Publicly traded REITs must conform to the same transparency standards that apply to listed stocks and bonds. That is, issuers must disclose material financial information that could affect the price, fees, and risk of a security or fund. Transparency allows independent analysts to evaluate REIT assets and helps traders make informed bids and asks. Liquidity and REIT transparency are closely related. A security that is transparent but illiquid presents a problem, in that an investor may have access to important information but might not be able to trade on that information without substantially impacting price. Such is the case with non-traded REITs, which are publicly issued but not listed on the major stock exchanges. Private REITs are even more problematic, as they can be both opaque and illiquid. Let’s focus on the middle case, non-traded REITs.
The Collapse of the Non-Traded REIT Market
Investment News documents the fall in fundraising for non-traded REIT asset class, from approximate $1.5 billion at the start of 2015 to $114 million in May 2016. In the first five months of 2016, broker-dealer sales of full-commission REITs dropped a staggering 70.5 percent from a year earlier, spurred in part by more transparent fee and cost disclosures mandated by FINRA Regulation Notice 15-02. The SEC accepted the regulation in October 2014, and it became effective on April 11, 2016.
When issued, these securities typically carry a charge of 3 percent commission to the broker/dealers and 7 percent for the investment adviser. Primary sales have been sinking by about $5 billion a year from their peak of $20 billion in 2013.
Prior to the advent of secondary alternative asset marketplaces for non-traded REITs, they were sold in the secondary market almost exclusively by broker-dealers. Independent broker-dealer LPL Financial saw a year-over-year swoon of 86.7 percent in alternative asset sales, mostly non-traded REITs, for the Q1 of 2016. Geneos Wealth Management’s sale of non-traded REITs is down 60 to 65 percent for 2016 YTD. Regulation 15-02 is an important factor depressing broker-dealer sales. The regulation mandates the calculation and customer account statement disclosure requirements for non-traded REITs to ensure that valuations are reasonable and fees are transparent. Non-traded REITs can report estimated share value in two ways, both GAAP:
- Net investment method: This is the preferred method for younger non-traded REITs, sharpening estimates by accounting for sales commissions, organizational, organizing and other related charges. It also requires disclosure of the effect of a return of capital on estimated NAVs.
- Appraised value method: Mostly used for mid- to late-cycle non-traded REITs, this method relies on NAV estimates from third-party, who must use generally accepted accounting principles.
The short-term effect of Reg. 15-02 is to increase investor awareness of high fees associated with broker-dealer transactions for non-traded REITs. In the long run, it might help the industry because of increased credibility of the investment.
With broker-dealer sales fees running as high as 15 percent, the advent of a secondary marketplace is fortuitous. One of the oldest marketplaces, CFX, charges 2.5 percent to the buyer and 2.5 percent to the seller.
The importance of secondary marketplaces for the purchase of non-traded REITs cannot be underestimated. This year’s new Department of Labor fiduciary standard for retirement accounts has caused an uproar in the broker-dealer community. The shift from “suitability” to “in the best interests” would seem to disqualify broker-dealer sales of non-traded REITs to investment accounts, in light of fees ranging from 7 to 15 percent. On the other hand, a buyer’s or seller’s fee of only 2.5 percent a secondary marketplace platform can be justified by the relatively high and uncorrelated returns of the non-traded REIT asset class.
Many non-traded REITs begin life as blind or partially specified property pools. The pools are bought and sold as a unit. There are approximately 1.2 million investors holding positions in the $84 billion non-traded REIT market, and statistics indicate that holders are happy to sell their positions when prices are within 5 percent of NAV. However, many of these securities are selling at a 40 percent discount. The advent of the secondary marketplaces creates price transparency that will drive up the price of undervalued non-traded REITs and facilitate secondary sales.
The non-traded REIT marketplace suffers from poor liquidity and lack of price transparency, which is one reason why these securities sell at a substantial discount. Without a secondary trading market, finding a buyer can be extremely difficult and, ultimately, costly. Clearly, relying on a broker-dealer network or issuer to sell one or more non-traded REIT holdings is subject to substantial liquidity risk. This is most acute for non-traded REITs held by retirees in an IRA because sudden spending requirements due to illness or other causes can force them to liquidate their holdings at a substantial discount. Secondary marketplaces neatly address this problem.