As co-founder of real estate private equity firm Hamilton Point Investments, I believe the current perpetual non-listed REIT (real estate investment trust) structure creates certain concerns that investors should be aware of and take into consideration.
Private REITs proliferated in the decade following the collapse of the real estate bubble in 2008-2009. Retail investors pumped money into these groups, primarily through independent financial advisors, and in return were told they expected dividends for a few years before the REIT would liquidate its portfolio or seek to go public. Investment and operations took a back seat, and focus and energy was put into recapitalization. They performed poorly, underperforming publicly traded REITs and direct private investments, and there were many examples of outright loss of investments.
After the collapse of American Realty Capital in 2014, other bankruptcies and the resulting arbitration awards led to a dramatic decline in non-listed REIT investments. However, a few years later, many large publicly traded financial companies entered the field, raising huge amounts of capital through well-known brokerages rather than independent broker-dealers. What makes this new structure different from previous non-listed REITs is that it is perpetual and there is no planned exit.
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Although these new sponsors are different in that they are experienced real estate investment firms with the institutional knowledge, infrastructure and track record to succeed, there are considerations that investors in these perpetual non-listed REITs should be aware of.
Issues investors should know
Stock valuation issues. Currently, non-listed REITs conduct monthly or quarterly share valuations, which are used to calculate both the price at which new investors enter and the price at which existing investors seek to redeem and cash out. The price at which the shares trade, or the net asset value (NAV) per share, is determined solely by the firm employing a third-party valuation advisor, but the final NAV is determined at the firm’s sole discretion and represented as accurate.
NAV calculations are not exact and can be way off. For example, consider a property that is declared to be worth $100 million. This is a rough estimate. No matter how experienced and wise the REIT principals are, that $100 million actually means between, say, $95 million and $105 million. Leverage then magnifies that difference. If the property above is 50% leveraged, the equity is $50 million. If the property’s final value is $95 million, the equity is worth $45 million. At $105 million, the equity is $55 million. A roughly 10% change in the value of this leveraged property is closer to a 20% change in the stock equity value. The NAV calculation gives a good guess at what the stock price should be, but it is far from perfect.
Legacy assets acquired at the top of the market. When you invest in perpetual-life non-listed REITs, you are not investing in the current real estate market. A significant portion of the real estate may have been purchased several years ago, and is now coinciding with the peak of this last market price appreciation. Some non-listed REITs are lagging in their valuations. While commercial real estate overall has fallen in value by about 20% since November 2022, some non-listed REITs have seen a much lower decline, perhaps significantly less severe, even when accounting for allocations to different property types.
Those currently investing in permanent assets may be thinking they are entering the market at an attractive time and benefiting from the price correction that has taken place over the past two years, but because many of these assets were purchased at the market’s highest prices in 2021 and 2022, their assets may be worth less now than they were when they were purchased.
For example, a hotel or student housing purchased in 2021 may have been a good investment as the COVID pandemic hurt these property types, but traditional apartments or industrial/warehouses less so. There may be good reasons why traditional REIT investments are attractive right now. Just don’t take the common “it’s just better property” or “we’re really good managers” as a good enough answer.
Liquidity is questionable. The liquidity (ability to recoup invested capital) of the new perpetual non-listed REITs is touted as “no problem” in some sense, noting that quarterly liquidity is up to a certain percentage of assets. But as we’ve seen over the past year, the ability to recoup invested capital and the pricing mechanisms to do so are less than ideal.
While liquidity is provided, in practice investors must essentially apply for a share redemption and it will either be approved in full, partially approved, or not approved at all. Aside from the investor’s potential need for liquidity, this removes a critical ability for investors to respond quickly to changing market conditions, up or down, or to changes in the sponsor’s views.
the dilutive nature of redemptions; Redemptions often strain the finances of a private REIT, to the detriment of remaining investors. Older REITs that underperformed had at least a stated goal of liquidating the company or going public after a certain period of time. Today’s perpetually private REITs have liquidity at the sole discretion of the REIT.
Often, REITs do not have the cash to make the redemptions and must dilute their current shares with capital from new investors to pay them off. Note that the net new cash to a REIT will always be less than the amount of cash redeemed, as there will be costs for the new shares in the form of fees to financial advisors.
Another way REITs handle redemptions is by selling assets when market conditions are poor or taking on new debt on the properties at higher interest rates.
None of these share redemption methods are beneficial to the remaining shareholders.
Conclusion
The principal sponsors of today’s largest perpetual private REITs are generally well-established groups that have successfully managed institutional equity in closed-end real estate funds for decades. They have the institutional capabilities and strong track records necessary to succeed. However, the four structural concerns above regarding perpetual private REITs are just now being put to the test, and it remains to be seen whether they will pan out.
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This article was written by and represents the views of a contributing advisor, not of Kiplinger editorial staff. The advisor’s record is available at SEC or FINRA.
