capital-raise leader board were some of the prior-generation leaders. CNL and Inland Real Estate Investment Corp. each raised less than 1 percent of the total. W. P. Carey raised enough in the first two quarters to make the top 10 for the year, before exiting the market completely in June 2017. Eleven programs closed in 2017, representing 18 percent of the capital raised and leaving only 22 active programs at year’s end. For the past five years, the industry has averaged 30 to 40 active programs. Two new nontraded REIT programs became effective in April 2018, both with money managers that have traditionally managed in the institutional or public markets. The Nuveen Global Cities REIT, managed by TSR — the real estate manager for Nuveen and TIAA — looks to invest in stabilized, income-oriented commercial real estate located in and around leading global cities. The Starwood Real Estate Income Trust, managed by Starwood REIT executives, looks to invest in stabilized, income-oriented commercial real estate in the United States and Europe. Both programs are structured to mirror the diversified, transparent, perpetual life, monthly net-asset-value structure of the Blackstone REIT.
It will be interesting to see whether these funds take market share from the current leaders or bring new capital to the market.
Real estate data providers are reporting a softening in real estate transactions and fundamentals. Colliers International reported overall U.S. transaction volumes in 2017 fell 7 percent from a year ago, after declining 9 percent from the prior year. Transaction volumes have declined year-over-year in seven of the past eight quarters. Jones Lang LaSalle reported rent growth is slowing and vacancy rates are drifting higher for a number of major property sectors. Cap rate compression has stalled, if not ended completely, for this cycle. Inflation has increased 3.0 percent as of first quarter 2018, and underlying trends signal inflation heading upward. Increasing inflation is usually coupled with increasing interest rates, which can, in the long term, influence property values if rising rates are not coupled with a strong economy. Although the slowdown in capital raise in the nontraded markets may be due more to structural challenges, the slowdown in the broader real estate markets appears to be based on investor caution. One could say the recent slow raise in the nontraded industry may turn out to be a blessing, if the market has, in fact, peaked and is beginning to turn.
The 94 open or closed nontraded REITs not liquidated as of Dec. 31, 2017, manage about $85.2 billion in assets. The 22 funds currently raising capital in the market manage $15.8 billion, with 63 percent of assets in the diversified category. Net lease is the second-largest category, representing 11 percent of total assets, followed by healthcare at 9 percent. The dominance of diversified programs in the space reflects the shift toward the perpetual life structure as opposed to the traditional sector-focused REIT. Perpetual life fund managers actively manage their allocations to the different real estate categories and acquire, manage and sell properties on a continual basis, in contrast to the lifecycle REITs that acquire a portfolio and eventually implement a liquidity event. The traded real estate markets have traditionally shunned the diversified category, which represents a little over 5 percent of the FTSE Nareit All REIT Index as of Dec. 31, 2017. In the past, a traditional nontraded REIT might face difficulties at liquidity if looking to sell into a market that prefers more-focused funds. Because the end game with perpetual REITs is less about a liquidity event, however, and more about continual management similar to how institutions invest, this is possibly less of a concern.
Distribution yields paid by nontraded REITs have declined from an average of 6.17 percent in 2012 to an average of 5.56 percent as of Dec. 31, 2017. A decline makes sense given the cap rate compression experienced in the markets over the past five years. Nontraded REITs still boast a higher average distribution rate (aka their illiquidity premium) than public equity REITs, which averaged 4.15 percent as of Dec. 31.
Nontraded REITs have seen largely no change in their debt ratios over the past five years. The industry average, including open and closed nontraded REITs, was 45.55 percent as of Dec. 31, which was identical to the average five years earlier. This is comparable to the traded markets, which have an average debt ratio of 41.9 percent. The average interest rate on debt declined about 80 basis points over the past five years, from 4.61 percent in 2012 to 3.89 percent.
Then we have the nontraded BDCs, which, in summary, posted the following 2017 numbers:
- $1.4 billion raised by open and closed nontraded BDCs, including distribution reinvestment program proceeds
- 12 programs were active during the year, raising just over $800 million. As of Dec. 31, there were only six remaining active programs, representing one-third of the capital raised for the year
- Average YTD return for nontraded BDCs was 4.70 percent, NAV return
- Several funds have converted from the nontraded BDC structure to a closed-end interval fund structure to allow for greater flexibility. Only one new program has registered as a nontraded BDC so far in 2018.
