After years of decline, the non-traded REIT market is back on the rise thanks to a combination of changes in regulation, product innovation, and stronger alignment of interests between sponsors, advisors and investors.
According to data from investment banking firm, Robert A. Stanger & Co., non-traded REITs raised $4.6 billion in 2018. Although that amount is still significantly lower than the market peak in 2013 when fundraising for the sector reached nearly $20 billion, the year-over-year increase from 2017 to 2018 of 9.5 percent is a positive indication for the market.
The positive momentum continued into the first quarter of 2019, with sales of non-traded REITs totaling more than $1.8 billion. This is up 30 percent compared to the fourth quarter of 2018, and 93 percent more than the first quarter of 2018.
Why did fundraising for non-traded REITs dry up and what’s changed since then?
At the asset class’s peak in 2013, $19.6B flowed into non-traded REITs. By the end of 2016, fundraising in the sector declined by 77% to under $5B. The decline continued in 2017 and only recently have things begun to tick back up.
Factors that led to the decline
Uncertainty about impact of the Department of Labor Fiduciary Rule in 2015
The much talked about, and now stalled, Department of Labor (DOL) Fiduciary Rule introduced in 2015 had initially precluded certain asset classes, including non-traded REITs, from being purchased into retirement accounts. Brokers have long sold non-traded REITs to retirees as a way for clients to potentially create an income stream. This has been a sought-after benefit in recent years as interest rates hovered near zero. Retirement accounts historically accounted for about 40 percent of sales in the sector.
In the final version of the fiduciary rule, the DOL eliminated its list of asset classes, opening the door for non-traded REITs to be placed in those accounts once again. However, the damage was already done. The uncertainty around the rule led brokers to seek alternative vehicles into which they could allocate their clients’ capital.
Non-traded REITs have historically been known to charge high upfront fees intended to cover selling commission and other costs associated with the funds’ formation. The sector has struggled to move away from high fees. Throughout the lifecycle of a non-traded REIT, property acquisition fees and asset management fees racked up. Fees of 10 to 15 percent of the gross investment amount were common. In reality, this meant that only 85 to 90 percent of an investor’s commitment would be put to work. However, investor statements still reported the REIT value at par before fees. This was referred to as the REIT’s Net Investment Amount (NIA), rather than the Net Asset Value (NAV).
Transparency of the valuation of underlying real estate
On April 11, 2016, FINRA published Notice 15-02, announcing that the SEC approved proposed amendments to NASD Rule 2340 and FINRA Rule 2310 that require general securities members to provide more accurate per share estimated values on customer account statements, shorten the time period before a valuation is determined based on an appraisal, and provide various important disclosures. The resulting transparency surrounding the underlying value of the real estate held in a customer’s account shed light on the fee drag associated with high upfront fee structures.
Prior to 15-02, the general industry practice was to report the par value of REIT securities as the per share estimated value during the offering period, which could continue as long as seven and a half years. This price would typically remain the same on customer account statements during this period even though fees reduced the investor’s principal and the value of the underlying real estate may have been reduced.
With 15-02 in place, the increased transparency forced sponsors and advisors back to the drawing board. Both sides of the market had to create innovative solutions to continue to meet investor demand for the asset class and make sure that product economics remained attractive.
Factors contributing to the turnaround of Non-traded REITs
Changes in fee structures create stakeholder alignment
In most industries, regulation inspires innovation, and the non-traded REIT sector is no exception. The reasons for including REITs in a well-diversified, thoughtful portfolio never went away. The income-driven, inflation sensitive, semi-uncorrelated nature of the asset class continues to make a strong argument for inclusion in sophisticated portfolios. While advisors may have shied away from the structural uncertainties of the sector, fundamental demand remains. As a result, sponsors like Blackstone, Griffin, and Cantor Fitzgerald began to engineer new REIT products that embraced the move toward greater transparency around value, fees, and performance.
By eliminating acquisition, disposition, financing and/or development fees from the overall fee structure and by reporting the NAV instead of the NIA, sponsors created a greater alignment of interests between sponsors, advisors, and their investors. Sponsors continue to be paid management fees and a performance incentive over an annual return hurdle while investors benefit from more frequent reporting, increased competition between product sponsors, and a greater portion of their investment “in the ground.” Attractive share repurchase plans are an added benefit, offering the potential for improved liquidity to shareholders over the non-traded REIT products of the past and strengthening the case for higher portfolio allocation.
More sponsors are following suit and creating non-traded NAV REITs with multiple share classes that make the asset class more accessible through a variety of channels. Broker-dealers and RIAs can offer the same product via different share classes with a transparent selling commission made available to selling brokers. Some sponsors are selling directly through RIAs and have the opportunity to attract retail investors directly.
From a tax perspective, the timing is opportune. The Tax Cuts and Jobs Act of 2018 afforded REIT investors with a 20 percent tax reduction on the pass-through income earned. According to Accounting Today, “Individual REIT investors who file jointly with taxable income less than $315,000, or file individually with income less than $157,000, may enjoy a 20 percent deduction on REIT dividends as qualified business income. REIT investors with higher taxable income — up to $415,000 jointly or $207,000 individually — also may enjoy a tax deduction on a reduced scale.”
Technology solutions create efficiencies
Sponsors and advisors are embracing new fee structures of non-traded REITs but are also incorporating technology solutions to streamline costly back office operations. In 2017, the North American Securities Administrators Association (NASAA) developed guidance on the use of electronic signatures for non-traded REITs. This has paved the way for straight through processing technology, which allows advisors and sponsors to save time and money by creating efficiencies in a traditionally error-prone and paper-laden investment process.
According to DLA Piper, NASAA's newly adopted Statement of Policy “will allow investors to sign subscription and related documents electronically, thereby increasing the likelihood that investor paperwork will be filled out and executed correctly and the investor's subscription processed quickly and efficiently.” This not only means that investments can be completed more quickly with less work, but it could also result in more timely commission payments to advisors.
REIT sponsors who offer straight through processing technology to their distribution partners can benefit as well by making their offerings easier for advisors to access and invest in on behalf of investor clients.
These exciting changes pave the way for advisors to give non-traded REITs a second look. As with any real estate investment, there are a number of risk factors that should be considered, such as loss of principal, illiquidity, declines in market value, local economic conditions, operating costs, natural disasters, and more.
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