Introduction to the Non-Traded REIT Industry

Transcription

1 LPL FINANCIAL RESEARCH March 2012 Introduction to the Non-Traded REIT Industry Table of Contents Executive Summary Introduction to Non-Traded REITs Unique REIT Strategies Mortgage REITs Daily NAV REITs 6-7 Risks to All Non-Traded REITs 14 REIT Pricing and Valuation 7 Non-Traded REIT Lifecycle 14 Dividend Yield and Dividend Coverage Differentiating Between Non-Traded REIT Strategies Operating Risk Sector Risk Liquidity Fees Non-Traded REIT Strategies Questions to Ask the Non-Traded REITs Member FINRA/SIPC FOR BROKER/DEALER USE ONLY NOT FOR CLIENT DISTRIBUTION

2 EXECUTIVE SUMMARY Overview In this white paper we will examine the attributes of public, non-traded REITs. Non-traded REITs pool the assets of several investors to purchase commercial real estate and real estate-related debt in a variety of real estate sectors including office buildings, retail centers, industrial buildings, apartments, medical office, and hotels. Non-traded REITs are considered public, in that they are required to register with and report regularly to the SEC. Unlike their traded REIT peers, however, non-traded REITs are not listed on a public exchange so their share prices are not as highly correlated to the equity markets. While each real estate sector and category has its own distinct risk and reward characteristics that we will discuss further in this paper, non-traded REITs generally have the same basic set of goals: Build a portfolio of real estate assets that can be managed and then either sold, listed, or merged with another real estate entity. Give investors direct access to the income and return stream generated by the real estate itself without the day-to-day volatility of trading on a public exchange. Executive Summary Publicly-Traded versus Non-Traded REITs While there are many similarities in investment strategy between traded and non-traded REITs, there are many differences. The primary difference between publicly traded and non-traded REITs is that publicly traded REITs trade daily on a national exchange. This gives investors greater liquidity, along with higher volatility. Other differences include the timing of the capital raise, costs, minimum investments, and share price transparency. Risks to Non-Traded REITs Non-traded REITs have many risks that investors should be aware of, including: High fees that range between 10 and 18% Dividends are not guaranteed and may be decreased or increased depending on the health of the real estate market. The underlying real estate is tied to the economy and may lose value in a real estate downturn. Offering prices may not be reflective of the underlying Net Asset Value (NAV). Financing risks may force REITs to liquidate assets at an inopportune time to pay off debt. Non-traded REITs are largely illiquid investments that should be considered illiquid for the life of the program. Risk that a non-traded REIT will implement an IPO where buckets of the REIT become liquid over time, leaving investors with an illiquid investment with public market volatility. Non-Traded REIT Lifecycle All non-traded REITs have three stages to their lifecycle: capital raise and acquisition, management, and disposition. The total timeline for most REITs is between 8 and 12 years, with each stage taking more or less time depending on the point in the market cycle. It is important to be aware of the point in the market cycle that a REIT is acquiring properties during the asset raise stage. The ideal time in the cycle for this stage to occur is after a market decline, when prices are lower and cap rates are high, making it more realistic for a REIT to cover a higher yield and return principal. Differentiating Non-Traded REIT Strategies While all non-traded REITs have the same basic goals, it is very important to understand that not all non-traded REITs have the same investment objective. In fact, they can vary widely and have distinct risk and reward characteristics that make them appropriate for different types of investors. While there are many risks associated with investing in real estate, two Page 2 of 18

3 EXECUTIVE SUMMARY Risk REITs Sector Risk vs Return Single Sector Strategies Satellite Sectors Income Value-Added Opportunistic Single Sector Strategies Core Sectors Income Value-Added Opportunistic basic characteristics determine the level of risk in a non-traded REIT: operating risk and sector risk. Unique REIT Strategies Mortgage REITs Diversified Sector Strategies Income Value-Added Opportunistic Return *please see page 11 for REIT strategy breakdown In addition to the different types of equity REITs, there are non-traded REITs that focus on acquiring or originating debt instead of acquiring properties. Unlike equity REITs, which make money on rents, mortgage REITs make money on interest payments and the spread between lending and borrowing costs, with moderate capital appreciation potential if loans are bought or sold, or if they are bought at distressed levels. Daily NAV REITs REIT Pricing and Valuation Most non-traded REITs have a set offering price, usually $10/share, while they are in their asset raising phase. Once a REIT is closed to new investors, it will remain valued at its offering price until it is required to undergo a formal appraisal to determine its new NAV approximately 18 months after it closes and then every year after, unless it has already been sold, merged, or listed. The NAV will either be adjusted up or down based on the appraisal and depending on the impact of the economy at that time. Dividend Coverage Dividend coverage refers to a REITs ability to cover its dividend through operating income (rent). Most non-traded REITs begin their lifecycle paying a yield that is not covered through operating income, and instead is paid through proceeds from the capital raise. In general a non-traded REIT should be making meaningful progress towards covering its dividend through operations within 2-4 years from beginning its capital raise, and should be fully covering the yield once it moves to the asset management and disposition stages. Insufficient dividend coverage can reduce share value over time. Liquidity Non-traded REITs should be considered illiquid investments, appropriate only for clients who do not need liquidity from the investment for 8-12 years. Fees There are multiple fees that investors should understand and analyze before investing in a non-traded REIT, including up-front, disposition, and on-going fees. Total fees are typically between 10 and 18% of total share price. Page 3 of 18

