Nontraded REITs set up for strong year but speed bumps loom

After posting a record $20 billion in sales in 2013, nontraded real estate investment trusts are headed for another banner year in 2014, with sales equaling or perhaps surpassing 2013, according to industry executives and bankers. In 2013, sales doubled from 2012, when the nontraded-REIT industry raised about $10.3 billion in equity. The industry, however, could hit two speed bumps that could slow down its incredible recent growth. The first is new industry rules that will require broker-dealers to list on client account statements a per-share price for each nontraded REIT that subtracts the various sales commissions and charges. Most nontraded REITs sell for $10 per share and have sales commissions and charges that typically add up to $1.10 or $1.20. Although the client pays that sales load immediately, the per-share value currently is still listed at $10. The Financial Industry Regulatory Authority Inc. and the nontraded-REIT industry have been hammering out new rules around valuation disclosure of REITs and other illiquid investments since September 2011. That was when Finra first proposed rule changes to address how broker-dealers report the per-share estimated value of nontraded REITs and other illiquid investments. When clients see on their account statements the adjusted value of REITs that take into account the sales commission, uncomfortable conversations between reps and clients might take place. Finra has told the nontraded-REIT industry that the rule change “will happen in early first quarter of 2014,” said Kevin Gannon, president of investment bank Robert A. Stanger & Co. Inc. “Then the Securities and Exchange Commission will probably give a six-month grace period, so it will go into effect late in the third quarter of 2014 or early in the fourth.” The other looming question facing the industry is the potential for interest rates to rise further. Many nontraded-REIT sponsors have been able to borrow money at less than 4%, especially if they are borrowing using a variable rate, Mr. Gannon said. Borrowing money at low rates has given REIT managers a bit of extra cash flow from which to cover their dividends, or distributions, to investors, he said. “Interest rate moves are important to the industry. Favorable interest rates help,” Mr. Gannon said. The Federal Reserve's announcement this month to pull back its bond-buying program over time should not jar interest rates, he said. “As long as the changes aren't done suddenly and are done gradually as the taper is supposed to be, it should be manageable for the industry,” he said. Driving another strong year in nontraded-REIT sales is recent performance of some REITs and the potential of half a dozen or so such REITs to have “liquidity events,” meaning returning capital to investors through listings on an exchange or through a merger. Still seeking yield and dividends in a low-interest-rate environment, investors are likely to reinvest as much as 50% of the returned money into a new REIT. Indeed, Nicholas Schorsch, chief executive and chairman of REIT sponsor American Realty Capital, believes that nontraded-REIT sales in 2014 could outpace those of 2013. “This year could see another $20 billion to $30 billion in sales,” he said. “Last year's money hasn't fully recycled,” which adds to the potential cash investors could pour into new offerings, he said. During and immediately after the credit crisis, nontraded REITs were widely criticized for locking up investors' capital for years and offering no clear exit strategy. Two ARC REITs, American Realty Capital Trust III Inc. and American Realty Capital Trust Inc., have gone through two full cycle liquidity events. Two more, American Realty Capital Healthcare Trust Inc. and American Realty Capital Trust IV Inc., both with $1.7 billion in equity raised, are scheduled to have liquidity events in 2014. ARC is not the only sponsor lining up liquidity events for investors in 2014. At the end of January, Corporate Property Associates 16 - Global Inc. is slated to merge with its adviser, the traded REIT W.P. Carey Inc., in a transaction valued at approximately $4 billion. Liquidity is not only good news for clients, Mr. Schorsch said. It keeps securities regulators at ease, thus lessoning pressure on the broker-dealers that sell the product. “Liquidity also reduces risk for broker-dealers by improving the regulatory environment for firms,” Mr. Schorsch said. “Broker-dealers are acutely aware it's not how much [REITs] they sell but how much they hold” and remain illiquid, he said.