Publications

- December 1, 2017: Vol. 4, Number 12

Taking Stock in Listed and Nontraded REITs: Publicly traded REITs have slumped after several banner years, while Wall Street players are entering the nontraded REIT space, indicating better times may be ahead

by Steve Bergsman

The real estate investment trust industry — including publicly traded and nontraded varieties — is having a discordant year. 2017 looks to be a flat year for nontraded REITs with about $4.5 billion in funds raised, while public REITs are running well behind other equities.

In 2016, the S&P 500 Index showed gains of 12 percent, ahead of the FTSE NAREIT All Equity REITs sector’s 8.63 percent and the nontraded REIT’s 5.6 percent. That trend line is holding steady in 2017. At the end of the third quarter, the S&P 500 was up 14.24 percent year-to-date, while the returns for FTSE NAREIT All Equity REITs rose 6.04 percent. Without any specific numbers, Scott Crowe, chief investment strategist and portfolio manager for CenterSquare Investment Management, says, “While the REIT market is delivering mid to high single-digit returns, the nontraded REIT market is probably behind that with low to mid single-digit returns.

For private REITs, there are the ongoing regulatory challenges and uncertainties that have dampened their fundraising efforts in recent years. About 11 percent of total capital invested in REITs was committed to the private variety, according to Robert A. Stanger & Co., which tracks the industry. Historically, during the past 15 years, private REITs have raised about 30 percent of total capital, underscoring their dramatic decline. That has left unsold inventory of nontraded REITs at about $45 billion to $50 billion, which means that at the current run rate there is about 10 years of unsold inventory.

Little wonder that one of the major nontraded REIT sponsors, W.P. Carey, is quitting the sector. Still, Kevin Gannon, managing director of Robert A. Stanger & Co., says: “We viewed this as a little hiccup in the space, as the space brings new products to market with more and bigger sponsors and the addition of Wall Street firms joining the category.”

Indeed, a slew of institutional players are rushing in and raising fresh capital, including Blackstone, Cantor Fitzgerald and TH Real Estate, among others. Why the attraction among institutional players to a category whose fortunes have been in decline? Gannon says they recognize the factors that have caused dislocation in business — high fees and loads and poorly timed valuations — have been cleaned up in recent years, in part by new regulations.

“They recognize that opportunity with the money that is available in tax-exempt accounts, controlled by individuals,” he says. “I’ve heard numbers quoted by some of those big firms that they think their equity under management will increase by $40-plus billion. That’s the kind of appetite they think the market will have for those big institutional sponsors.”

Among public REITs, some analysts expect REITs will end up with a strong year in 2017, but others say REITs remain a risky investment. Regarding individual companies, one analyst goes all-in on publicly traded Public Storage, the large self-storage REIT, while another puts self storage on its “REITs to avoid” list.

Public REITs are not in negative territory, but they are not punching at their weight either — which has been a problem for about two years.

Some in the nontraded REIT space advocate the use of NCREIF’s National Property Index (NPI) as a comparative performance metric for the overall space. The index reflects returns associated with private real estate ownership, which is the fundamental basis of a nonlisted REIT. If that be the case, the second quarter NPI rose 1.75 percent, up from 1.55 percent in the first quarter.

Now that more nontraded REITs are reporting daily or monthly net asset value, that affords another look at performance — although the total number of nontraded REITs doing so are is still very small.

Blackstone Real Estate Income Trust, a relatively new nontraded REIT, first reported NAV per share at end of first quarter 2017 at $10.02 and at the end of second quarter at $10.29. Others reporting NAV beginning at year-end 2016 were Jones Lang LaSalle Income Property Trust (class A) of $11.22, first quarter at $11.31 and second quarter at $11.38; Cole Real Estate Income Strategy (class W) at $18.15, first quarter at $18.08 and second quarter at $18.14; and RREEF Property Trust (class A) at $13.35, first quarter at $13.32 and second quarter at $13.49.

The Stanger NAV REIT Total Return Index through the second quarter 2017 rose 2.90 percent.

Although public and private REITs are essentially both pools of commercial real estate assets, the similarities pretty much end there in regard to how desirable those investment vehicles are to the general investing public. A case can be made that public REITs follow too closely to the wider equity markets and what plagues or boosts all stocks will be reflected in the REIT sector. On the other hand, private REITs, being a newer investment class, saw rapid, lightly regulated growth after the global financial crisis. Unfortunately for investors, that masked a host of problems that had to be corrected by regulators. Some big, private REITs folded, and that part of the REIT industry is still working to find its place in the market. Or, as Crowe observes, “The nontraded REIT is a good idea that was executed badly.”

THE PUBLIC MARKET

REITs have underperformed the broad stock market during 2017, admits Brad Case, senior vice president of research and industry information at the National Association of Real Estate Investment Trusts, or NAREIT. “And that was because 2017 has been a boom year for large-cap growth stocks, and REITs tend to be value stocks. This year, large-cap growth stocks demolished small-cap value stocks in the broad market so it is no surprise that REITs have lagged.”

There is also a theory that interest rates negatively affect REITs because these structures are heavily dependent on debt. As interest rates rise, debt becomes more expensive and how individual REITs absorb those costs will shape the outlook for the industry. This suggestion also affects nontraded REITs. The second quarter Non-Listed REIT Market Snapshot by Summit Investment Research noted: “In 2Q17, the leverage ratio for nonlisted REITs increased to a moderate 42 percent, which is comparable to listed REITs. Variable debt ratios have increased from 17 percent in 2012 to a high of 38 percent in 2Q17. Nonlisted REITs also have a high 36 percent short-term debt ratio.”