4 EXECUTIVE SUMMARY Key Questions to ask Non-Traded REITs What asset classes do you plan to invest in, and are you targeting core, value-added, or opportunistic properties? What is your total return target, and how does that break down between income and capital appreciation? What amount of leverage (if any) are you targeting for this REIT? Is there a certain level of interest rates above which your return expectations are unachievable? Is the product covering its current distribution with Funds from Operations or Modified Funds from Operations (MFFO)? If not, when is full coverage expected? Are distribution payments being made from offering proceeds? Who are the key decision makers for the REIT, and how much experience do they have with this asset class? How much of their time will be devoted to responsibilities outside of the REIT? How many REITs has the sponsor launched in the past, and how many have been brought full cycle? Are there other private programs you have run? What kind of returns did investors experience in your prior programs, and how similar were the investments and objectives to those for the REIT in question? How did the leverage you used in those programs compare to this REIT s target leverage? Are other products run by the sponsor that could compete for potential acquisition targets? If so, what are the allocation procedures? Do you expect there to be or have there been any related party transactions between this REIT and the sponsor, advisor, or similar party with a beneficial interest in properties sold to or purchased from the REIT? What is it about your team and its processes that differentiate you from your competitors? How does your team expect to add value? Are there certain economic conditions under which you would stop raising capital? If cap rates fall below a certain level, will you suspend the raise? What are your disposition options, and how long do you project your asset management stage to last? If a listing is anticipated, do you plan to internalize the Advisor, and if so what would this cost be? Are there conditions under which you would liquidate earlier or later than expected? If so, what are they? Page 4 of 18

5 To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate, and it must distribute at least 90% of its taxable income to shareholders annually in the form of a dividend. Publicly traded REITs The primary difference between publicly traded and non-traded REITs is that publicly traded REITs trade daily on a national exchange. This gives investors greater liquidity, along with higher volatility. There are other key differences in addition to the trading aspect. The accompanying table compares the characteristics of publicly traded and nontraded REITs. Publicly traded REITs trade daily on a national exchange. This gives investors greater liquidity, along with higher volatility. Introduction to Non-Traded REITs What is a REIT? Real Estate Investment Trusts (REITs) are investment vehicles that invest in commercial real estate or real estate-related debt. The structure has been around since the early 1960 s, and was developed as a way to allow individual investors access to large-scale, income-producing real estate. In order to qualify as a REIT, a company must have the bulk of its assets and income connected to real estate, and it must distribute at least 90% of its taxable income to shareholders annually in the form of a dividend. Qualifying as a REIT allows a company to deduct the distribution paid to shareholders from its corporate taxable income. Because of this special tax treatment, most REITs pay out at least 100% of their taxable income to shareholders. Comparison of Publicly Traded and Non-Traded REITs Overview Investment Objectives Underlying Investments Publicly Traded REITs REITs that file with the SEC and trade on a national exchange. Typically focused on appreciation of share value and income. Real estate and real-estate related assets, with the ability to invest in development and construction for a portion of revenue. Non-Traded REITs REITs that file with the SEC but do not trade on a national exchange. Typically focused on providing consistent income, with appreciation of share value secondary (with the exception of Opportunistic REITs). Real estate and real-estate related assets, with less of an ability to invest in development and construction. Time Horizon Long-term time horizon. Typically an 8 12 year time horizon. Capital Raise Liquidity Volatility Transaction Costs Management Shares are offered perpetually. Daily liquidity on the public exchanges. Daily volatility that is linked to the real estate markets and the stock markets. Brokerage costs which are the same as buying or selling any other publicly traded stock. Typically the managers are employees of the company (internally managed). Shares are offered for a limited period of time. Limited liquidity, with redemption programs that vary by company and can be shut off depending on market conditions. Investors should be prepared for limited or no liquidity for the life of a non-traded REIT. No daily volatility in share price until shares are re-priced 18 months after the close of an offering period. However, the underlying value of the real estate is linked to the real estate markets and can fluctuate up or down upon re-pricing. Typically between 10 18%, including up-front offering costs, commissions, acquisitions, management and other on-going expenses. Typically the company has no employees and is managed by a third party pursuant to a management contract (externally managed). Page 5 of 18

