The latest iteration of the public, non-traded REIT leapt onto the investment scene over the past five years with much fanfare and bravado as several of the biggest names in real estate private equity saw an opportunity to repurpose a much-maligned structure and mass-market that structure to retail investors and small institutions via broker/dealer networks and independent financial advisors from across the globe. The foray into non-traded REITs or NAV REITs as they are often described, was a smashing success for much of the past five years as low interest rates and demand for “non-correlated” returns, both prior to the Covid pandemic and in the wake of its aftermath, provided investors with much of what they were looking for, a sizeable distribution rate (sweetened by the tax-advantaged nature of that distribution) and predictable returns which were not impacted by the vagaries of market based pricing.
The marketing of non-traded REITs has focused on a handful of talking points which warrant more discussion than is necessarily provided in the materials furnished by the sponsors. The primary selling points for these vehicles usually highlight sponsorship from a well-recognized investment manager, firm track record and juicy distribution rates. Finally, the subscription/redemption methodology is detailed as an efficient mechanism for liquidity.
While we applaud the “democratization” of real estate investment and access to the expertise of real estate private equity firms, we do question the “price of admission” that goes along with this sponsorship along with the conflicts of interest associated with an externally advised REIT structure. We are of the opinion that history has dictated that internally advised REIT structures with a dedicated leadership team that is responsible for all aspects of investment and capital allocation is a superior and more cost-effective business model which accrues to the long-term success of shareholders. Instead of being an innovation that improves upon the modern REIT era of the early 1990’s, the NAV or non-traded REITs of the 2020’s are a throwback to the days of real estate syndication which often ended badly for small investors.
One of the primary hurdles with NAV REITs and the external management/advisory structure relates to fees which are quite onerous. Sponsors charge a management fee of approximately 125 basis points coupled with a performance fee of approximately 12.5% above a specified hurdle rate AND a selling fee to the broker/dealer that can aggregate upwards of a 9.0% load over a 5–7-year period.[1] As has been the case historically, these fee structures incentivize the sponsors to raise as much capital as possible regardless of the investment environment into which the proceeds are being allocated. NAV REITs raised tens of billions of dollars from late 2020 through early 2022 and invested that capital at “cap rates” which arguably were extremely aggressive and top-ticked the cycle for growth-oriented property types such as industrial and rental housing.
The long-term track record for real estate private equity has been quite good as secular forces coupled with middling economic growth have kept interest rates low, providing an excellent backdrop for levered real estate, especially for those investors that avoided the pitfalls of regional malls in the 2010s and urban office more recently. Only time will tell where interest rates will normalize in the future, and that determination will be vital in terms of the eventual return proposition for the vast amount of capital that was invested in rental property over the past few years. We would highlight that listed REITs have utilized considerably less leverage over the past cycle and were also less aggressive in putting capital to work in 2022 than their non-traded peers, and thus we are more confident in the former’s ability to rebound as we see an eventual turn in the interest rate and economic cycle.
As we note several of the material differences between traded versus non-traded REITs, another nuance materializes when it comes to distributions, or dividends. Non-traded REITs were conceived with distribution rates that were meant to attract investors to the vehicle and to date have had no relationship to fund level cash flow. A distinct hallmark of the modern listed -REIT structure has been the notion of covering the dividend with operating cash flow from recurring rental income and using the remaining cash flow after dividends as growth capital to be invested either organically or externally. The non-traded REITs of today are primarily paying distributions out of borrowings, asset sales and new stock subscriptions and not from recurring cash flow.
One perceived positive for NAV REITs is that this form of capital allocation does lead to a tax efficient distribution with many of these vehicles reporting distributions that are upwards of 95% return of capital, which equates to a higher net of tax yield than if the distribution is more skewed towards return on capital. By way of comparison, we note that per NAREIT (National Association of Real Estate Investment Trusts) data, listed REIT dividends had an average 17% return of capital in 2021. Unfortunately, higher leverage and a distribution rate that is primarily funded from external capital sources does not always bode well for shareholders, which leads to the topic of liquidity.