A counter-theory suggests rising interest rates augur good news for REITs, not bad.

“When interest rates go up, so do discount rates, and when the discount rates go up, future net cash flow projections are worthless,” says Case. “That’s why bond values go down. If that was the only thing going on, that would be bad news for real estate.”

The alternative view is that REITs tend to hold debt, but that debt is mainly fixed-rate with long maturities, which means when interest rates go up, and you are holding fixed-rate debt, the value of that debt goes down. Debt is a liability and if liabilities go down, the value of your company goes up. Secondly, interest rates rise when the economy is improving and when the economy gains, rents elevate and net operating incomes improve.

One other issue driving down the public REIT market is the gloom pervading the retail sector. The effect of e-commerce on department stores and individual retail brands such as in clothing, electronics, even sporting goods, has been brutal with continued bankruptcies, including such recent filings by Toys ‘R’ Us, Gymboree and Payless ShoeSource.

Retail is just one piece in the public REIT universe, and often when one sector suffers, others thrive. So while the retail sector was down –10.82 percent through the end of the third quarter 2017, data centers were up 27.95 percent; infrastructure REITs, 24.39 percent; mortgage REITs, 20.04 percent; industrial, 18.46 percent; and manufactured homes, 17.03 percent.

THE NONTRADED SPACE

It would be difficult to make a similar comparison to nontraded REITs, because historically valuations have been opaque — although that is rapidly changing. Under old rules, a par value of $10 was set during the offering period of the nontraded REIT and, in a sense, that offering period went on for years. So it would seem valuation remained $10 although the underlying value of the investments either went up or down. Secondly, that $10 was not in reality $10 because high upfront fees reduced that amount by as much as 12 percent, which meant $8.80 was going into the ground on the investor’s behalf and not $10.

Three recent things happened to change the nontraded REIT industry, reports Mike Kell, vice president of Program Management and Business Development at AI Insight.

First, the implementation in 2016 of the Financial Industry Regulatory Authority’s Notice 15-02, which required broker/dealers to include a per-share estimated value for any nonlisted REIT on customer statements, as well as make other disclosures noting illiquidity and return of capital.

Second is the much stalled Department of Labor fiduciary rule, which partially went into effect in 2017, that, in some regards, requires investment advisers to justify the high fees charged to investors.

“The ability of nontraded REITs to raise equity capital in this market environment has been problematic over the past year or so largely as a function of regulatory pressure, including FINRA’s NTM 15-02 and the uncertainty surrounding adoption of the DOL Fiduciary Duty Rule,” says Kevin Shields, CEO of Griffin Capital. “The impact of these regulatory pronouncements was underestimated, but the significant downward sales pressure is painfully evident.”

Third was the rise and fall of American Realty Capital, which was once the great white whale of nontraded REITs. Historically, nontraded REITs have had a long cycle, seven to 10 years, but really closer to the 10-year mark between raising capital and liquidity event. ARC raised a significant amount of capital in a short period of time and then completed quick liquidity events, where it would return capital to shareholders who would then invest in other programs. An accounting scandal brought down ARC, but its model may have been breaking even before the demise.

“The peak fundraising year of 2013 was largely driven by the rapid recycling of capital in a market environment where capitalization rates compressed fast enough to overcome front-end loads,” says Shields. “Recycling wasn’t necessarily in the best interest of shareholders.”

After the fall of the “ARC empire,” as Kell notes, “capital raising dropped off the cliff.”

One way to judge the health of the nontraded REIT sector is to see if investors have come back. According to Summit Investment Research, capital raising hit an all-time high of $20 billion in 2013, then slid to $15.7 billion in 2014, before dropping all the way to $4.8 billion during 2016. By the second quarter 2017, nontraded REITs had raised $2.2 billion with expectations they would hit about $5 billion by end of year.

While capital accumulation is trending lower than average, one interesting feature about the monies raised this year is that capital raising has been dominated by new entrant Blackstone. At midyear 2017, it took in more than 40 percent of all capital infusing this sector of the market. At the end of the third quarter, Blackstone Real Estate Income Trust had raised $1.3 billion. In second place was W.P. Carey with $306 million before abandoning the market. Blackstone was able to do that because it eschewed the typical independent broker/dealer market and primarily raised capital via the big institutional investment banks such as Morgan Stanley, Merrill Lynch and UBS.

The institutional managers are creating “an alternative to the public market where you have to buy at publicly traded prices,” says Gannon. “Here you buy at NAV, while the public markets can be at a premium or discount to NAV. It gives investors a fairly stable way to enter the real estate business with an investment that is much like what the institutions invest in.”

In a sense, Blackstone further legitimized the product known as the daily NAV, which raises money, deploys it, and makes the capital available to investors who need to liquidate.

“Lifecycle and Perpetual Life NAV [nontraded] REITs are pivoting to a place where the broker/dealer market, which has traditionally raised capital for this industry, is re-engaging after the rollout of new product structures that address regulatory changes, including enhanced fee structures and multi-share class options,” says Tony Chereso, CEO of Investment Program Association. “In addition, the wirehouses continue to see a tremendous value in our product structures, especially since Lifecycle and Perpetual Life NAV REITs are not correlated to the traditional equity markets. To date, the majority of capital raised by Blackstone and other institutional players, such as Jones Lang LaSalle, has been through the wirehouses.”

“We know of several high-caliber institutions, similar to Blackstone, that will be entering the nontraded space,” says Gannon. “These firms will bring additional Wall Street distribution of the nontraded REIT product. Our experience is when Wall Street enters the space, it will easily double the size of equity that is deployed in the space. Right now, it is between $60 billion and $70 billion, so we expect it to double over the next few years.”

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

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