6 Comparison of Publicly Traded and Non-Traded REITs (Continued) Minimum Investment One Share. Typically $1,000 $2,500. Independent Directors Stock exchange rules require a majority of investors to be independent of management. North American Securities Administrators (NASAA) guidelines require a majority of directors to be independent of management. Investor Control Investors elect directors. Investors elect directors. Corporate Governance Disclosure Obligation Share Value Transparency Specific stock exchange rules on corporate governance. Required to make regular SEC disclosures, including quarterly financial reports and yearly audited financial reports. Real-time market prices that are publicly available. Stocks are typically covered by stock analysts. Subject to state and NASAA guidelines. Required to make regular SEC disclosures, including quarterly financial reports and yearly audited financial reports. No independent information about share value available. Company must provide an estimated share value 18 months after offer has closed, but there is no requirement for this to be completed by an independent party. The health of the real estate markets is tied to the health of the economy and the health of the fixed income markets. Real estate may lose part or all of its value in an economic downturn, or in the event of a credit market freeze. Risks to All Non-Traded REITs While non-traded REITs offer a way for investors to access the income stream of large-scale commercial real estate assets, investors should be aware of many risks to non-traded REITs. High Fees Non-traded REITs have high up-front and on-going fees, with average total fees between 10% and 18%. High fees reduce the amount of cash available to invest in properties, which could result in lower dividend yields and lower total returns, or potentially a liquidity event below the offering price if a REIT sponsor was unable to overcome the fee hurdle. Proposed Regulations Proposed FINRA rules are increasing pressure on sponsors to adjust pricing for fees, shorten capital raise periods, eliminate follow-on offerings, and re-price their shares more often in order to provide greater transparency for investors. Final regulations and the timing of their implementation are not yet determined. Most of these regulations would be positive for investors, but could change the landscape for non-traded REITs. Dividends Are Not Guaranteed The amount and frequency of dividends paid by non-traded REITs are not guaranteed. Non-traded REIT boards set dividend policies each month or quarter, and can adjust dividends up or down or eliminate them altogether in severe downturns. Real Estate is Tied to the Economy The health of the real estate markets is tied to the health of the economy and the health of the fixed income markets. Real estate may lose part or all of its value in an economic downturn, or in the event of a credit market freeze. Non-traded REITs are subject to this same real estate risk, even if offering prices remain stable at $10/share. Investors should be aware of the point in Page 6 of 18

7 the market cycle that a REIT is acquiring properties. Those properties acquired when the market has appreciated may have greater principal and income risk than those acquired after the market has softened. Offering Price Not Reflective of Net Asset Value (NAV) With the exception of Daily NAV REITs, the offering price of non-traded REITs may not reflect the per share net asset value, especially if the REIT has issued one or more follow-on offerings over multiple years. Financing Risks Non-traded REITs that use leverage to enhance returns are subject to interest rate risk and liquidity risk, which could limit their ability to make distributions or increase NAVs, and could force them to sell properties at a loss if funds are needed to pay off debt in a downturn. If a REIT is unable to sell properties to pay down debt, they could be forced into default or bankruptcy. Illiquidity While most non-traded REITs have liquidity provisions that allow investors to request liquidity after a certain period of time, these share redemption programs (SRPs) are not guaranteed. Investors should be prepared to have no liquidity for the entire investment period outlined in a REIT s offering documents. While most non-traded REITs have liquidity provisions that allow investors to request liquidity after a certain period of time, these share redemption programs (SRPs) are not guaranteed. SRPs can and have been eliminated by REIT boards in order to preserve value in a downturn. Investors should be prepared to have no liquidity for the entire investment period outlined in a REIT s offering documents. Risks With Listing on an Exchange One of the primary liquidity options for non-traded REITs is to list on a national exchange. This may be an attractive option from a total return standpoint, but there are risks to be aware of. Most importantly, the shares are typically listed in a tiered manner, with a portion of shares immediately listed and the remaining shares listed in buckets over the next months. This means that investors may own a publicly-traded stock for a portion of time while the REIT is implementing its liquidity event, with no liquidity on the remaining shares. This exposes investors to the volatility of the publicly traded stock markets. Non-Traded REIT Lifecycle All non-traded REITs have three stages to their lifecycle: capital raise and acquisition, management, and disposition. The total timeline for most REITs is between 8 and 12 years, with each stage taking more or less time depending on the point in the market cycle. It is important to be aware of the point in the market cycle that a REIT is acquiring properties during the asset raise stage. The ideal time in the cycle for this stage to occur is after a market decline, when prices are lower and cap rates are high, making it more realistic for a REIT to cover a higher yield and return principal. Page 7 of 18

