A handful of sponsors have created nontraded real estate investment trusts that directly address some of financial advisers' deepest misgivings about such products: a lack of liquidity and timely valuation of the units.
For example, Clarion Partners Americas LLC and American Realty Capital are actively shopping their new nontraded REITs — Clarion Partners Property Trust Inc. and American Realty Capital Daily Net Asset Value Trust Inc. — to dozens of independent broker-dealers and registered investment advisers.
A key challenge of nontraded REITs is that real estate is an illiquid asset class, but some investors — and their advisers — want the REITs to act as much as a mutual fund as possible, executives said.
The new nontraded REITs will establish daily net asset values. In the past, it was difficult to value the products, with sponsors offering only spotty and periodic valuations.
The new nontraded REITs solve the problem of investor redemptions by placing a much greater amount of the trust's assets — up to 20% — into a liquid portfolio of cash and bonds. In a typical nontraded REIT, all the money raised is put directly into real estate, and redemptions are tightly controlled.
And the new wrinkle to nontraded REITs could spur other product sponsors to innovate, observers said. “I think you could see a wave of different approaches and structures associated with these products as the industry continues to mature,” said Kevin Hogan, executive director of The Investment Program Association, a trade group that includes nontraded-REIT sponsors as well as the broker-dealers that sell them.
Nicholas Schorsch, chief executive of American Realty Capital, said that the daily valuation of the REITs will outweigh any liquidity concerns. “Fund managers require [net asset value] to put it on 401(k) plan platforms,” he said. “To open up that market, it's huge. Wirehouses can now house it on platforms because of daily NAV.”
More importantly, fee-based advisers might be more inclined to sell nontraded REITs. They have been reluctant in the past because it's difficult to determine continuing fees without established valuations. Most nontraded REITs were sold by brokers, who typically took a one-time 7% commission.
New products that show a daily NAV will have an impact on the industry, observers said, particularly if fee-based financial advisers and financial planners embrace them.
“The big picture is, we'd love to have a fee-based product, and one of the prerequisites to having a fee-based product is daily pricing,” said John Rooney, managing principal of Commonwealth Financial Network. Commonwealth reps and advisers do not sell American Capital or Clarion Partners REITs, he added.
“It absolutely makes sense that sponsors would take this course of action,” said Stacey Chitty, a partner with Blue Vault Partners LLC, which analyzes the nontraded-REIT market. “No. 1, every REIT sponsor is trying to be different. And they're also trying to expand their audience.”
The Securities and Exchange Commission does not approve such products but deems them “effective,” meaning sponsors can solicit broker-dealers to sign selling agreements. Clarion Partners Property Trust was declared effective by the SEC in May, while American Realty Capital Daily Net Asset Value was declared effective this month.
In the wings is another nontraded REIT to be valued daily, the Cole Real Estate Income Trust Inc., which was registered with the SEC last year. It has not been declared effective.
PROBLEMS PERSIST
The new-style REITs, however, do face hurdles, executives noted. Nontraded REITs often cap the amount of units they will repurchase from investors at 5% of the units outstanding. The REITs are not listed on an exchange, and the number of units investors can redeem still remains in the hands of the REIT's management.
Geneos Wealth Management Inc. has not approved the new American Realty Capital product yet, and it's still being looked at by the firm's due-diligence team, said Dean Rager, senior vice president and chief advisory compliance officer.
The REIT has two share classes, he noted, one that's in line with a traditional nontraded REIT and one that investors can sell within days rather being required to wait until the end of the quarter to redeem shares.
“I doubt if we will allow it to be sold as a daily liquidity product,” Mr. Rager said. “If I'm not mistaken, it's up to the board of directors of that entity if there is liquidity. That's kind of liquidity until somebody says there's not. That's why we would call it illiquid.”
The new products are arriving after a decade when the market for nontraded REITs exploded. Since 2004, the number of sponsors has doubled, and now the industry has more than 63, according to Blue Vault. The sharp economic downturn and credit crisis brought negative attention to the products, as some sponsors cut dividends and suspended programs to purchase shares back from investors.
Regulators began to take notice. In 2009, the Financial Industry Regulatory Authority Inc. told independent broker-dealers that sold the REITs that valuations of shares had to be more current. Broker-dealers now must update the REITs' value 18 months after they have finished selling, instead of the previous three-year lag.
“No doubt, there's a lot of conversation about improving the structure of nontraded REITs,” Mr. Chitty said. Changes such as using valuations based on NAV put more weight on the performance of the management team and the portfolio in general, he said.
That means sponsors of nontraded REITs will not be able simply to collect their fees and then not perform well, he said.
“Daily pricing allows you to take a close look or look more often at how the REIT is performing,” Mr. Chitty said. “If they've taken a lot of fees upfront early on, it's not going to look good.”"STORY IS CONFUSING'
For example, if investors pay $10 per unit for a nontraded REIT and then, after commissions and various fees, see it listed immediately at $8.70, that would “leave a bad taste in investors' mouths,” Mr. Chitty said.
“No one has come out with products like this before and valued them this way,” Mr. Chitty said. “The story is confusing. Advisers will have to be upfront with clients to make sure they understand that: "You're giving us a dollar, but a chunk is being taken out for fees. Don't be alarmed by it. That's the nature of investing in real estate.'”
“My initial reaction is that it sounds to be a pretty interesting spin on a REIT product,” said Brian Kovack, president of Kovack Securities Inc. “It's about distribution. If this security can provide a broader distribution channel, it could be successful.” Kovack Securities sells several American Realty Capital products, but not the new one or the Clarion REIT.
bkelly@investmentnews.com
