Is the new generation of nontraded REITs really any better than the last?

Back in 2016, the nontraded real estate investment trust industry was in the dumps, with sales falling to a paltry $4.5 billion that year after reaching a record of nearly $20 billion three years earlier.

Facing new industry rules that made fees and pricing more transparent, nontraded REIT sales had plummeted at independent broker-dealers, the primary venue for selling the product for decades. Making matters worse, American Realty Capital Properties Inc., the flagship real estate acquisition vehicle of former nontraded REIT czar Nicholas Schorsch, was facing an accounting scandal that would end with its former chief financial officer found guilty of federal securities fraud and related charges and, separately, a settlement entailing $60 million in penalties with the Securities and Exchange Commission.

Perhaps most dire of all for the managers of nontraded REITs and sales was the looming Department of Labor fiduciary rule. For decades, nontraded REITs were a notorious high-commission product, routinely paying brokers and financial advisors an upfront load of 7%, along with another 2% to 3% to various links in the chain of sales, including broker-dealers and wholesalers. That load, which hit securities industry ceilings of 10%, made it almost impossible for REIT managers to turn substantial profits for investors, the product’s critics claimed. The Department of Labor’s fiduciary rule, in part designed to flatten and homogenize the pricing of investment products, would have made the product — in that form — obsolete.

Fast forward half a dozen years or so: Fortunes have changed. Nontraded REITs, it appears, are back and hotter than ever, with sales reaching $32.1 billion over the first 11 months of 2021, an 8% increase year over year. Upfront commissions are down, and fee structures are revamped, making the product more palatable to registered investment advisors and — for the first time — financial advisors at the large wirehouses, who on average work with the wealthiest clients in the financial advice industry.

Launching right around the time the nontraded REIT industry hit its nadir, new nontraded REITs managed by Wall Street giants like Blackstone Inc. and Starwood Capital Group have revitalized the product, selling billions of shares per year to yield-hungry investors. But nontraded REITs from those two firms, the $70 billion Blackstone Real Estate Income Trust Inc. and the $14.6 billion Starwood Real Estate Income Trust Inc., have recently hit snags — informing some investors looking to pull money out of the REIT through redemptions that they had hit their limits. In other words, if those investors wanted to pull more money out of the REIT in the future, they would have to get back in line.

STEADY YIELDS

The pitch for nontraded REITs, past or present, has always been simple: They are a way for clients to diversify portfolios, and invest in commercial real estate and reap steady yields. In the past (meaning REITs of the old generation, created before 2017), some

REITs had issues that were brought to light in large part by the real estate and credit crisis of 2008 — shutting off redemptions, unclear valuations, high fees, a lack of liquidity and not generating enough revenue to cover monthly and quarterly distributions.

That begs the question: Is the new style of REITs, including the Blackstone REIT and Starwood REIT, really a better mousetrap, given recent questions spurred by redemptions?

“Both REITs were structured intentionally with a liquidity sleeve with the ability to provide a limited amount of liquidity because previous generations of nontraded REITs were criticized for lacking that,” Kevin Gannon, CEO and chairman of Robert A. Stanger & Co. Inc., said in an interview last month. “These deals were built to address that and have liquidity or redemption caps of 2% a month and 5% a quarter, which is 20% a year, roughly. That’s a big number, and fairly substantial liquidity we never saw before.”

The old generation of nontraded REITs, he said, had much lower levels of redemptions at 3% and used the REIT’s dividend reinvestment plan, or DRIP, to facilitate the process for investors who wanted out.

Such limited withdrawals earned some of those REITs the critique of being zombie-like companies, half alive and half dead, with investors trapped in a security with no reliable valuation or secondary market to cash out.

That’s changed, said Gannon and industry executives. “We never saw liquidity opportunities in alternative investments like this before,” Gannon said. “And [the Blackstone and Starwood REITs] have been getting hit with redemptions from investors. But they’re meeting those redemptions up to the cap.”

REVAMPED REITs

In 2022, revamped REIT products were put to the test. Analysts and executives last year noted that with rising interest rates and fears of a recession hanging over the commercial real estate market, investors would be eager to get out of REITs and redeem shares.

On Dec. 1, Blackstone REIT told investors that redemptions had exceeded the monthly limit of 2% of its net asset value in October and 5% for the entire quarter, which pushed the company to prorate, or limit and portion, investor demands. Alarm bells rang across Wall Street, with shares of the REIT’s parent eventually falling from a mid-November high of $108.77 to $72.16 a few days after Christmas — a 34% decline. That meant some investors who wanted to get their money out of the fund were turned away — at least temporarily. A few days after Blackstone REIT’s announcement, a published report indicated that the Starwood REIT was also limiting client withdrawals.