8 Non-Traded REIT Lifecycle Asset Raise Stage Management Stage Disposition Timeline Between 2 4 years, with 1 2 follow-on offerings Between 4 6 years Between 0 2 years NAV NAV is the offering price (usually $10/share) NAV is the offering price until 18 months after the close of the offering stage. Portfolio is appraised at this point and NAV is set at the appraised value. Portfolio is re-appraised every year thereafter and NAV is re-set to the most current appraisal. NAV will be set at the most current appraisal, and will be adjusted down if needed to reflect any asset sales during this time period. Activity REIT sponsor is raising capital and REIT advisor is acquiring properties REIT advisor is managing the properties and completing any required capital expenditures. REIT advisor looks to do one of 3 options: sell individual properties and return principal and any gains/losses to investors over time, sell the entire portfolio or merge with another REIT, or list on a public exchange. Liquidity Typically limited liquidity, with redemption programs that vary by company and usually have a minimum 12 month lockup. Typically limited liquidity, with a greater risk of the redemption program being shut off as the manager looks to optimize the portfolio. Typically limited or no liquidity until properties are sold, or the portfolio is merged, sold, or listed on an exchange. If a REIT is listed, shares are usually liquid in a tiered manner, with typically one-quarter to one-third of shares immediately liquid with the remaining becoming liquid over months Years Two basic characteristics determine the level of risk in a non-traded REIT: operating risk and sector risk. Differentiating Between Non-Traded REIT Strategies While all non-traded REITs have the same basic goals, it is very important to understand that not all non-traded REITs have the same investment objective. In fact, they can vary widely and have distinct risk and reward characteristics that make them appropriate for different types of investors. While there are many risks associated with investing in real estate, two basic characteristics determine the level of risk in a non-traded REIT: operating risk and sector risk. Operating Risk Operating risk refers to the stability of the income generated by the real estate and the level of management needed to stabilize the income. Properties tend to be classified on an operating risk spectrum as either income-producing (lowest operating risk), value-added (moderate operating risk), or opportunistic (high operating risk). Non-traded REITs will employ one of three operating strategies: Income-producing,value added, or opportunistic. Income-producing real estate (also referred to as core ) tends to be fully or almost fully occupied, with investment grade or stable tenants and a minimal likelihood of lease rollover where tenants could terminate their leases. Triple net, long-term contractual leases are characteristic of this style. Because they are more stabile, income-producing real estate has minimal operating risk and requires the least amount of management oversight. Income-producing real estate is sensitive to economic changes, but is the least sensitive on the operating risk spectrum. This type of real estate also tends to pay higher current income, with lower potential for appreciation. Value-added real estate tends to have a moderate level of operating risk through significant lease rollover, vacancies, un-stable tenants, or minor construction needed to attract new tenants. These types of properties may produce a moderate level of income but have the potential to appreciate Page 8 of 18

9 in value if an experienced manager can solve some of the vacancy, lease rollover, or construction issues. Value-added real estate has a lower current yield but the potential for greater capital appreciation. Opportunistic real estate tends to be non-income producing real estate that has severe vacancy or construction issues or a combination of both caused by poor management, debt issues, or market declines. Property development falls under this category. Opportunistic properties require significant asset management in order to stabilize them and produce little to no current income. They are the most susceptible to recessions when investors look for stability, but they have the highest potential for capital appreciation if they are managed and sold properly. Often referred to as the Big Four, the core sectors consist of: office retail industrial multi-family The satellite sectors are those that make up a smaller part of the investable universe and include: hotels medical office student housing storage golf courses resorts Sector Risk Sector risk refers to the sector and combination of sectors in which a non-traded REIT invests in. There are two categories of sectors in real estate: core and satellite. Core sectors make up the largest part of the investable universe and tend to be the largest component of a real estate portfolio for many institutional real estate investors. Often referred to as the Big Four, core consists of office, retail, industrial, and multi-family. Because of the market size and allocation within many institutional portfolios, and their more liquid nature, the core sectors tend to be less risky than other types of real estate. The satellite sectors are those that make up a smaller part of the investable universe and include hotels, medical office, student housing, golf courses, resorts and storage. These sectors tend to be less liquid which makes them more risky than the core sectors, but they may also sell at a premium because there are fewer portfolios available to institutional investors. Non-traded REITs tend to focus on one or more of the sectors. Diversified REITs invest in a combination of different sectors, including both core and satellite. The diversification across sectors reduces sector risk, as the sectors tend to respond to the economy in different ways. Therefore, owning multiple sectors reduces the risk that all of the properties in the portfolio will lose value at the same point in the market cycle. In theory a diversified REIT also gives management more options for an exit strategy, as they could look to sell individual properties or groups of properties at different times. However, this may limit management from listing the REIT on a public exchange, as there is very little acceptance of diversified REITs on Wall Street at this time. Single sector non-traded REITs that focus on the core sectors have more sector risk than diversified REITs because there is a greater chance that all of the properties will either gain or lose value at the same point in the market cycle. Single sector non-traded REITs that focus on the satellite sectors have the most sector risk in that the less liquid satellite sectors can lose more value when they are out of favor as opposed to core sectors that are more liquid. However, some of the satellite sectors may offer diversification because their values respond differently than core sectors to economic growth or weakness. Page 9 of 18

