As co-founder of real estate private equity investment firm Hamilton Point Investments, I believe the current perpetual non-traded REIT (real estate investment trust) structure creates certain concerns that investors should be aware of and take into consideration.
Non-traded REITs proliferated in the decade after the real estate crash of 2008-09. Individual investors placed money with these groups largely through independent financial advisers and, in return, were told to expect distributions for a number of years after which the REIT would pursue liquidation of the portfolio or list to go public. The focus and energy were on raising equity, with investment and operations seemingly an afterthought. Their results were poor, underperforming public REITs and direct, private investments, with numerous examples of complete losses of investment.
After the collapse of American Realty Capital in 2014, other failures and accompanying arbitration awards led to a dramatic decline in non-traded REIT investment. Several years later, though, a number of large publicly traded financial firms entered the space, raising huge amounts of equity through the name-brand wirehouses instead of independent broker-dealers. A twist from the previous non-traded REITs is that this new structure is perpetual, with no planned exit.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
While these newer sponsors differ in that they are experienced real estate investment companies with the institutional knowledge, infrastructure and track record to be successful, there are considerations investors in these perpetual-life non-traded REITs should be aware of.
Issues that investors need to know about
Share valuation issues. Current non-traded REITs offer monthly or quarterly share valuations, which are used to calculate both the price at which new investors come in and at which existing investors may endeavor to redeem and cash out. The share transaction price, or net asset value (NAV) per share, is solely determined by the company, which employs third-party valuation advisers, but the ultimate NAV is at the sole discretion of the company and is portrayed as exact.
NAV calculations are not exact and can be far from. Take for example a property declared to be worth $100 million. This is an approximation. No matter how experienced and smart the REIT principals are, that $100 million really means somewhere between, say, $95 million and $105 million. Leverage, in turn, magnifies that disparity. If the above property has 50% leverage, the equity is $50 million. If the ultimate value of the property is $95 million, that equity is worth $45 million. At $105 million, the equity is $55 million. This roughly 10% swing in property value, leveraged, translates to closer to a 20% swing in share equity value. NAV calculations are a good guess of what the share price should be, but they are far from perfect.
Legacy assets acquired at market peak pricing. When investing in a perpetual-life non-traded REIT, one is not investing in the real estate market as it sits now. A good portion of the real estate may have been purchased several years ago, which currently coincides with the peak of this last market pricing run-up. Some non-traded REITs have been slow to adjust their valuations — where overall commercial real estate values have fallen around 20% since November 2022, some non-traded REITs have stated much lower declines, perhaps materially light even taking into account different property-type allocations.
Current investors in a perpetual-life vehicle may believe they are getting into the market at this attractive time, taking advantage of the pricing correction that occurred over the last two years. But with many of those properties purchased at 2021 and 2022 market peak pricing, the assets are likely worth less now than what was paid for them.
While hotels and student housing bought in 2021, for example, may have been good investments as the COVID pandemic beat those property types down, conventional apartments and industrial/warehouses were likely much less so. There could be a good reason why the REIT’s legacy investments are currently attractive. Just don’t take the often shared “it’s better real estate” or “we’re really good managers” as a sufficient answer.
Questionable liquidity. Liquidity (the ability to get one’s investment capital back) in newer perpetual-life non-traded REITs is touted as sort of “no problem,” with passing reference to quarterly liquidity up to some percentage of assets. However, as we’ve seen over the last year, the ability to get your money back and the price-determining mechanism for such are not ideal.
While liquidity is offered, in practice an investor essentially must apply for an equity redemption, which could be approved fully, in part or not at all. Potential investor need for liquidity aside, this removes an important ability of investors to react quickly to changing market conditions, up or down, or changing views of the sponsor.
Dilutive nature of redemptions. Redemptions if met often strain the finances of the non-traded REIT to the detriment of remaining investors. The older REITs, which underperformed, at least had a stated target of company liquidation or public listing after some period. With today’s perpetual non-traded REITs, you get liquidity at the REIT’s sole discretion.
Often the REITs do not have the cash to perform on redemptions, requiring dilutive repayment of current equity with capital coming in from new investors. Note there is a cost of new equity in the form of commissions to financial advisers, so the net new cash to the REIT will always be less than the amount of cash redeemed.
Another way REITs handle redemptions may include sales of assets into poor market conditions or placing of new debt on properties at high interest rates.
None of these equity redemption methods is helpful to the remaining shareholders.
Conclusion
The major sponsors of today’s largest perpetual-life non-traded REITs are generally successful groups with decades of experience successfully managing institutional equity in closed-end real estate funds. They’ve got the institutional capabilities needed for success and strong track records. However, the four structural concerns noted above regarding perpetual-life non-traded REITs are only just now being tested, and the jury is out on how well it will go.
Related Content
- How Non-Traded REITs Could Give Your Roth IRA a Boost
- How to Find the Best REIT Stocks
- REITs Unveiled: A Comprehensive Guide for Investors
- Can You 1031 Exchange into a REIT?
- How Two Tax Laws Make REITs More Tax-Friendly
-
Cord Cutting Could Help You Save Over $10,000 in 10 YearsHow cutting the cord can save you money and how those savings can grow over time.
-
The '8-Year Rule of Social Security' — A Retirement RuleThe '8-Year Rule of Social Security' holds that it's best to be like Ike — Eisenhower, that is. The five-star General knew a thing or two about good timing.
-
You Were Planning to Retire This Year: Should You Go Ahead?If the economic climate is making you doubt whether you should retire this year, these three questions will help you make up your mind.
-
Are You Owed Money Thanks to the SSFA? You Might Need to Do Something to Get ItThe Social Security Fairness Act removed restrictions on benefits for people with government pensions. If you're one of them, don't leave money on the table. Here's how you can be proactive in claiming what you're due.
-
From Wills to Wishes: An Expert Guide to Your Estate Planning PlaybookConsider supplementing your traditional legal documents with this essential road map to guide your loved ones through the emotional and logistical details that will follow your loss.
-
Your Home + Your IRA = Your Long-Term Care SolutionIf you're worried that long-term care costs will drain your retirement savings, consider a personalized retirement plan that could solve your problem.
-
I'm a Financial Planner: Retirees Should Never Do These Four Things in a RecessionRecessions are scary business, especially for retirees. They can scare even the most prepared folks into making bad moves — like these.
-
A Retirement Planner's Advice for Taking the Guesswork Out of Income PlanningOnce you've saved for retirement, you'll need your nest egg to support you for as many as 30 years. For that, you need a clear income strategy, not guesswork.
-
Why Smart Retirees Are Ditching Traditional Financial PlansFinancial plans based purely on growth, like the 60/40 portfolio, are built for a different era. Today’s retirees need plans based on real-life risks and goals and that feature these four elements.
-
To My Small Business: Well, I've Been Afraid of Changin', 'Cause I've Built My Life Around YouWhile thinking about succession planning might feel like anticipating a landslide (here's to you, Fleetwood Mac), there are strategies you can implement to manage the uncertainty and the transition.
