Non-traded REITs (NTR) have garnered a bad rep after years of high fees and questionable practices. A few years ago, we would’ve told you to run away from these investments.
But spurred by regulatory changes introduced in 2016, a new generation of funds like Blackstone’s BREIT is breathing life into the industry.
Non-traded REITs require extra scrutiny and a healthy dose of skepticism. But for investors seeking low volatility, income-generating investments, it’s time to take another look.
First Things First: What Are They?
What's a REIT?
REITs are investment vehicles that hold a portfolio of rental properties such as apartment buildings, commercial real estate, storage units, data centers, etc.
Investors buy shares of a REIT and receive a dividend which is funded from the portfolio’s rental income. The dividend is taxed at ordinary income rates, unlike corporate dividends.
Most REITs are traded on an exchange like the New York Stock Exchange. But there’s a growing niche of REITs that are non-traded.
When people talk about REITs, they are usually referring to traded REITs, like Public Storage ($PSA), Realty Income ($O), and American Tower ($AMT), all of which are listed on the New York Stock Exchange. They have $35 billion, $19 billion, and $73 billion assets under management, respectively.
In contrast, non-traded REITs are not listed on stock exchanges. To gain access, you typically purchase shares from broker-dealers or financial advisers. A new breed of eREITs like Fundrise, Realty Mogul and Rich Uncles sell shares directly to investors.
Non-traded REITs can be public or private
Some articles talk about non-traded REITs and private REITs interchangeably but there’s an important distinction between the two. Unlike their private counterparts, public REITs register their securities with the SEC under the Securities Act of 1933.
This means they must follow SEC regulation with regards to public reporting, tax qualification, auditing, and governance requirements. Private REITs don’t file anything with the SEC. For this reason, 99.9999% of investors should never go near a private REIT. We’ll focus on public, non-traded REITs for the rest of this article.
How Do You Exit Non-Traded REITs?
How do you exit your position in a non-traded REIT if you can’t sell your shares on an exchange?
Typically when one of the following needs to happen:
the REIT lists its shares on an exchange
the REIT is acquired by or merges with another fund
the REIT sells off its real estate portfolio
The Average Time to Liquidity
On average, it takes five to seven years to get liquidity. But FINRA warns investors it can take over 8 years. New REITs are trying to solve this liquidity problem by enstating stock buyback programs.
Perpetual Life REIT
If waiting over 8 years to get your investment back isn’t appetizing, a new generation of REITs called perpetual life REITs solves for that.
Older, non-traded REITs (called “lifecycle REITs”) were structured to to have five-year to 10-year lifespans. In contrast, perpetual life/NAV REITs never liquidate. Instead, funds publish a monthly NAV, and offer to buy back shares priced to the most recent NAV. The upshot for investors? You get to decide when to sell your shares, not the sponsor.
Don’t let these buyback programs lull you into a false sense of security. Most perpetual life REITs state that they can cancel the buyback program at any time. If there’s a credit crunch and many investors are trying to redeem their shares, the non-traded REITs can decide not to honor those requests.
For example, the Resource Office Innovation REIT suspended its share repurchase program in 2017. Rich Uncles recently stopped its buyback program in January 2019, (likely due to the fact that they are quickly running out of money).
Benefits of Non-Traded REITs
According to the National Association of Real Estate Income Trusts, publicly listed REITs have a volatility that ranges between 14% and 17%. Non-traded REITs have volatility of around 2%, (the volatility of bonds is 3%).
Can't Panic Sell
In 2016 and 2017, fueled by fears around the death of retail, shares of traded REITs sold at double-digit discounts their NAV, even though many of the funds didn’t own any retail properties.
Call it the upside of illiquidity, non-traded REITs aren’t prone to this type of panic selling.
In 2009, when traded REITs saw a 67% drop in their shares, non-traded REITs “only” dropped 15% (fun times), according to Texas Enterprise, a research publication by the University of Texas at Austin.
Why Should You Care About Share Price?
