The future of non-traded REITs
“All under heaven is in utter chaos. The situation is excellent.”
Mao Zedong (1)
Non-traded REITs, in most incarnations, have been reprehensible financial products sold by the unscrupulous to the naive. Nevertheless, they persisted. The 7% commission was just irresistible to brokers while it lasted.
Now the mess of legacy products is left for vulture investors to cleanup. Technologically advanced secondary markets will make the process a little smoother than last time. While the traditional group of Sponsors and brokers struggle to raise capital, institutional players such as Blackstone and Oaktree are launching new non-traded REITs, and finding no shortage of demand. The next generation of non-traded REITs are a major improvement over the previous generation,although the bar isn’t exactly that high.
New entrants distributing newly improved product to new distribution channels will define the future of non-traded REITs. Several large “brand name” asset managers have recently launched non-traded REITs. They are selling via wirehouses, which have generally avoided non-traded REITs for over 20 years. They’re also selling via registered investment advisers, who, as fiduciaries, previously avoided non-traded REITs. Furthermore several well known real estate firms are launching non-traded REITs or other products and selling directly to investors online, a phenomenon completely unheard of a decade ago.
Legacy non-traded REITs and secondary market
There is a massive overhang of legacy product that is preventing sales of new non-traded REITs via the independent broker dealer(IBD) channel. Post financial crisis, non-traded REIT Sponsors tried to take non-traded REITs full cycle(either via merger or IPO) after 2-4 years. This allowed financial advisers to collect the 7% commissions over and over again. Constant recycling became a critical source of income for IBDs, and an absolute bonanza for Sponsors However, after the AR Global scandal, fiduciary standard, and FINRA 15-02, the pace of new product slowed down suddenly.
When closed programs delay liquidity events, it slows down new fundraising because most broker-dealers have allocation limits for illiquid alternatives. Making matters worse, many REITs(especially AR Global programs) have shutoff repurchase programs to protect the balance sheet and/or preserve AUM for the manager. As of December 31, 2017, the combined equity value of closed programs is about 13 x the annualized run rate of non-traded REIT sales to the IBD channel. For comparison purposes, that same ratio was 2.2x at the end of 2015.
The industry experienced a similar phenomenon when the market for new real estate private partnerships collapsed in the late 80s/early 90s. The collapse in new issues leads to an overhang of legacy product that investors were expecting to go full cycle. Financial services and tech firms worked to create a secondary market, and deep value investors entered the space looking for bargains. This time however, there is much better technology available to make the secondary market efficient.
During the 1980s and 1990s Merrill Lynch and other major broker dealers offered matching services. Several other specialists focused on secondary market solutions. Cantor Fitzgerald made an apparently aborted attempt at creating a centralized exchange for non-traded private real estate funds in the early 1990s. Most of these efforts fizzled because the transfer process was so cumbersome and manual. With few exceptions, transactions required actual phone calls and voluminous paperwork. Discounts to NAV were often 20-40%.(See: Obstacles and Opportunities in the Establishment of a Secondary Market for Real Estate Limited Partnerships.)
Legacy non-traded REITs comprise $90 billion in assets held by over 1 million different investors, but the secondary market is still in the early stages of a smooth solution . Over the past few years technological solutions for non-traded liquidity have improved drastically. CFX Markets has a website that functions similar to trading of over the counter stocks with any broker online. Central Trade and Transfer (CTT Auctions) also has online capability, although the trading process requires a bit more human involvement.
In these markets, the sellers are retail investors in need of liquidity. But who are the buyers?
Since the beginning of the retail alternatives industry, firms such as Mackenzie Capital Management, Everest REIT Investors, and CMG Partners=, have provided non-traded REIT investors with via deeply discounted tender offers. (Back in the 1990s, Carl Icahn was involved in this space as well). Recently firms such as Liquidity partners and Comrit Investments have entered the space. Further, both CFX and CTT Auctions have reported institutional buyers looking to purchase large quantities of non-traded REITs on the secondary market. The shareholder bases of legacy non-traded REITs is in the process of transforming.
Entrance of institutional asset managers
As traditional alternative product sponsors struggle, many large “brand name” asset managers(Blackstone, Apollo, Carlyle, etc) are in the early stages of launching products. Blackstone, Starwood, TH Real EState and Nuveen recently launched non-traded REITs. Oaktree has one in registration.
Sponsors applying the “Blackstone model” design products differently. These REITs are perpetual life vehicles, unlike the earlier non-traded REITs that followed a defined liquidity cycle. Additionally, these new REITs plan to build diversified portfolios, rather than focus on one niche. Overall this new breed of product more closely resembles private equity real estate solutions offered to institutional investors.
The largest asset managers launching non-traded REITs are breaking open new distribution channels while conspicuously bypassing the independent broker dealer space Wirehouses have mostly avoided non-traded REITs for the past 3 decades (after the blowup of the private partnership market destroyed Pru-Bache) . Broker dealers selling Blackstone now include UBS, Morgan Stanley, and Bank of America Merrill Lynch. Nuveen, Oaktree, Starwood, TH Real Estate, etc are following similar paths.
Also notable, Blackstone has successfully been able to raise capital from advisors serving as fiduciaries. (based on sales of Class I Shares). Form ADV filings indicate that every week dozens of new RIAs are launching. Many are breakaway branches formerly affiliated with large IBDs. They still want to allocate a portion of their client’s portfolio to illiquid alternatives. Yet as fiduciaries, their decision making process is driven by asset allocation logic, not commissions. This bodes well for institutional non-traded REITs.
Cutting out the middleman
Crowdfunding is the great new frontier for non-traded REITs. KBS recently started selling its REITs directly to investors online. Dozens of other Sponsors are selling directly to investors online, either as REITs or partnership structures. Regulation A+ has made it much easier to launch a small non-traded REIT targeting non accredited investors. Crowdfunding platforms such as Realty Mogul, Fundrise, Crowdstreet, etc. have proliferated. Older investors who trusted intermediaries without doing their own research, are dying off. Younger generation is more likely to be skeptical of overpriced intermediaries, and is comfortable doing everything online. So far the impact has been small, but over the long term this could actually be the biggest change to the ecosystem.
See Also History Repeats: The Serpent on the Rock
(1) There are multiple Chinese and English sources attributing this quote to Mao. It was most likely in a personal letter to his wife, which is now lost. See for example:
http://cpc.people.com.cn/GB/69112/118416/118419/6993613.html (Chinese)
Ockham's Notebook 