As published in Seeking Alpha
Investors looking for tax-advantaged income from institutional quality commercial real estate often purchase a publicly-traded real estate investment trust through exchanges like the NASDAQ or the NYSE – the so-called publicly traded REIT (PTR). On the other hand, publicly registered non-traded REITs (NTRs) are sold to advisors and investors through brokerage houses and independent dealers on an upfront and continuing commission basis. Non-traded REITs have been the source of SEC and FINRA enforcement actions and compliance regulations in light of the Bonfire of the Vanities behavior of a few high-flying broker-dealers in the mid-2010s who cared mostly about commissions and cars than investors and IRRs. In response, higher yielding no-upfront commission institutional quality NTRs are now available for purchase directly and securely online with investor-friendly management compensation arrangements. This article briefly explores the key differences between NTRs and PTRs. It then discusses why and how each type of REIT – public and private -- may have a place in an investor’s alternative investment portfolio, and when it is may be reasonable to invest in a non-traded REIT.
Liquidity versus Illiquidity
Publicly-traded REITs offer shareholders liquidity through major stock exchanges. With a PTR, an investor can get out of a perceived financial fire by selling shares on an open exchange. So, just like any other stock, publicly-traded REIT shares possess price volatility. Generally, share prices trade based on a snapshot picture on the date of recalculation of a REIT’s “Net Asset Value” (NAV), which may be reset on daily, weekly, monthly, quarterly, or annually. REIT NAV is the value of a REIT’s real estate holdings less its liabilities.
More specifically, supply and demand do the rest in setting the share price. While investors desire ever increasing NAV on their investment, NAV may be depressed temporarily by a host of things too long to list, like Black Swans, tax changes, political unrest, natural disaster, management changes, disintermediation and technology, interest rates, political factors, and other matters impacting the state of the financial markets in general. Stated simply, the value of the real estate underlying a publicly traded REIT is not necessarily a true proxy for the value of the stock price. Rather, it is an important factor that a buyer will assess when bidding for public REIT shares in the secondary market.
The cloud to the silver lining of liquidity is that investors often sell PTRs at inopportune times, whether from a prank like Orson Wells’ “War of the Worlds” or from a market moving tweet during a Presidential “War of the Words.” Numerous studies from academia and management consultants support that neither the individual investor nor the professional investment advisor can time the stock market with success. Indeed, a strong correlation exists between trading frequently and receiving lower returns. As Baron von Rothschild advised investors long ago, “The time to buy is when there’s blood in the streets.” Note the conspicuous absence of advice to sell in such hematologic episodes.
Yet the individual investor often sells publicly-traded REIT shares at a discount in reaction to emotionally perceived risk due to the deeply ingrained “fight or flight” mechanism in our brain’s limbic system. Business literature is rife with research and findings that an investor’s instinctive behavior to sell stocks in reaction to a perceived but unsubstantiated threat of financial loss materially adversely impacts investment returns.
Volatility and Risk Mitigation
Every investor wants to be insulated from broader market selloffs. Many experienced investors are familiar with the concept of “Beta,” which is a measurement of how correlated an asset’s price is to the health of the broader stock market. Beta is also a measure of volatility or risk. Even large and well-diversified real estate funds, such as Vanguard’s Real Estate ETF ($VNQ), are correlated to the broader stock market (with a Beta of 0.82).
Conversely, because non-traded REITs possess a limited secondary market and are intended to be held until liquidation of the underlying assets, they have a much lower price correlation to the broader equity markets. Non-traded REITs provide an initial offering period for share purchases and a maximum amount to be raised by the non-traded REIT’s sponsor. Afterward, capital raising is restricted, and trading in the REIT shares is authorized only during limited redemption periods until the sale of all the assets. When the professional managers of the REIT believe an opportunity exists to sell one or more of the REIT’s holdings at prices that would produce profits for its investors or avoid a negative event from creating losses, the REIT’s shareholders receive the gains from the asset sales as well as income from the assets prior to sale. In this scenario, the non-traded REIT investor is free from worry about the REIT’s valuation or from trying time the market to maximize returns.
Purchasing shares in a non-traded REIT is thus very similar to investing in a real estate partnership from a business perspective. If you own a partnership interest in an apartment complex undergoing rehabilitation, for example, selling that partnership interest before completion of rehabilitation, lease-up, and rental stabilization will most likely be a highly inefficient and expensive proposition (usually in the form of significant discounts to asset value and high fees for selling the security).
Similar to a partnership structure, non-traded REITs often allow principal redemption only upon an investor’s death or disability or following completion of the REIT’s business plan. This limited liquidity can be an immediate deal breaker for investors who are unwilling to give up access to stock market liquidity in exchange for a materially higher rate of return from a non-traded REIT. Some would argue that the redemption rights offered in publicly traded REITs are somewhat illusory since the board of the REIT can always suspend redemptions when too many investors seek their money back. Investors should study redemption provisions carefully to see if there is a “there” there.
On the other hand, a non-traded REIT can forego creating large cash reserves or paying out of current income for a credit facility to fund redemptions, which results in more capital going into income-producing real estate for the shareholders.
Who Should consider investing in non-traded REITs?
It’s easy to see that investors who need liquidity should put their money in liquid investments like money market funds and T-bills. Money that is invested in publicly traded REITs may be liquid but is subject to general market risk. So, should all of their money go into public REITs? Could higher yielding lower Beta alternatives play a role in safely boosting investor income over a longer horizon?
Many investors and advisors correctly shied away from higher yielding non-traded REITs because of well-publicized abuses by overcompensated intermediaries reducing investor earnings through extraordinary fees and commissions. Non-traded REITs with no upfront commissions may be appropriate for investors who seek steady income and higher IRRs from institutional-quality, professionally managed income-producing real estate. Commission-free, non-traded REITs may be appropriate for investors who seek to avoid the temptation to time the real estate market. And, non-traded REITs with no upfront commissions may be appropriate for investors who seek to mitigate stock market volatility and receive passive, tax-advantaged income from institutional-quality, professionally managed income-producing real estate.
I reiterate that non-traded REITs are not appropriate for every investor, especially those who need immediate access to their wealth. But for investors with longer-term horizons, and who can afford to leave money invested during the typical five- to 10-year non-traded REIT lifespan, non-traded REITs may offer an appropriate investment vehicle to enhance income while reducing volatility.