If you’re a buy and hold investor, you might wonder, why should I care about short-term fluctuations in my shares?
First, if you own shares in a perpetual life REIT, you could sell those shares at the NAV price. This insulates you from market pricing (though, again, the buyback program is at the REIT’s discretion).
A second reason to care about short term movements is: a depressed share price hurts the REIT’s ability to raise more money.
Since REITs give back 90% of their profits to investors every year, they often raise more money by selling more shares. If its share price is trading at a large discount to NAV, the REIT will need to sell more shares to raise x amount of money. This dilutes its shareholders.
Non-Traded REITs Offer Higher Yields
On average, non-traded REITs pay out higher yields than traded REITs. Nontraded REITs produce average dividends of 5.5% to 6.5% per year—after fees are taken out. Traditional REITs yield closer to 3%.
Downsides of Non-Traded REITs
High Fees (This is Quickly Changing)
The largest criticism of non-traded REITs is their high fees. Since they aren’t listed on exchanges, you have to go through a broker/dealer or a financial adviser to buy shares. These middlemen traditionally charge commissions up to 15%.
This means that if you invested $100 investment, only $85 actual goes into the fund.
Regulations Bring Lower Fees
In 2016, the SEC came out with a new FINRA rule that forced non-traded REITs to disclose their fund’s cost structure. Before this rule, REITs published inflated share values that didn’t net out fees and expenses. FINRA hopes these new disclosure requirements will move the industry away from high front-load fees.
The rule has been effective on this front. Firms like Blackstone and Oaktree Capital management are shaking up the industry by reducing commissions from 6%-7% to 2%-3%. (Note: different classes of shares often have different fees, so read through each class carefully.)
Instead, they make money via a hurdle fee. They take a cut of the profits if the profits meet a certain threshold. This type of fee structure is widely used in private equity and we’re happy to see it catch on. Profit-sharing incentives align the fund’s incentives much more closely with investor interests.
Cashflow Can't Cover Distributions
Non-traded REITs offer high yields, but they sometimes fund these distributions with borrowed money or worse, other investors’ capital instead of rent generated by the properties.
In 2016, FINRA issued an investor alert about non-traded REITs and highlighted this practice, warning that distributions are sometimes "heavily subsidized by borrowed funds and include a return of investor principal."
That’s why you should always look at the financials to verify that a REIT is generating adequate cash flow to cover the dividend.
Historic Performance of Non-Traded REITs
The performance of non-traded REITs over the past decade can be summed up in two words: really poor.
A study by Blue Vault Partners tracked the returns of the 45 non-traded REITs that experienced full-cycle events, meaning investors were able to completely cash out their shares.
The return for these 45 funds ranged from -8% to 21% (assuming dividends were reinvested). The average IRR was 7.50%, and the median was 8.13%.
Another study published in the Journal of Wealth Management in September 2016 tracked the performance of 89 non-traded REITs over a longer timeline: from 2000 to 2015. The authors found non-traded REITs had a paltry average annual return of 4%, compared to 11% for traded REITs over the same period.
Dr. Brian Henderson, professor of finance at George Washington University, concludes, “Our analysis reveals that non-traded REIT investors would have had significantly higher returns had they invested in publicly traded REITs rather than non-traded REITs.”
It is interesting how widely the fees vary. Dr.Henderson et al found commissions ranged from 5% to 24.6%. He attributes much of the poor performance to high upfront brokerage fees.
For years, lack of transparency in the non-traded REITs industry fueled bad actors that charged high upfront commissions and over-inflated the value of shares they reported to investors.
Fortunately, the 2016 FINRA regulations brought much-needed reform to the industry. By forcing funds to disclose commissions, these rules pressured the heavy sales incentives that plagued the industry.
The most recent reincarnation of non-traded REITs from high-quality funds like Blackstone, Oaktree Capital Management and Nuveen feature low front-load fees with performance-based payouts.
However, since research analysts don’t scrutinize non-traded REITs to the degree they do traded REITs, we only recommend these funds for financially literate investors who are comfortable performing their own due diligence.