The issue of liquidity in non-traded REITs has gone from being an afterthought for the first several years of fundraising by this new class of NAV REITs to now being a debated factor which could impair subscriptions for years to come. The reason for this heightened level of awareness is that several of the largest and fastest growing NAV REITs have begun to “gate” or limit redemptions over the past five or six months as redemption requests have bounded above the 2% per month and 5% per quarter maximum allotment which has become an industry norm. There does not appear to be one specific reason for the heightened interest on the part of shareholders to exit these vehicles, however, performance in the form of reported monthly net asset value (NAV) has remained surprisingly strong over the past year as other asset classes, including traded REITs have seen material retracements in valuation since the Federal Reserve began raising rates in late 2021 and the economic outlook for the U.S. and other countries has begun to moderate. The pricing and valuation disparity between NAV REITs and market-priced assets appear to have reached a point wherein shareholders see better return opportunity in other places. Also, market psychology would dictate that redemption queues will beget more queues as investors get concerned when told access to their funds are being limited.
Liquidity, and a related characteristic, price discovery is one of the biggest differentiators between listed REITs and non-traded REITs and leads to a good bit of confusion. Listed REITs share their DNA with other publicly traded corporations and are “valued” each trading day based on short-term and long-term expectations of intrinsic value. Trading and valuation are also impacted by externalities including macro-economics, geo-politics, regulation and countless other items that drive markets. It is also worth noting that listed REITs have tended to trade at premiums to the underlying value of their assets, or at a premium to NAV because markets have been inclined to apply value to the internal management structure of these vehicles, assuming they demonstrate proficiency in execution on things like investment decisions, property management and asset allocation to name a few.
Non-traded REITs on the other hand represent a collection of real estate and other assets. They usually have no employees or only a small handful of administrative staff with all corporate, investment and finance functions being outsourced to the sponsor and other third-party entities. Non-traded REITs are referred to as NAV REITs because a monthly NAV calculation is the valuation metric utilized by the sponsor to convey value to shareholders and this is also the unit of measure utilized in the subscriptions and redemption process.
Given the vital role that “NAV” plays in the inner workings of the public, non-traded, NAV REITs it is surprising that a greater amount of transparency is not provided when sponsors explain the valuation methodology. Many sponsors describe the process as including an annual appraisal of all assets, but appraisals can quickly become outdated, especially in fast-moving market environments. These sponsors also highlight a discounted cash flow methodology (DCF) as an important valuation tool, yet in most instances, many of the key inputs to the DCF methodology are undisclosed. While sponsors and distributors of these products underscore the notion that monthly NAVs are less volatile and provide greater stability than the daily price discovery provided by listed REITs, the debate over which valuation mechanism is superior will only intensify as NAV REITs continue to gate redemptions and the valuation dislocation between the two vehicles widen. Many investors are disappointed with the current valuations on listed REITs, but they likely take some satisfaction in knowing that they can monetize their positions at any given time, even if they are unhappy with the price.
With many sub-sectors of the U.S. listed REIT industry trading at substantial discounts to net asset value it is hard to reconcile the NAV pricing being applied to non-traded peers. Our recent analysis of two vehicles in the non-traded REIT space concluded that both funds were being valued at implied cap rates of approximately 4.0% per their yearend 2022 valuations. By contrast, a portfolio of traded REITs with a similar property sector and geographic footprint traded at an implied cap rate closer to 5.75%. Applying that 5.75% cap rate to the NAV REITs would reduce the reported NAVs by just over 50%, demonstrating the remarkable disparity in value. While senior statemen in the real estate private equity world are quick to argue that “illiquidity premiums” are the latest trend in modern finance, we are more cautious and favor the transparency of liquid markets knowing that while they are sometimes “wrong” over the short-term, they are always right in the long run.
Footnotes:
[1] Blackstone Real Estate Income Trust, Inc. (BREIT): Prospectus dated February 25, 2022 and Starwood Real Estate Income Trust, Inc. (SREIT): Prospectus dated April 7, 2023
