First Drips Of Liquidity Felt In Non-Traded REITs

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David Evanson and Nick Schorsch, Winter, 2012

So-called non-traded REITs (NTRs) represent a rapidly growing income producing niche among “alternative” investments. In its nascent history, the NTR industry has raised some $80 billion, largely from individual investors. This compares with $430 billion for the entire REIT industry, traded and non-traded.

Historically, NTRs had very limited redemption features, namely in the case of death or disability of the investor. However, investors were compensated for this lack of liquidity with higher yields.

Since day one, pundits and real state cognoscenti have roundly criticized the absence of liquidity and transparency in these investment products. Certain real estate investment trusts have recently addressed these criticisms with what is now known as “Daily NAV” products that offer both a liquidity feature and daily mark to market.

For investors this is clearly good news: receiving a current annual yield that in many cases is 250 basis points or more above the dividends paid by their public traded counterparts (e.g. Vornado Realty Trust (VNO), Boston Properties (BXP), Public Storage (PSA)) with real liquidity and daily net asset value reporting. However, the structure of NTRs with liquidity features present risks as well. A popular proxy for publicly traded REITs, iShares Cohen & Steers Realty Majors (ICF) yields 2.85%. Another, the iShares Dow Jones U.S. Real Estate (IYR), yields 3.66% Investors should understand these risks before committing capital to this new breed of investment.

As a first step, it’s important to understand the liquidity feature. Daily NAV products allow investors the opportunity to sell shares up to 5% of the total outstanding shares every quarter on a first come, first served basis; this equates to 20% of the shares outstanding annually. The price at which the REIT buys shares from investors would be struck at the net asset value on a specified day. NAV is established by a routine valuation conducted by a qualified third party consistent with industry accepted valuation metrics.

The rub comes from the need to provide this level of liquidity for the REIT. This requires the REIT to keep more cash on hand as well as to maintain unencumbered assets to support a line of credit.

Keeping more cash on hand to cover redemptions appears to be a simple, yet elegant solution. However, the ultimate effect is more far reaching than it first appears. For example, a daily NAV REIT capitalized with $50 million of equity and another $50 million of debt, might keep something like $5 million on hand to cover redemptions. This has the effect of constraining the REITs investable capital, because in truth, it doesn’t have $100 million to purchase properties, but rather just $95 million. And this $95 million needs to work quite a bit harder to deliver the promised 6% or so yield.

Moreover, the management team must be able to deploy capital efficiently. If cash were to build up, the yield would likely drop causing redemptions to occur further creating drag on the REITs investment program.

Protecting yourself comes down to that old real estate adage repacked for business: Management, management, management. That is, if you are attracted to a so-called Daily NAV REIT, management’s track record deploying their capital really matters. I would recommend avoiding management teams that have not been able to deploy substantially all of the capital raised within the quarter raised. The total real estate purchased for the quarter can be easily pulled from the Statement of Cash Flows contained in each quarterly Securities and Exchange Commission 10-Q filing. The total capital available to the REIT is described in detail in the Liquidity and Capital Resources section of the annual 10-K filing and or in the notes to the consolidated financial statements.

I suspect the new breed of Daily NAV products may ultimately make the current generation of non-traded REITs obsolete. I must confess to a range of mixed feelings regarding this development. On the whole, daily NAV REITs are a net positive, since they represent the real estate investment management industry responding to customer concerns regarding liquidity and fair valuation. I can’t help but think however, that the non-traded REITs were good for customers as well as management teams, where a long-term focus enabled the inherent value of real estate to work its magic.