Nontraded REITs have been the subject of much debate in the investment community because many of the companies are fraught with fees that tend to diminish investment returns.
Other complaints include the lack of liquidity for investors who may have to wait years before they can get their money out of a nontraded REIT (real estate investment trust).
Nontraded public REITs are public companies that invest in commercial properties, but are not traded on an exchange. They are required to file their financial information with the Securities and Exchange Commission, just like any other public company, yet their shares do not trade on a stock exchange.
The industry's bad reputation is not unwarranted, as certain companies and brokers have generated huge fees while returning relatively little to investors.
However, not all nontraded REITs are alike and not all investment advisers charge a commission. Some nontraded REITs have generated good returns for investors in a timely manner. Investors who purchased successful nontraded REITs and bypassed a brokerage commission did even better.
Fuel was added to the fire last month when Blue Vault Partners, an independent research firm that tracks nontraded REITs, and the University of Texas issued a report that found nontraded REITs underperform two general REIT indexes. The study tracked 21 nontraded REITs that experienced liquidity events from 1990 through May 2012.
The study determined the average annualized rate of return for nontraded REITs was 10.3 percent, 140 basis points below the two customized benchmarks. One of the primary conclusions was that the underperformance of nontraded REITs was because of the investor's "loads" or commissions. Average annualized returns jumped to 12.5 percent once fees are taken out of the equation.
According to the Blue Vault Partners study, the average load in a nontraded REIT is 12 percent, of which 7 percent is a commission to the stock broker that sold the investment and 5 percent goes to the nontraded REIT's management team. So if an investor puts in $100,000, only $88,000 actually goes to purchasing bricks and mortar.
The fee structure is different for investors who purchase nontraded REITs from a non-commission, fee-only adviser. By buying through a fee-only adviser, such as a registered investment adviser (RIA), the 7 percent is waived. Most nontraded REITs sell shares at $10 per share with a full load. Through an RIA, each share is purchased at $9.30.
The study failed to incorporate the after-tax returns of nontraded REITs, a relevant factor because much of their distributions are typically tax-deferred. As opposed to older, publicly-traded REITs that have held the same properties for years, many nontraded REITs have newly purchased properties, so their depreciation expense typically is larger. This allows most or all of the dividend to be distributed as return of capital, rather than income, thus deferring taxable income.
Another factor affecting investor returns is the fee a nontraded REIT may charge to "internalize" their management. Most nontraded REITs utilize a corporate structure where their manager is a separate but affiliated company. When a nontraded REIT lists on an exchange, traditionally they will internalize or essentially acquire the management team. This fee can be significant. According to InvestmentNews, between 2000 and 2007, seven nontraded REITs paid $68 to $375 million in fees to internalize their own management teams.
Realty Capital Trust
Some nontraded REITS have waived the internalization fee, opting for a performance fee that is tied to the stock's performance after being listed for several months. One example of a recent nontraded REIT success is American Realty Capital Trust.
The company listed its shares on Nasdaq in March and waived the internalization fee. Investors who purchased this nontraded REIT through a fee-only adviser bought the shares at $9.30. After paying an annualized dividend of about 7 percent, it listed on the exchange in March at $10.50 per share.
The stock price hit a recent high of $11.25 in April.
Rather than an internalization fee, management will receive an incentive fee in September if the stock trades over a certain price. Original investors who enjoyed the ride can sell their shares in advance of the management payout if they so desire.
Good investment opportunities can often be found by reading beyond the headlines and looking deeper into industries or investment categories that are out of favor. The nontraded REIT space may be a good example of such opportunity.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken is a certified financial analyst with Campbell Asset Management LLC. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Time Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfree press.com.