From the June 2011 issue of Investment Advisor • Subscribe!

COUNTERPOINT: A Secondary Market for Non-Traded REITs

The illiquidity that plagues non-traded REITs make the products right for only a small number of investors

The financial landscape is littered with investment vehicles designed to allow your clients to invest in the real estate market. The hottest new products, and the ones garnering the most attention are non-traded REITs.

In the 1970s and 1980s, large general partners syndicated real estate limited partnerships (LPs) through financial planners’ networks and large wirehouses. Merrill Lynch and others pushed the highly profitable LPs to their clients, as did financial planners’ broker-dealers. Built into the products were high commissions often exceeding 10%, unusually high continuing management fees, full control by the generals, instant illiquidity and a lack of transparency.

Capital was flowing into these products and fees were soaring until the real estate re-evaluation of the late 1980s. Once LPs became an investment taboo, it became almost impossible to raise capital in an LP wrapper. The large syndicators and the financial planners’ network were in a quandary. With no new money flowing in, how could they maintain their networks, and I might add their lifestyles?

Limited Partnerships

In the early 2000s, the name was changed from limited partnership to non-traded REIT. These new REITs still offered high commissions, exorbitant fees, complete control by the sponsors and instant illiquidity, but they did have to concede to file financials with the SEC and thus became more transparent than they were previously.

Valued Added Strategy

Non-traded REITs have qualified management, economies of scale and a well-thought-out business plan. Unfortunately, the fee structure limits the upside potential.

A very small secondary market exists for previously syndicated units. Nearly every prospectus for a non-traded REIT offers a redemption program that provides liquidity to the investor. They state that the REIT will redeem the units at 90% to 95% of face value. Once the offering period expires, nearly all REITs immediately cancel the redemption option. After commissions, most units are worth around 85% of face. They certainly can’t buy units back at 95% of face when they are worth 85% of face. The investors are now saddled with instant illiquidity.

This is a difficult market to navigate, but with help, opportunity exists. No one should buy an illiquid asset unless the discount to value and the upside potential exceeds the inconvenience of owning something difficult to sell.

Advantages of Secondary Market Non-Traded REITs

When you purchase a unit of a non-traded REIT on the offering, you have no idea how the REIT will perform. You have only the sponsor’s pro forma on which to base your judgment. If you buy on the secondary market years after the original offering began, you will have a sense of how the REIT is performing.

FINRA now requires the REIT management to publish a net asset value (NAV) 18 months after the offering closes. The units trade on the secondary market at discounts of at least 20% to 25% of the NAV. This means that a buyer on the secondary market will gain 25% if the REIT liquidates at the posted NAV. If it increases, they will gain even more. Another way to look at it is that even if the REIT’s value drops 20%, the buyer will not lose capital.

Since you are buying at a discount to value, the closer you buy to the program’s end, the more profitable the investment will be.

How to Join the Secondary Market

Define your objectives, filter the possible programs to hone in on the ones that meet your objectives, do your own research and seek out someone who understands the market.

Most REITs focus on a specific area of the real estate market. It may be multi-family housing, retail, industrial, commercial, single-tenant lease backs, hotels and recreation, or any combination of them. Is there an area with which you are more comfortable or have more knowledge about?

Finally, find someone who understands the market. There are consultants who can help you set up a plan for you or your clients. They can even buy for you from a number of sources or sell to you directly. The secondary market is fraught with pitfalls; be sure you have the help to navigate it properly.

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