The changes in liquidity and redemptions, along with the cachet of private equity giant Blackstone, clearly have opened doors for this new generation that were closed shut to the old guard such as Schorsch and other notable managers like Chris Cole and Leo Wells. The Blackstone and Starwood REITs were also designed as net asset value, or NAV, REITs, meaning that they are structured to generate long-term returns.

That’s a key difference with the former generation of such REITs; many were built to raise investor capital from mom-and-pop investors quickly, gobble up triple net lease real estate properties or apartment buildings, and then return principal to investors by selling the company to a larger, publicly listed company or having their own initial public offering.

“B REIT revolutionized the nontraded REIT space with enhanced transparency, lower fees and incentives aligned with investors, all while bringing high-quality institutional real estate to individuals,” a Blackstone spokesperson said, adding that senior Blackstone executives had recently commented publicly that just 3% of U.S. investors were seeking liquidity from the product.

A Starwood spokesperson did not respond to a request for comment.

Unlike publicly traded companies, nontraded investments like REITs or business development companies aren’t listed on an exchange, which means there’s no immediate market for investors to sell shares if they’re worried or thinking it’s time to get out. What’s different about the Blackstone REIT, referred to as B REIT in the industry, and Starwood REIT are their huge size and the exposure of wirehouse and RIA advisors and clients.

Not only are institutional managers like Blackstone and Starwood managing these products, Wall Street’s largest retail investment houses, Merrill Lynch, Morgan Stanley and UBS, are selling them. The wirehouses had long shunned the product, preferring instead to sell proprietary, private real estate deals to their millionaire clients.

The bigger near-term issue ... is Blackstone having enough liquidity to meet these redemptions ... and the potential hit it could take reputationally.

Greggory Warren, Morningstar analyst

According to one alternative investment industry executive, who asked not to be named, industry clearing data suggested that over the 12 months ending in November, at least $11 billion of the giant REITs were sold at the above-mentioned wirehouses, and that data doesn’t reflect all of the trades, the executive said.

To put that into perspective, that’s almost 2 ½ times the amount of nontraded REITs sold by the entire brokerage industry in 2016.

VOTE OF CONFIDENCE

Meanwhile, Blackstone REIT started the year by announcing that the University of California would invest $4 billion in the company, a public vote of confidence.

“In the current environment, investors can benefit from stable cash-flowing investments that can grow with high global inflation,” Jagdeep Singh Bachher, the University of California’s chief investment officer, said in a statement.

But when it comes to such giant, newfangled REITs, delivering liquidity to investors and reputational risk go hand in hand, according to one analyst.

“The elevated redemption requests [at B REIT] could be a sign that investors, [who] have done well in nontraded REITs, are looking to move some of that capital into other yield-generating vehicles or perhaps even publicly traded REITs, which have done poorly [in 2022] as they’ve been affected not only by the effect that rising rates has had on their core operations, (as higher interest rates raise the cost of capital for real estate companies, making external growth more expensive), but on their stock prices,” Morningstar analyst Greggory Warren wrote in a research note last month. He noted that Blackstone REIT investors have received an annualized distribution rate just over 4% since its inception in 2017, and the fund’s value rose 13% on an annualized basis since inception through the end of last October.

But at this size, does B REIT have enough cash on hand to meet future potential redemption demands, calming the nerves of both investors and the financial advisors who sold the product?

“The bigger near-term issue, in our view, is Blackstone having enough liquidity to meet these redemptions — such that it is not a forced seller of assets — and the potential hit it could take reputationally on the fundraising side of things from raising gates on one of its more popular funds,” Warren wrote. “On top of that, now that Blackstone has limited withdrawals, investor redemption requests may intensify in the near term. Blackstone has noted that BREIT has $9 billion of immediate liquidity and another $9 billion of debt securities that could be sold in the near term if the capital was needed.”

“News that the fund has also agreed to sell its nearly 50% stake in MGM Grand Las Vegas/Mandalay Bay to co-owner Vici Properties in a deal that values the properties at $5.5 billion should provide additional liquidity in the near term,” he added.

Gannon of Stanger is optimistic about the changes in the product.

“These REITs hit their redemption caps,” he said. “I think it’s a small bump in the road.”