The Other Side Of Liquidity

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David Evanson and Nick Schorsch

Forbes.com, Winter, 2012

Investors like words that end in “Y”: transparency, accountability, scalability and the big one, liquidity.

The last of these, liquidity, has a darker side often not fully appreciated that can facilitate the loss of substantial wealth. Yes, liquidity can be good, but it may also enable an investor to do the wrong thing at the worst possible moment.

As a case in point, consider Health Care REIT (HCN). In July 2008, just before the global capital markets came unglued, shares of HCN were trading at about $52.50. As the crisis deepened, HCN shares bottomed out at about $27 in March 2009. Today’s price: about $55.

An ill-timed departure from HCN cost an investor nearly half of his or her investment. In this case, a little less liquidity might have prevented the loss.

Though there are many “U-shaped” charts out there to prove my point, within the REIT industry exist a class of assets, so-called non-traded REITs, that insulate investors from this type of mistake, by affording very limited liquidity while their property portfolios are under construction; these investments deserve careful consideration.

Such acquisition vehicles do not trade on a stock exchange during their asset accumulation stage, usually lasting up to thirty-six months. Once seasoned, these property portfolios have a planned liquidity event, such as an outright sale of the company, or a listing.

Non-traded REITs deserve a thoughtful review because they enforce a kind of discipline, as noted, and because they compensate the investor for the lack of liquidity with a higher yield. For instance, today 10-year Treasury yields are hovering at about 2%, 5-year CDs pay 1.15%, and investment grade corporate bonds, using the Barclay’s iShares Aggregate Bond Fund index (AGG), are offering investors about 2.9%.

The average yield for listed REITs, using weighted average of the The Morgan Stanley REIT Index (^RMS) and the MSCI REIT Index (^RMZ) provided by MSCI/Barra currently is about 3.8%. By comparison, most non-traded REITs are paying between 6% to 8%. (See chart below.)

The spread over corporate bonds is even larger than it appears at first glance. Interest income is taxed at ordinary rates, taking into account state and federal taxes can top 50% for some investors. Meanwhile, dividends from non-traded REITs get more favorable treatment with tax rates as low as 10% and as high as 35%, depending on a variety of factors.

The common criticism of non-traded REITs, that fees are high, with an initial sales load of 7% to 8% on top of annual management fees, bears looking into. Some non-traded REIT sponsors will waive their fees when income is not sufficient to pay and cover the dividend. This voluntary positioning of management behind investors gives potential buyers a valuable clue as to which non-traded REIT sponsors have properly aligned investor interests.

Liquidity is important. However, it need not be the yardstick by which all investments are measured, especially when investors are compensated for the risk that lower liquidity presents. Moreover, when properly positioned as a small portion of a diversified portfolio, lower liquidity need not be avoided, but rather embraced.