Letting Go of the Status Quo in REITs
Non-traded REIT companies are having a bad year. Sales of non-traded REIT investments began dropping steadily in 2014, first-time buyer purchases plateaued in 2015, and sales across the industry fell off a cliff in April 2016 when changes to Finra rules governing direct participation program statement valuations (explained in Regulatory Notice 15-02) came into effect.
Why have non-traded REIT companies seen such a dramatic decline? It’s simple. While many of these companies have repeated talking points that mention reduced fees, transparency and similar verbiage, they have failed to do the one thing that can keep regulators, plaintiffs’ attorneys and bad publicity at bay: they are failing to put investors first.
Instead, these companies are trying their hardest to maintain the status quo. Historically, the industry has feasted on fees (underwriting compensation) set at 10%, right at the upper limit Finra allows. Typically, the fees comprise a 7% selling commission and a 3% dealer manager fee. The 7% selling commission goes to the brokerage firm that sells the product to the investor, while the dealer manager fee is split between the primary distributing broker-dealer and the retail brokerage firm.
The Finra rule was designed to make these sales charges transparent to investors, but before the rules came into effect many non-traded REIT sponsors responded by constructing a new share class, called T shares, which spread out the sales charges over time instead of triggering the fees when the purchase is made. Research from Blue Vault Partners shows that 21 of 27 open non-traded REIT offerings included Class T shares in their prospectuses.
Why are T shares so popular? Any change that causes front-end underwriting compensation as well as the REIT’s organization and offering expenses to decrease is beneficial from a statement valuation perspective. Although spreading out these expenses makes the offering look good on a client statement, the total commissions paid does not go down. It’s simply a cunning way to evade the new rules.
There are a handful of non-traded REIT sponsors who have elected to absorb some of the fees that would have previously been assessed to the shareholder. This is beneficial from a client statement valuation perspective and an overall cost perspective. Unfortunately, this has turned out to be another ruse, as many sponsors have increased other fees/charges somewhere else to recoup the cost of having absorbed the fees on the front end, effectively eliminating the benefit.
It doesn’t have to be this hard. There is a simple, elegant solution: reduce the underwriting compensation present in non-traded REITs.
History should guide us. The mutual fund segment of the industry once had very high underwriting costs. As those costs came down, and innovation brought new lower-cost products into the marketplace, the market didn’t contract -- it expanded. Today, there is no more mainstream product than the mutual fund and similar products, like unit investment trusts, ETFs, etc.
Listen up, non-traded REIT companies: There’s your blueprint. Let’s stop being reactive and start being proactive. You can cling to a decaying status quo or reduce your fees and thrive. Reduce non-traded REIT fees to more comparative levels with other more mainstream products like mutual funds, and take the wind out of sails the naysayers.
Recent positive developments in this area emerging from Hines and Inland give me hope for the future of the non-traded REIT industry.
We all know that the basic legal structure of a non-traded REIT is an exceptionally viable structure to accomplish the investment thesis of providing an investor with exposure to many of the exceptional benefits (and, of course, the risks) of owning commercial real estate but without the significant barriers to direct ownership of that asset class. Lower underwriting costs only make that investment thesis that much more compelling.
I strongly urge non-traded REIT sponsors as well as my fellow executives at other retail financial services firms that sell non-traded REITs to stop talking the talk and start walking the walk.
It’s time to reduce underwriting compensation. It’s time to stop the T share shell game. It’s time to accept our fiduciary responsibility and put investors first.