10 Non-Traded REIT Strategies: Risk & Return Characteristics Operating and sector risk can be viewed on risk-return grid, with lowest to highest expected risk on the vertical axis, and lowest to highest expected return on the horizontal axis. The most risky type of non-traded REIT would be one that invests in opportunistic properties in a single satellite sector. These would be appropriate only for investors who have a higher risk tolerance, a capital appreciation goal, and no need for current income. Investors should expect the NAV of these types of assets to fluctuate based on the economy more than any other type of REIT. On the other side of the spectrum would be non-traded REITs that invest in income-producing properties in diversified sectors. These would be most appropriate for clients looking for a more stable income stream and less risk for downward price pressure in a recession. While they are not immune to economic changes, they are the least impacted both on the up and down side of the market cycle. REITs Sector Risk vs Return Single Sector Strategies Satellite Sectors Income Value-Added Opportunistic Risk Single Sector Strategies Core Sectors Income Value-Added Opportunistic Diversified Sector Strategies Income Value-Added Opportunistic Return Page 10 of 18

11 Differentiating REIT Strategies Satellite Sectors Income Producing Value Added Opportunistic Primary Objective Income Primary Risks Concentration risk Liquidity risk Potential for interest rate risk if leases are contractual. Primary Opportunities Potential to create value through building a portfolio. Typically higher yield than core sectors. Market cycle may offset core sectors. Primary Objective Income and Growth Primary Risks Concentration risk Liquidity Risk Moderate to high potential for loss of capital in a downturn if leases rollover. Primary Opportunities Potential to create value through building a portfolio. Typically higher yield than core sectors. Market cycle may offset core sectors. Potential to create capital appreciation through lease turnover. Primary Objective Growth Primary Risks Concentration risk High Liquidity risk High potential for loss of capital in a downturn due to lease rollover or loss of funding to complete capital projects. Primary Opportunities Potential to create value through building a portfolio. Market cycle may offset core sectors. Potential to create significant capital appreciation through lease turnover and capital projects. Primary Objective Primary Objective Primary Objective Income Primary Risks Income and Growth Primary Risks Growth Primary Risks Concentration risk Concentration Risk Concentration Risk Core Sectors Potential for interest rate risk if leases are contractual. Liquidity options dependent on a single sector. Primary Opportunities Lower than average risk of capital loss in a downturn, if leases are contractual. Moderate potential for loss of capital in a downturn if leases rollover. Primary Opportunities Greater public market acceptance than diversified sector portfolio, which increases the potential for an IPO. High potential for loss of capital in a downturn due to lease turnover or loss of funding to complete projects. Primary Opportunities Potential to create significant capital apprecia- Stable income. Potential to create moderate capital appreciation and tion and offset inflation through lease turnover Greater public market acceptance than diversified sector offset inflation through lease rollover. and capital projects. portfolio, which increase the potential for an IPO. Primary Objective Primary Objective Primary Objective Income Primary Risks Income and Growth Primary Risks Growth Primary Risks Diversified Sectors Less acceptance in the public markets, may limit the potential for an IPO. Primary Opportunities Potential to acquire and sell property sectors at different points in the market cycle. Stable Income. Less acceptance in the public markets, may limit the potential for an IPO. Moderate potential for loss of capital in a downturn if leases rollover. Primary Opportunities Potential to acquire and sell property sectors at different points in the market cycle. High potential for loss of capital in a downturn due to lease turnover or loss of funding to complete projects. Primary Opportunities Potential to acquire and sell property sectors at different points in the market cycle. Lower than average risk of capital loss in a downturn, if Potential to create moderate capital appreciation and offset Potential to create significant capital apprecia- leases are contractual. inflation through lease rollover. tion and offset inflation through lease turnover and capital projects. Page 11 of 18

