The Department of Labor's fiduciary standard, and new securities industry account statement rules for greater clarity in the prices of products, have forced nontraded real estate investment trusts to slice their commissions. Since then, sales of the product have collapsed.
No fat commissions on REITs means poor sales by brokers.
REIT managers and broker-dealer executives are likely reluctant to make the connection, at least publicly. But there is no denying that brokers' appetite for the product disappeared almost overnight once upfront commissions were cut from 7% on an A share to 3% for a T share.
When REIT sales were booming a few years ago, the product's pitch was simple: real estate kicks off an income stream of 6% to 7% annually, real estate is an asset class that is not correlated to the stock market, and with interest rates at record lows, investors needed the yield.
Those conditions haven't changed dramatically, but nontraded REIT sales have tanked regardless.
InvestmentNews reported last month that Robert A. Stanger & Co. expects nontraded REIT sales this year to reach just $4.4 billion, about $100 million less than last year and the lowest levels since 2002.
If the "income, diversify and interest rate" pitch was accurate back in 2012 and 2013, when REIT sales were booming, why isn't it working today? There is little change in the narrative.
Interest rates have risen only marginally, and with the stock market roaring, wouldn't it make sense for a broker to peel off some clients' gains and invest in commercial real estate, a hard asset not correlated to stocks?
With brokers no longer getting juicy commissions for REIT sales, they simply don't appear interested in selling the product.
Most brokers who still sell nontraded REITs no longer earn the eye-popping 7% commission, the standard rate paid to brokers who sold the product back in 2013, when REIT sales hit their all-time high and brokers sold $19.6 billion of the product.
The DOL fiduciary rule has forced brokerage firms and product sponsors like REIT managers to compress and flatten commissions. Most broker-dealers are selling REITs in the form of a T Share, which typically carries an upfront 3% commission and an 80-basis-point trail. It's a better deal for the investor; more of the client's cash immediately is invested in real estate and therefore working to generate a return.
The fallout from the lack of sales has had serious consequences for the industry. W.P. Carey Inc., one of the companies instrumental in the evolution of the nontraded real estate investment trust business, said in June it was pulling out of the nontraded REIT market and stopped offering new products.
Last month, Vereit Inc., a large listed real estate trust, said it was exiting the nontraded REIT business and selling Cole Capital for $120 million in cash and up to another $80 million in fees to be paid over six years based on Cole's future revenue.
Cole Capital was the investment arm of Cole Real Estate Investments Inc., a publicly listed REIT which American Realty Capital Properties Inc., or ARCP, the forerunner of Vereit, paid $11.2 billion for in 2014. At the time, ARCP was controlled by real estate investor Nicholas Schorsch, and the acquisition of Cole capped a feverish buying binge in his rush to amass a real estate empire.
With brokers and advisers trying to make sense of the new landscape for the product, the fever has gone out of the nontraded REIT business, one brokerage executive noted.
"It's an industry in transition and it's a matter of time before the new equilibrium emerges," said John Rooney, managing principal with Commonwealth Financial Network, a leading independent broker-dealer that sells nontraded REITs and used W.P. Carey as a sponsor.
FINRA PRICING RULE
The Financial Industry Regulatory Authority Inc. recently put into place a new rule, known as 15-02, that makes pricing of illiquid securities like nontraded REITs more transparent to investors. In the past, client account statements showed illiquid securities like REITs at the value they were bought by the client and did not subtract commissions, which were high.
"Now that REITs are getting priced on statements, with Finra 15-02, advisers are having to consider these positions from a total return standpoint, not just income," Mr. Rooney said. "They are re-evaluating the client's perception of the product."
Back in 2013, Mr. Schorsch and his company, American Realty Capital, were selling a variety of REITs, raising billions of dollars annually and focusing on flipping the individual REIT so the investor would get liquidity in two to three years. New entrants to the REIT market, such as The Blackstone Group and Jones Lang LaSalle, are managing nontraded REITs that are not meant to be flipped or merged quickly but will be offered perpetually, Mr. Rooney noted.
"The quick turn scenario was for the investor's benefit—they got liquidity events that made these attractive," he said. "Now, it's a perpetual life REIT instead of a transaction. The adviser has to rethink the value proposition for clients. And advisers don't yet know Blackrock or JLL."
"It's like when mutual fund A share was the historic way of doing business and then it changed into fees. We are seeing a similar change now in this industry," Mr. Rooney said. "It's a temporary nadir. Sales will be back up. Non-correlation to stocks, income and relative price stability versus traded REITs still makes these products attractive."
Mr. Rooney may be right. The nontraded REIT industry will change for the positive.
But to many brokers, nontraded REITs no doubt looked a lot better wrapped in a 7% commission.