The big story in the BDC market is the continued shift toward the more flexible interval fund structure. As the leveraged loan market has tightened and opportunities dwindled, many of the original BDC sponsors have either converted existing BDCs or focused on interval funds for new offerings. FS Investments (formerly Franklin Square), the first sponsor to bring a program to the industry back in 2009, has switched to an interval fund focus after offering four nontraded BDCs. The original program, FSIC I, was listed on the New York Stock Exchange in April 2014. Since listing, the stock price has declined more than 26 percent. The PowerShares Senior Loan ETF, which correlates to the S&P/LSTA U.S. Leveraged Loan 100 Index, declined 6.24 percent over the same period. FS Investments launched FS Credit Income Fund and FS Energy Total Return Fund as interval funds in 2017.
Other transitions in the industry include the acquisition of the Griffin-Benefit Street Partners BDC by Griffin Capital Co.’s Institutional Access Credit Fund (an interval fund), and the conversion of VII Peaks Co-Optivist Income BDC II into an interval fund currently registered with the Securities and Exchange Commission as the VII Peaks Co-Optivist Income Fund. Two nontraded BDCs closed in first quarter 2018. CNL’s Corporate Capital Trust II BDC closed in January, ahead of the large merger between FS and CNL’s BDCs. Highland Capital Management closed its healthcare-focused NexPoint Capital BDC in February. As of March 31, 2018, six nontraded BDCs were actively raising capital.
Nontraded BDC NAVs increased by 4.70 percent during 2017, including open and closed programs. NexPoint Capital increased 10.06 percent, the industry leader for the second year in a row, while Triton Pacific Investment Corp. reported its NAV declined 8.90 percent during the year. The PowerShares Senior Loan ETF reported a decline of 1.28 percent for full-year 2017.
In terms of capital stack, nontraded BDCs have maintained a focus on senior debt. For the past five years, the average allocation to senior debt ranged between 75 percent and 85 percent.
BDCs have increased their allocations to variable-rate debt over the same time period, while decreasing fixed-rate debt allocations. This makes sense given the increasing potential for interest rate hikes and inflation going forward.
The highly popular closed-end interval funds continue to see the greatest growth in the nontraded market. The structure, which allows a fund to own illiquid and liquid funds and assets, has a limited track record, however, through a full economic cycle.
The interval fund was the only nontraded category to see assets increase and, despite the structure’s relatively new presence in the nontraded industry and lack of track record during economic downturns, it appears to be the new favorite structure. As of Dec. 31, there were 43 active interval funds with total net assets of $22.1 billion, an increase of 10 percent from prior reporting periods. Former BDC-focused sponsors FS Investments, Griffin, CION Investment Corp., Sierra Income Corp. and Highland (NexPoint) all converted BDCs or opened new interval funds in 2017. Six funds registered with the SEC in first quarter 2018, for a total of $5.2 billion in maximum offering amounts. Fiscal-year-end 2017 returns averaged 6.61 percent, although performance varied greatly by strategy, and many of the newer funds have not yet reported returns for the fiscal year.
While the interval fund seems to be the structure of choice for many sponsors in the nontraded industry, few nontraded interval funds existed during the global financial crisis to give investors an idea of how a fund would perform over a full economic cycle. Two funds that were around — Voya Senior Income Fund and Invesco Senior Loan Fund — declined 46.33 percent and 54.07 percent, respectively, from peak to trough between 2007 and 2008. Both funds invest in relatively liquid floating-rate loans, so they were able to fulfill their monthly redemptions and recover. Funds with less-liquid holdings may be pressed to lock in losses if their liquid holdings are not adequate to meet investor redemptions. Investors who were sold the idea of greater liquidity than traditional nontraded funds may also be concerned if they are unable to redeem shares immediately, should a fund’s maximum redemption threshold be exceeded in a downturn. It is not to say this is a category to avoid; it is simply to suggest caution, education and proper expectation setting for advisers and clients prior to investing.
While the nontraded sector experienced its slowest year in more than a decade, the entrance of institutional managers and the acceptance of the interval fund structure may provide a much-needed turning point. Many believe the movement of institutional money managers into the nontraded space is a longer-term trend, as pension assets continue to decline and managers seek additional markets to tap. The access to this caliber of manager and the unique strategies allowed in the interval fund structure give retail investors greater options within the nontraded space.
Laura Sexton is senior director of program management at AI Insight.