Nontraded REIT returns: Where to put cash now?

The independent broker-dealer industry fattened up last year on the sale of nontraded real estate investment trusts. The question hanging over IBDs now is whether advisers are prudently reallocating the money of clients who are invested in nontraded REITs, particularly as the trusts continue to perform well and return capital to investors through listings or mergers.

What to do with client money and how to allocate it properly is particularly relevant as these so-called liquidity events for nontraded REITs continue. Business development companies also are beginning to get in on the act. This month alone has seen three listings of formerly illiquid products: two REITs (the American Realty Capital Healthcare Trust and the American Realty Capital New York Recovery REIT Inc.) and one BDC (FS Investment Corp.).

Remember, nontraded REITs are sold almost exclusively through IBDs. The wirehouses have flirted with nontraded REITs, as have registered investment advisers in a somewhat different form, but neither has embraced the product.

But the $20 billion per year independent-broker-dealer industry and nontraded REITs are tied at the hip. And that connection is only getting cinched tighter.

First, the numbers. InvestmentNews each year surveys the independent-broker-dealer industry and tallies that data in a special report, which begins on Page 14 of this issue. With the S&P 500 up about 30% in 2013, it was a good year for the IBD industry. The biggest firms in 2013 returned to low-double-digit revenue growth after a lackluster 2012.

ALTERNATIVES REVENUE

It was, however, a spectacular year for sales of nontraded REITs. Firm revenue from the sale of alternative investments, in large part nontraded REITs, climbed an astonishing 63.6% in 2013, when compared with the previous year.

According to 63 IBDs that provided 2013 and 2012 alternative revenue data, revenue from alternative investments reached $1.33 billion last year, as opposed to $812.9 million a year earlier. Alternatives as a percentage of total broker-dealer revenue reached 6.5% last year, compared with 4.5% in 2012, again according to the 63 IBDs that reported.

Most, not all, of that money comes from the sale of nontraded REITs. A smattering of firms reported sales of other alternative investments such as managed futures and private placements, but nontraded REIT revenue dwarfs those other alts.

It’s clear that the business of independent broker-dealers is becoming more closely aligned with the sale of alternative investments in general and illiquid REITs in particular. With the industry awash in revenue from nontraded REITs, broker-dealers and advisers need to show extra caution and vigilance when allocating client assets into real estate with an illiquid REIT.

It’s positive that nontraded REITS are performing, providing income for investors in an environment where traditional bonds and bank certificates of deposit remain low-yielding products. And that means 2014 most likely will look a lot like last year when broker-dealers tally up their revenue from the sale of these investments.

Yet despite those positive indicators, nontraded REITs, with a 7% commission to the adviser and a 1% to 1.5% commission to the broker-dealer, remain a lightning-rod product. The commissions are high. State regulators are keeping close tabs on broker-dealers to make sure client allocations to nontraded REITs do not surpass mandated thresholds, in some states 10% of a client’s portfolio.

REITs are also controversial because some advisers and investors were badly burned during the credit crisis, when some of the most substantial REITs in the industry lost 30% or more of their value. Those advisers vowed never to sell the product again while those investors continue to feel the pain from having invested in them.

Other advisers are grumbling that nontraded REITs are returning capital to investors too quickly, and that forces them to search for new income-producing products in a market filled with questions. Plaintiff’s attorneys and their consultants, meanwhile, are constantly blasting nontraded REITs for the high sales load, claiming clients would be better off in traded, or liquid, investments, like an indexed fund of traded REITs. The load is too high a hurdle for the REIT’s manager to overcome and undermines performance, they say.

Tune out all this chatter about nontraded REITs and focus on the clients who buy the product, one industry executive says.

“Clearly, there’s been an increase of assets in the alternatives space, and that’s really nontraded REITs,” said Brian Kovack, president of Kovack Securities Inc., which he founded along with his father, Ronald Kovack. “The real issue is not the money being poured into the space, but whether [the nontraded REIT] is suitable with respect to its concentration in the client’s holdings. Are firms reviewing the concentration of REITs with regards to their suitability for clients?”

IMPLICATIONS

Mr. Kovack understands the implications of that question. Like most independent broker-dealers, revenue from alternative investments made up a bigger chunk of the firm’s revenue in 2013 than it did in 2012. Kovack Securities generated $46.3 million in revenue last year, of which 17% — $7.9 million — was from alternative investments. In 2012, Kovack Securities’ revenue from alternatives was $2.5 million, or 6.3% of the firm’s total revenue of $40.5 million.

Will advisers and the IBD industry heed Mr. Kovack’s advice and allocate client capital properly or will they put too much client money in high-commission REITs and BDCs and thus overconcentrate clients in illiquid products? When a shift or correction in the commercial real estate market comes, and it will eventually, it will be clear who in the industry followed Mr. Kovack’s lead and who did not.

Related Topics: Asset Allocation