February 2012

The Rise of the Non-Traded REITs

The past few years have seen an accelerating number of registration statements being filed for nonexchange-traded real estate investment trusts, or “non-traded REITs.” Just what are non-traded REITs and how do they differ from listed REITs?

Basically, non-traded REITs are syndicated real estate investment partnerships brought to the investing public. Since shares of nontraded REITs are registered with the Securities and Exchange Commission (SEC), investors in them are not required to be “accredited investors” as defined in Rule 501 of Regulation D. Non-traded REITs are available to all investors that meet certain “suitability standards(₁),” which set a lower threshold than the accredited investor standards.

Generally, a non-traded REIT is formed by a sponsor entity. The sponsor entity will provide the non-traded REIT with asset and management services over the life of the REIT. As of June 30, 2011, there were 66 non-traded REITs according to the Blue Vault Partners Nontraded REIT Industry Review Second Quarter 2011 issued by Blue Vault Partners, LLC.

(₁) Suitability standards vary by state but are generally are individuals with a net worth of $150,000 or with both a $45,000 annual income and a $45,000 net worth.

The Similarities
There are many similarities between traded and non-traded REITs. They both register their shares with the SEC, they both are required to file reviewed quarterly financial statements and both are required to file audited annual financial statements. In fact, all of the SEC reporting requirements (including proxies, and Form 8-K and Form 4) are applicable to non-traded REITs in the same manner as any other SEC filer. In addition, the financial statements of non-traded REITs must follow the same accounting principles as other listed companies (currently accounting principles generally accepted in the United States, or “GAAP.”

The Differences
A number of key differences separate traded from non-traded REITs, and they should be considered by any potential investors. For example, non-traded REIT shares are only sold through broker/dealers and financial advisors rather than over a national exchange. At times, the broker/dealers or financial advisors may be related to the non-traded REIT’s sponsor.

Another key difference is that non-traded REITs lack the liquidity of traditional REITs since they are not traded on a national exchange. Generally, an investment in a non-traded REIT is recovered by the eventual liquidation of the entity, a process that may take longer than expected and may affect investor returns. A number of newer offerings include redemption provisions to deal with the liquidity concerns of investors, but these provisions are very limited and subject to management override.

There is also a disparity in the front-end fees between traded and non-traded REITs. Generally, in an initial public offering, a traded REIT will pay approximately 7 percent (or more) of the offering proceeds to the underwriter, with individual investors paying commissions to their brokers when they acquire shares. Conversely, front-end fees in a non-traded REIT offering can be 15 percent of the per-share price going to the sponsor. This is another area where newer offerings have taken investor concerns into account, and the fee structures of some of these deals have lower overall fees or, more likely, may have shifted some of the front-end fee load to the back-end in the form of a bigger carried interest for the sponsor.

Non-traded REITs have also increased their transparency, complementing their disclosures with benchmark information and appraisal-based valuation reports. However, some of the new-found transparency has come in response to previous investor lawsuits and new Financial Industry Regulatory Authority guidance. Another promising development is that as the industry grows, the number of companies providing industry and company data is growing. Now, much more information is available to investors through reports published by companies that track the non-traded REIT industry. All of this additional information is shedding new light on the various opportunities in non-traded REITs.

The Draw
Regardless of concerns about transparency or the lack thereof, what investors want are returns, and non-traded REITs are promising them. Generally, non-traded REITs provide quarterly distributions to shareholders and a return of capital upon liquidation. Currently, quarterly distributions of non-traded REITs vary widely, from as low as zero to over 8 percent. These distributions are based on the performance of the entity, but are also significantly impacted by the stage of the entity’s life. Some early distributions may be funded with new offering proceeds, which may trouble newer investors.

Through their carried interests, the sponsors share in the performance and capital appreciation of the assets with the shareholders, thereby aligning their interests. The enticement is the hope of receiving a steady income stream over the holding period and then sharing in the significant capital appreciation of the real estate at liquidation.

If the new and more transparent non-traded REITs can deliver the returns investors seek, there should be a long and prosperous future for this budding market. Investors then will be happy they gave non-traded REITs a chance.

This article was written by Anthony La Malfa and originally appeared in BDO USA, LLP's "Real Estate Monitor" newsletter (Winter 2012). Copyright 2012 BDO USA, LLP. All rights reserved. www.bdo.com. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.