Morningstar gathering nontraded REIT information

Morningstar Inc. is gauging the interest of brokerage firms and financial advisers in research coverage of nontraded real estate investment trusts.

If Morningstar were to offer a research product, it would mark the first time that a national, high-profile financial services firm covered the $10 billion-a-year industry.

Until now, a hodgepodge of due- diligence firms, attorneys and bankers have written opinions about nontraded REIT offerings, but such due-diligence analysis rarely winds up in the hands of the registered representatives and investment advisers who sell the REITs to clients. Instead, broker-dealers control the flow of information around such products, and reps typically need to request a due-diligence report from their firms.

Morningstar hired Philip J. Martin six months ago to spearhead the expansion of its REIT coverage. Mr. Martin, whose title is REIT strategist, covering equity, credit and research, is in the process of gathering research to determine what financial intermediaries need to know about nontraded REITs.

“We’re going to see what clients want, and then make an informed decision,” he said in an interview at the Investment Program Association’s fall conference in Phoenix last week.

After Mr. Martin made his remarks, Morningstar took pains to stress that the company is merely gathering information.

“At this time, we have no plans to cover nontraded REITs,” said Catherine Odelbo, president of equity and credit research.

Morningstar is a giant of independent research for mutual funds, stocks and other investments. It counts 4,300 institutional and advisory clients, along with 7.3 million retail investors.

Mr. Martin sees plenty of room for improvement in the nontraded-REIT space, which recently has gained attention from securities regulators with regard to its sales practices. Most notably, the Financial Industry Regulatory Authority Inc. in May filed a complaint against broker-dealer David Lerner & Associates Inc. for allegedly marketing REITs with misleading returns.

Since then, Finra also has published an “investor alert” about the products, an unwelcome signal for many both in the brokerage and nontraded-REIT industries.

In a note last week to clients, Mr. Martin made his questions about the nontraded, or nonlisted, REIT industry clear, particularly whether the products are appropriate as a holding at this time.

“Presently, Morningstar does not believe a significant investment in nonlisted REITs makes sense for most investors, as there are still too many drawbacks and unresolved issues,” he wrote in the note. “We believe listed REITs to be the most appropriate option, from the standpoint of both the alignment of shareholder interests and long-term risk/return potential.”

But the deficiencies can be remedied, Mr. Martin said.

“That said, a better nonlisted-REIT product is possible. The segment is currently in a state of transition, with efforts under way to improve investor suitability, transparency, standardization, fee structure and incentive programs,” Mr. Martin said.

Members of the nontraded-REIT industry, which is growing, said that coverage by Morningstar — if it were to be offered — would be a positive for the business.

“I would have thought the [REIT sponsors] would have more anxiety over it, but to a person, every sponsor has said [Morningstar’s coverage] would bring nontraded REITs into the mainstream,” Kevin Hogan, executive director of the IPA, a trade group for nontraded-REIT sponsors and the broker-dealers that sell them, said in an interview at the conference.

Morningstar decided to look into the information needs of nontraded- REIT sellers because of persistent shortfalls in information needed to analyze the products, including how they communicate to the public, Mr. Martin said at the IPA conference.

“Many of our clients were clearly lost,” he said.

It is clear how “underserved” the sector is by investment analysts, he said.

Wall Street’s sell-side research neglects the sector, in large part due to the fact that it covers publicly traded REITs that its firms underwrite or provide financing to, Mr. Martin said.

The industry is “chaotic,” but the nontraded-REIT sector is “going through a transition,” he said.

In the case of some nontraded REITs, marketing has trumped a focus on managing a portfolio of real estate assets, he said.

The emphasis has also been on REITs’ bulking up on acquisitions, rather than employing a complete strategy that also includes real estate development, redevelopment and property management, Mr. Martin said.

“However, that seems to be shifting,” he said.

Mr. Martin compared the nontraded REIT industry to the similar, nascent position that traded REITs were in 20 years ago.

At that time, traded REITs had corporate-governance concerns and were over-leveraged in some cases, Mr. Martin said.

Morningstar now covers 42 REITs based in the United States and 23 in Asia.

There is similar potential for an upside to the nontraded-REIT industry as a whole, Mr. Martin said.

“If they can fix some of what ails the sector, it can grow tremendously in the next 10 years,” he said.

Email Bruce Kelly at [email protected]

Related Topics: Morningstar Inc.