Are nontraded REIT commissions headed for a fall?

New rules proposed by Finra will make fees more transparent, but could result in lower upfront commissions for brokers

Jun 19, 2014 @ 11:16 am

By Bruce Kelly

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Registered representatives who sell nontraded real estate investment trusts should brace themselves for upfront commissions that will likely be lower than in the past.

Reps and their broker-dealers saw a bonanza last year from nontraded REIT sales. The typical commission to a rep and firm is 7%, and independent broker-dealers sold almost $20 billion of REITs last year. That translates roughly into $1.4 billion in commissions for reps and broker-dealers.

What's prompting the potential cut in upfront commissions, or loads, is the consideration of new industry rules that would give investors a truer picture of what it costs to buy shares of a nontraded REIT.

Such investments generally are sold for $10 a share, although a total of 10% or more of that amount goes toward the total upfront commission, split among several different players involved in selling the REIT.

The problem identified by regulators, however, is that investors can receive accounts statements for several years that show the value of their investment as $10 a share, even though it is less than that. Currently, nontraded REITs do not have to show an estimated per-share valuation until 18 months after the REIT sponsors stop raising funds, which in many cases can take two to three years, or longer.

First proposed by the Financial Industry Regulatory Authority Inc. in September 2011 and then amended into current form, the new rules affect NASD Rule 2340, customer account statements. It not only will apply to nontraded REITs but to illiquid private placements known as direct participation programs, or DPPs. Both nontraded REITs and DPPs have been criticized for high commissions.

Finra in February issued the final version of the account statement rule proposal, known as 14-06. The Finra proposal drastically speeds up the time frame in which broker-dealers will have to show investors a valuation of a REIT for less than $10 per share.

The proposed rule has two methodologies that broker-dealers can use when an estimated value of the REIT or private placement is presumed reliable, according to the Finra proposal.

Those methodologies are net investment and independent valuation. The net investment methodology could be used for two years following the nontraded REIT's breaking of escrow, or when the issuer is permitted to access the offering proceeds to buy real estate. Most established nontraded REIT sponsors break escrow within the first year of the offering.

As the new industry rules create more transparency, they will create more pricing pressure, according to Ryan Smith, president and chief executive of DFPG Investments Inc., an independent broker-dealer with a focus on alternative investments such as REITs.

“We've heard more sponsor and broker-dealer discussion about lowering fees,” Mr. Smith said. “The pushback is from reps who don't understand the whys.” Those reps “want that 7% commission,” he said.

The big question is whether the industry will truly lower fees or simply realign or adjust them in a way that the upfront load may be less but the overall fee remains the same.

The total 10% load for a nontraded REIT is usually split into two parts.

First, there's a 7% commission split between the individual rep who sells the REIT and the broker-dealer. While the rep can receive the entire 7%, that amount is often split, with the rep typically receiving 6 percentage points and the firm taking 1 percentage point. Larger broker-dealers often grab a bigger piece of the commission, taking 2 percentage points and leaving 5 percentage points to the rep.

Next, there is a 3% percent commission to the REIT sponsor's wholesaling broker-dealer, known in the industry as the dealer manager. That dealer manager is able to boost the pay of the broker-dealers that sell the REITs by splitting or peeling off part of that 3% and sending it back to the broker-dealer. It's not unusual for the wholesaling dealer manager to peel off 1% to 1.5% for the broker-dealer, industry observers said.

The dealer manager also can pay for a part of broker-dealer conferences or other marketing expenses from general business revenues.

Other offering expenses commonly increases the load by another 1.5 to 2 percentage points or more.

In the 2013 prospectus for American Realty Capital Healthcare Trust II Inc., the company listed that 88.5% of the nontraded REIT's potential $2 billion offering as the “amount available for investment.”

That's after subtracting 10% for “selling commissions and dealer manager fee” and 1.5% for “organization and offering expenses.”

The Investment Program Association, the trade association for nontraded REITS and other direct participation programs favors the rule changes.

“Since 2011, the Investment Program Association has been very supportive of the rule and what it's going to do,” said chief executive Kevin Hogan. “I personally am extremely optimistic as to where this will end up. The rules provide clarity. This will be beneficial to the investor and the industry.”

When asked about whether the rule proposal would affect nontraded REIT fees, Mr. Hogan said that he was unsure of the impact and that it would be too speculative to comment at the moment.

In preparation for the new client account statement rules, which the Securities and Exchange Commission is considering and could be in place by the start of next year, the nontraded REIT industry is offering new REITs with different types of share classes, industry observers said. Those different share classes commonly pay a smaller upfront load of 2% or 3% and then a commission “trail” that is paid out over a period of years.

In that scenario, the rep would still receive close to 7%, but it would be amortized over several years.

“I don't think you'll see change in the short run, the short run being the rest of the year,” Dan Arnold, chief financial officer for LPL Financial, said at an investor conference this month.

That will likely change, he said. “I do think we're seeing some product innovation and fees changing,” he said. “We're very favorable of, and advocates of, a lower upfront fee and a trail over the long haul.”

With 13,700 registered reps and advisers, LPL Financial is a leading seller of nontraded REITs.

Such changes to nontraded REITs would bring them in line with other investment products that have changed as their popularity with investors increased, Mr. Arnold said. Nontraded REITs will “begin to look more like a mutual fund and the evolution of what variable annuities have gone through in terms of their pricing. We think that's a favorable outcome.”

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