Nontraded real estate investment trusts, the oft-criticized high-commission alternative investments sold primarily by independent broker-dealers, are under siege.
After reaching record sales of nearly $20 billion in 2013, nontraded REITs may not even reach the $10 billion mark this year, a 50% drop in productivity, according to investment bank Robert A. Stanger & Co. That could have a negative impact on revenue levels at IBDs and commissions for their advisers.
The industry is facing a number of hurdles. First, it is under intense scrutiny from securities regulators, particularly in the states. Second, a new fiduciary standard for brokers proposed by the Department of Labor for retirement accounts could further depress sales. And finally, sales could be dampened even further by a new rule from the Financial Industry Regulatory Authority Inc. that will make prices more transparent to investors.
“Nontraded REITs are going to face more scrutiny than they have in the past,” said Rob Molinari, vice president of compliance at Commonwealth Financial Network. “There will be more due diligence than before.”
SCHORSCH FADES
Adding to the tough times for nontraded REITs is the fact that Nicholas Schorsch's REIT empire has unraveled. In 2013, Mr. Schorsch's companies were responsible for a substantial portion of all nontraded REIT sales. That has changed. In the wake of market changes and regulatory inquiries, one of the companies he founded, AR Capital, recently announced
it was no longer selling new REITs.
(More on Schorsch: How the REIT titan's empire unraveled)
Another company he founded, RCS Capital Corp, said it was closing its wholesale brokerage, Realty Capital Securities, and laying off 150 employees. The brokerage, which specialized in marketing nontraded REITs to IBDs, recently reached a $3 million settlement with the Massachusetts Securities Division for allegedly rounding up fraudulent proxy votes in real estate deals sponsored by AR Capital.
Mr. Schorsch's troubles certainly have not helped the reputation of nontraded REITs, which were already laboring under somewhat of a cloud before he came along. Other than brokers at IBDs, many advisers frown on them because of the high commissions they carry and the fact that they can tie up investors' money for years.
But all of the industry's problems can't be traced to Mr. Schorch. Regulators in the past two years have gone after a number of independent broker-dealers. Just last week, for example, LPL Financial, the nation's largest broker-dealer,
agreed to pay $750,000 to New Hampshire for selling nontraded REITs to an 81-year-old resident that the state claimed were unsuitable and unlawful. Such increased regulation could have a chilling effect on nontraded REIT sales since they are generally sold by advisers at IBDs.
Independent broker-dealers are also sounding the alarm over the DOL's new fiduciary standard. “As written, the current version of the proposal would not permit sales of certain alternative investments in brokerage retirement accounts,” LPL's CEO Mark Casady told investors during a conference call in April. The majority of alternative investment sales at LPL are nontraded REITs.
Mr. Casady's comments were echoed by executives at Commonwealth, who recently predicted that the falloff in sales of nontraded REITs because of the DOL fiduciary could lead to failure and consolidation in the IBD industry.
The industry is also facing new rules next spring that will give investors much more accurate information about the actual cost of nontraded REITs.
Nontraded REITs traditionally have been a high-commission product, with advisers receiving a 6% to 7% commission on a sale. After other fees and commissions from the sponsor and affiliates are added in, investors can pay a total of 11% to 12% of their initial investment upfront. The initial cost of the nontraded REIT, however, is not currently reflected on a client's account statement.
According to a Finra notice from January, the general industry practice is to use the offering price, or par value, of a nontraded REIT as the per share estimated value during the offering period, which can continue as long as seven and a half years. The offering price, typically $10 per share, often remains constant on customer account statements during this period even though various costs and fees have reduced investors' principal and underlying assets may have decreased in value.
(Related read: Nontraded REIT sponsors changing compensation for advisers)
TRUE VALUE
Under the new rules, broker-dealers will have to reflect the true value of the investment on customer account statements much sooner. When that happens, nontraded REITs may become a tougher sale.
In response, nontraded REIT sponsors are devising a new share class dubbed a “T share” that cuts the upfront commission brokers are paid when selling a nontraded real estate investment trust but creates an annual trailing commission, executives said.
“I think the industry, by and large, will go to T shares and away from high [commission] front end A shares. That's where the major programs are telling us they are headed,” said Joseph Price, senior vice president and counsel for Finra. “The advantage of T shares is the combination of front and trail commission. That means you will get more of the investor's money in the ground and in real estate early on.”
That will lead to more investor money being deployed to generate returns rather than being paid back to investors in the form of distributions, Mr. Price said.
Industry executives sounded sanguine about the business of nontraded REITs despite the changes and turmoil. In interviews, they cited investors' continued need to invest in products that steadily produce income and are not correlated to the volatile stock market as two of the most significant reasons for a possible rebound in nontraded REITs.
“Fees will come down and the market will find its own equilibrium,” said Glenn Rufrano, CEO of Vereit Inc., a large traded net lease REIT that also owns a nontraded REIT sponsor, Cole Capital. Vereit changed its name from American Realty Capital Properties Inc., formerly a Schorsch-controlled company. “Fees should be related to total returns. If you want higher returns you have to reduce the fees but that may create a much bigger market and that would be beneficial for everybody.”
The current variety of difficulties facing nontraded REITs is an opportunity for nontraded REIT sponsors to firm up corporate governance and make the retail-focused product akin to real estate investments for institutions, executives said. For example, Cole Capital recently announced a variety of changes in the structure of the individual boards of its REITs in order to increase their independence form management.
PRODUCT EVOLUTION
“We should be moving towards nontraded REITs that are more liquid, have lower upfront costs, with the focus on more performance driven compensation,” said Mitchel Sabshon, CEO and president of Inland Real Estate Investment Corp. “That would makes the nonlisted REIT product much better for investors. Products evolve over time.”
The number of changes the nontraded REIT industry is currently grappling with “should be a net positive in the long run, although there's going to be a bump in the road,” said Kevin Gannon, managing director with Stanger. “AR Capital's issues are seemingly isolated, and they have withdrawn from the space.”
“The capital raise is down in part because of new regulatory rules, in part because of the impact of AR Capital and in part due to fewer liquidity events because the traded REIT market hasn't performed as well,” said Thomas Sittema, CEO of CNL Financial Group and the 2016 chairman of the board of the Investment Program Association, an industry trade group.
“For many years in this space, you had a one-size fits all investment approach,” said Mr. Sittema. “Today, there are more and better managers and sponsors, along with an array of new products.”