12 Unique REIT Strategies Mortgage REITs Mortgage REITs that originate debt tend to own the loans to maturity, or until a sale of a portfolio to another owner. This strategy is often referred to as loan to own, and requires significant underwriting skills. Investors should be aware that the majority of the returns from these types of REITs will come from the yield, with minimal capital appreciation potential. The risks of distressed debt investing are significant if leverage is used to acquire them. This risk is mitigated if leverage is only used when properties are stabilized, but there is still a risk that the underwriting was off on either timing or return potential. The majority of returns for this type of REIT will come from appreciation at the end, with minimal current income. In addition to the different types of equity REITs, there are non-traded REITs that focus on acquiring or originating debt instead of acquiring properties. Unlike equity REITs, which make money on rents, mortgage REITs make money on interest payments and the spread between lending and borrowing costs, with moderate capital appreciation potential if loans are bought or sold, or if they are bought at distressed levels. There are essentially three types of mortgage REITs: REITs that use leverage to buy and sell high quality government-backed loans. REITs that act like a bank by originating private loans to non-investment grade borrowers. REITs that purchase high risk distressed loans and work with the debtor to increase the chances of repayment. Most of the non-traded REITs available today fall into the last two categories, with the majority focused on either originating debt or buying and restructuring distressed debt. However, they can also from time to time buy and sell debt in the market if pricing is beneficial. Mortgage REITs that originate debt tend to own the loans to maturity, or until a sale of a portfolio to another owner. This strategy is often referred to as loan to own, and requires significant underwriting skills. Credit risk based on poor or aggressive underwriting standards is the most substantial risk with this type of REIT strategy. Interest rate risk is moderate, as most of these types of loans are variable rate. However, a flattening yield curve could reduce profits on the spread between lending and borrowing. Investors should be aware that the majority of the returns from these types of REITs will come from the yield, with minimal capital appreciation potential. Mortgage REITs that acquire distressed debt have three different options for creating value. The first is to foreclose on a borrower and end up owning a property. If done correctly, this type of strategy can create significant value, but it can also be difficult and lengthy. The second is to re-structure a loan with a borrower, so that the borrower is able to pay debt payments based on a reduced interest rate, reduced par value, or a combination of both. The third option is a discounted payoff, where a borrower would pay off a reduced par value to the REIT immediately, rather than over time. The risks of distressed debt investing are significant if leverage is used to acquire them. This risk is mitigated if leverage is only used when properties are stabilized, but there is still a risk that the underwriting was off on either timing or return potential. The majority of returns for this type of REIT will come from appreciation at the end, with minimal current income. In addition to Non-traded REIT risk, investors should be aware of the risks that are specific to investing in mortgage REITs: The value of real estate loans tends to be more volatile than the value of Page 12 of 18

13 Daily NAV REITs What they are Real estate funds that own and manage commercial real estate properties. They are not listed on an exchange, but are valued daily through on-going property appraisals. The theory is that they should be considered a hybrid strategy, with attributes of both traded and non-traded REITs. Potential Benefits Daily pricing of shares offers greater transparency into the underlying value of the real estate than traditional nontraded REITs. Daily liquidity allows investors to redeem shares on a regular basis. Important Points In order to provide daily liquidity, these REITs will hold up to 20% in cash and liquid securities. This may create a drag on returns. The share redemption programs for daily NAV REITs could be suspended for one or more quarters in the event of a severe real estate downturn. Investors should be aware that this could happen roughly every 8 10 years. Daily NAV REIT share prices will be more volatile than traditional non-traded REITs, but less volatile than traded REITs. real estate properties. There is more risk that a mortgage loan REIT s NAV will fluctuate once it is required to be priced, 18 months after the close of the offering. The mortgage REIT markets can tighten quickly. Loans that are levered and in default are nearly impossible to sell, and could cause permanent damage to a REIT s balance sheet and NAV. Underwriting risk is substantial for all mortgages, but especially for origination and distressed strategies. Daily NAV REITs Several sponsors are beginning to offer a new non-traded REIT product type in response to investor demand and the changing regulatory climate. These so called Daily NAV REITs are an attempt to address several of the issues that investors have had with traditional non-traded REITs. First, they introduce greater liquidity by allowing for up to 20% of outstanding shares to be redeemed per year (higher than the 5% afforded by most standard REITs). While there is still no guarantee that liquidity will always be available and the REITs will still have the option to discontinue the share redemption program at any time, this additional liquidity is seen as valuable to many investors. Of course, this liquidity does come at a cost. To meet higher potential redemptions with a primary investment in illiquid real estate, the REITs will maintain a liquid sleeve that may be invested in real estate securities, debt securities, and cash. In most cases, this will create a slight drag on overall returns. It may also result in a portion if the portfolio being exposed to nonreal estate related assets and greater volatility. The second issue that these products address is pricing transparency. These REITs not only allow for greater liquidity, but they also price on a daily basis. Each day, the REIT will strike a new Net Asset Value and shares may be redeemed at this price daily. This feature also comes at a cost. Daily NAV REITs will have to continually re-appraise properties in their portfolios to be able to determine a reasonable NAV so frequently. These additional appraisals and associated monitoring needs will increase REIT expenses and create a slight drag on returns. The premise is that the greater liquidity and transparency will be worth the cost to investors. These products bridge the gap between traditional non-traded REITs and REIT mutual funds. They offer exposure to private real estate with a more moderate level of liquidity without being subject to high correlation to the equity markets. While more liquid than their predecessors, investors must understand that the underlying real estate investments in these REITs remain inherently illiquid and the share redemption program may be shut down occasionally during deep market declines (roughly once every 8 10 years). Page 13 of 18

