Mention commercial real estate and visions of high-rises, office parks and malls come to mind. These aren’t the kind of assets that most investors — even those that are ultra-high net worth — can purchase on their own. So investors turn to private or non-traded real estate investment trusts (REITs) and private equity real estate funds.
Private REITs and private equity real estate funds can strengthen portfolios. They offer diversity, increase risk-adjusted performance, temper the ups and downs of the stock market, earn income, reap tax benefits and take advantage of wealth-building appreciation. Best of all, they do so without the headaches of owning and managing their own properties.
However, the reality is that these investment vehicles have structural and management differences that can have a big influence on an investor’s ultimate rate of return. We recently discussed the most significant differences between private REITs and private equity real estate in Forbes, but here’s a deeper dive into two factors that recently gained visibility with FINRA, the Financial Industry Regulatory Authority.
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1. The High Cost of Private REIT Fees
Like a new car that drops in value as soon as you drive it off the dealer’s lot, a new issue of a private REIT loses value almost immediately. Why? Sales commissions, offering and organizational expenses and broker-dealer management fees all reduce the amount of capital that can be put to work investing in properties. Typically, according to the Securities and Exchange Commission, high upfront fees and commissions represent up to 15% of the offering price.
Another discrepancy in value can be attributed to the fact that non-traded REITs typically list the offering price as the estimated value as long as shares are being sold. That could have been seven years or more until last year, when FINRA issued a new rule that requires private REITs to issue more up-to-date — though not immediate — share value estimates.
The provisions of FINRA’s new regulation is a step toward recognizing private REITs’ actual costs — not only the high fees, but also the length of time that non-traded REITs can hold investor funds without actually doing deals.
Instead, at Origin, a private equity real estate firm, we put money to productive use immediately by:
- • Making capital calls only when transactions are in place, giving us the time to find optimal deals and letting investors hold onto their money longer;
- • Buying and executing on deals directly, which lets us deploy capital efficiently and hold down fees; and
- • Using a convenient investment platform to give real-time portfolio updates online — a process that is less expensive and more transparent.
2. When Payouts Aren’t Profits
The SEC requires REITs to pay 90% of their earnings in distributions, so REITs are structured to pay steady distributions — whether or not that’s in the investor’s long-term interest.
How? In trying to show a high dividend yield, non-traded REITs may begin distributions entirely from borrowings or investor capital. These payouts are not necessarily the result of rental income or other income generated by the real estate itself, since private REITs are allowed not only to fund distributions with other investors’ money, but also to borrow amounts exceeding their assets’ net value.
Paying one investor with another investor’s capital sounds a lot like a Ponzi scheme, yet it’s a common way to prop up private REIT distributions — even if this means shares are actually shrinking in value. More significantly, these payouts can obscure what’s profit and what is simply a return of the original investment.
In 2016, FINRA required non-traded REITs to be more transparent about this issue. Now statements must include the following caveat: “IMPORTANT — Part of your distribution includes a return of capital. Any distribution that represents a return of capital reduces the estimated per share value shown on your account statement.”
By contrast, private equity deals at Origin are structured to keep real estate assets at work. We pay profits first, with a preferred return to investors, and then pay back our original capital. Only after this happens do we share in the proceeds.
The Bottom Line
Investors have lost billions of dollars in non-traded REITs. Two years ago, the Securities Litigation & Consulting Group noted that it’s difficult to amass data on these private funds, which have taken in about $116 billion from investors over the last 25 years. But they estimated that investors are “about $50 billion worse off” for putting money into more than 80 non-traded REITs. That helps explain why non-traded REITs raised only $4.5 billion in 2016, a sharp fall in sales for a real estate investment vehicle that raised almost $20 billion in 2013, notes the investment bank Robert A. Stranger & Co.
Whether high net worth investors choose a private REIT or a private equity firm, they need to understand the fees and dividend structure. Investors should ask the right questions to choose investments that meet their personal goals.