14 Most non-traded REITs have a set offering price, usually $10/ share, while they are in their asset raising phase. During this phase the share price will not move, but the underlying value (Net Asset Value or NAV) of the real estate will move depending on the economy. Dividend Coverage Statistics Dividend coverage may be expressed in relation to a number of different performance metrics. While we do not advocate the use of one specific ratio over another, there are a number of measures that the investor should consider when analyzing coverage. The first is Funds from Operations (FFO), which starts with Net Income, adds back non cash depreciation, and adjusts for non-recurring charges. Another measure is Modified Funds from Operations (MFFO). This measure allows for more comparability between REITs in different life stages due to the exclusion of acquisition expenses. One drawback of MFFO is that it allows for discretion when it comes to revenue recognition by removing the adjustment for straight-line rent. A third measure that investors should consider is cash available for distribution. Ultimately cash flow is the most important measure over the entire life of the REIT. REIT Pricing and Valuation Most non-traded REITs have a set offering price, usually $10/share, while they are in their asset raising phase. During this phase the share price will not move, but the underlying value (Net Asset Value or NAV) of the real estate will move depending on the economy. Once a REIT is closed to new investors, it will remain valued at its offering price until it is required to undergo a formal appraisal to determine its new NAV approximately 18 months after it closes and then every year after, unless it has already been sold, merged, or listed. At this time the NAV will either be adjusted up or down based on the appraisal and depending on the impact of the economy at that time. The NAV could also be impacted by fees, and the over or under payment of the distribution yield during the REIT s early stage. There is a common myth that non-traded REITs have no volatility. While they are not exposed to the day-to-day volatility of the public markets, REIT NAVs are exposed to economic volatility. Real estate is not immune to economic changes; in fact it is very sensitive to them with some categories more sensitive than others. In an economic recession where businesses look to reduce space and people move home rather than into apartments, real estate will lose value, and NAVs of non-traded REITs could be adjusted down 18 months after they close as rents are lowered and vacancies increase. Conversely NAVs will be adjusted upward with economic growth. There s no way around this real estate is tied to the economy, even if it s not directly correlated to the stock market. Rents and occupancies tend to lag the economy by about months as it takes a while for the impact of economic weakness or growth to filter down to the real estate level. Therefore the NAVs of non-traded REITs could be expected to rise or fall about months later than their traded peers, and maybe to a lesser or greater extent depending on the type of real estate, how they are managed, the extent of the market decline, and the type of leverage used. Dividend Yield and Dividend Coverage Income-oriented non-traded REITs tend to pay yields that are higher and more consistent than their traded REIT peers. This is because most nontraded REITs invest only in properties, and are not looking to actively trade properties during the life of the REIT or reinvest dividends in development activities. In fact, the non-traded REIT rules limit them from participating in many of these strategies that the traded REITs can invest in from time to time. Also, non-traded REITs tend to return more of their total return in the form of a dividend yield, rather than at the back end as appreciation. Regardless of the level of the dividend yield, yields on non-traded REITs are subject to economic changes just like traded REITs, and can fluctuate up or down depending on the strength of the economy. Investors in incomeoriented REITs should expect to see yields adjusted down in a period of economic weakness, when tenants are either vacating space or looking to landlords to reduce rents. Conversely yields could potentially increase in periods of economic growth, as landlords have more power to raise rents during these time periods. Page 14 of 18

15 Dividend coverage refers to a REITs ability to cover its dividend through operating income (rent). Most non-traded REITs begin their lifecycle paying a yield that is not covered through operating income, and instead is paid through proceeds from the capital raise. In general a non-traded REIT should be making meaningful progress towards covering its dividend through operations within 2 4 years from beginning its capital raise, and should be fully covering the yield once it moves to the asset management and disposition stages. Insufficient dividend coverage can reduce share value over time. Liquidity Non-traded REITs should be considered illiquid investments, appropriate only for clients who do not need liquidity from the investment for 8 12 years. Most REITs do have liquidity provisions, which allow clients to request liquidity after they have owned shares for a certain period of time. However, the REITs can terminate this provision during real estate downturns, so that they are not forced to sell properties at the wrong time to fund redemptions. This potential illiquidity should be considered a risk for non-traded REITs, but the ability to hold assets and sell them at a more opportune time should be considered a benefit. Selling properties at the wrong time creates a permanent loss of capital. Fees Non-traded REITs tend to have high fees. There are multiple fees that investors should understand and analyze before investing in a non-traded REIT. Total fees incurred during the lifecycle of a REIT usually amount to between 10 18% of the share price. The remaining 82 90% goes into the ground, which is to say it is invested in real estate. The greater the fees, the more the property in the portfolio must appreciate to reach the break even price of $10 by the time of a re-pricing or liquidity event. The initial fees usually consist of: Commission (6.5% 7% for brokerage accounts) Other Offering and Organizational Costs (3% 5%) Acquisition Fees (0% 5%) Financing Fees (0.5% 0.75%) In addition to up-front fees, there are ongoing fees that will be incurred during the management phase of the REIT. These include: Asset Management Fee (0.75% 1% per year) of property in the portfolio at cost or fair market value Dealer Manager Fee (0% 0.6% range per year) Property Management Fee (varies based on market conditions) Finally, non-traded REITs also charge fees at the disposition stage of the REIT s life. These fees may include: Page 15 of 18

16 Performance Fee (around 15% of returns above some hurdle rate usually 6%) Internalization Fee (may be charged if REIT becomes publicly listed to purchase the advisor from the sponsor) Disposition and Commission Fees (0% - 3%) Here are a number of important questions to ask Non-Traded REITs and why they are important questions to raise. Questions to Ask the Non-Traded REITs Q: What asset classes do you plan to invest in and are you targeting core, value-added, or opportunistic properties? To better understand the REIT s strategy and accompanying risk profile. Q: What is your total return target and how does that break down between income and capital appreciation? To better understand total return expectations and match them up with operating and sector risk being taken. Q: What amount of leverage (if any) are you targeting for this REIT? Is there a certain level of interest rates above which your return expectations are unachievable? To understand the REIT s planed use of debt to boost equity returns. Higher leverage is generally indicative of more risk. Leverage around 50% is common but a REIT may take on more or less leverage depending on a number of factors including interest rates, access to debt markets, operational risk, and sector risk. Q: Is the product covering its current distribution with Funds from Operations or Modified Funds from Operations (MFFO)? If not, when is full coverage expected? Are distribution payments being made from offering proceeds? To make sure that the distribution accurately represents the cash flow stream being produced by properties in the fund. Excessive distributions can lead to a lower share value at the time of liquidation. Q: Who are the key decision makers for the REIT and how much experience do they have with this asset class? How much of their time will be devoted to responsibilities outside of the REIT? To determine the management team s familiarity with the REIT s property type and investment strategy, general experience in real estate, and focus on the success of this specific REIT. Q: How many REITs has the sponsor launched in the past and how many have been brought full cycle? Are there other private programs you have run? What kind of returns did investors experience in your prior programs and how similar were the investments and objectives to those for the REIT in question? How did the leverage you used in those programs compare to this REIT s target leverage? To gauge the past success of management and their investment process (and to determine if prior programs are comparable to this REIT). Page 16 of 18

17 Q: Are other products run by the sponsor that could compete for potential acquisition targets? If so, what are the allocation procedures? Do you expect there to be or have there been any related party transactions between this REIT and the sponsor, advisor, or similar party with a beneficial interest in properties sold to or purchased from the REIT? To determine potential conflicts and ensure that all acquisitions are fairly priced and fit with the REIT s investment strategy. Q: What is it about your team and its processes that differentiate you from your competitors? How does your team expect to add value? To determine the aspects of this REIT s people and or processes that are unique and value-enhancing. Q: Are there certain economic conditions under which you would stop raising capital? If cap rates fall below a certain level, will you suspend the raise? To ensure that the REIT sponsor has shareholders best interests in mind and will not continue to raise capital to create fees when investment opportunities are no longer attractive. Q: What are your disposition options and how long do you project your asset management stage to last? If a listing is anticipated, do you plan to internalize the Advisor and if so what would this cost be? Are there conditions under which you would liquidate earlier or later than expected? If so, what are they? To gauge the breadth of liquidity options, expected holding period, and potential fees under a listing scenario. Page 17 of 18

18 LPL FINANCIAL RESEARCH This research material has been prepared by. The family of affiliated companies includes and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that is not an affiliate of and makes no representation with respect to such entity. Member FINRA/SIPC Member FINRA/SIPC FOR BROKER/DEALER USE ONLY NOT FOR CLIENT DISTRIBUTION Page 18 of 18 RES