From the June 2011 issue of Investment Advisor • Subscribe!

June 1, 2011

POINT: Non-Traded REITs—A Stability Play

Non-traded REITs may have limited liquidity, but they provide more stability than their publicly traded counterparts

Advisors looking for diversification and risk management strategies to protect their clients’ assets from losing value in volatile markets need not settle for just stocks and bonds. Michael Black, of the CCIM Institute, which educates commercial and investment real estate professionals, suggests real estate investment trusts, or REITs, are a valuable tool for stability and diversification in clients’ portfolios.

Although non-traded REITs have relatively limited liquidity, among the benefits of using non-traded REITs versus publicly traded REITs, according to Black, is that they lack the volatility normally encountered in the markets.

“By definition, the key benefit of non-traded REITs is that they are not yet publicly traded. Subsequently, they offer the reasonably predictable cash flow of publicly traded REITs without the volatility incumbent in the public markets.”

Furthermore, he says, “non-traded REITs receive the same tax benefits as publicly traded REITs. That is, by meeting certain requirements for taxable income distribution to shareholders, the REIT itself is not taxed, thereby reducing tax on the potential return on the investment.”

REITs are structured to allow common ownership of multiple properties, Black notes. The compelling difference between publicly traded and non-traded REITs, he says, is the balance between liquidity and market volatility.

“Assuming the REIT remains non-traded, the investor incurs a lack of liquidity since the primary outlet for selling shares is the REIT company itself (although one could find another investor to buy one’s shares),” according to Black. “However, as noted, reduced exposure to market volatility is an off-setting benefit. The reverse is true of publicly traded REITs: Investors gain increased liquidity, but increased volatility exposure as well.”

A counterbalance to the lack of market liquidity, Black says, is that “most non-traded REITs offer repurchase agreements” if an investor changes his mind before public listing. To cover acquisition and organizational costs incurred by the investor, the repurchase agreement will specify a discount, which will decrease over time as appreciation increases the property value, to the initial purchase price.

Black cites the dot-com craze as an example. “Investment dollars flooded the technology sector of the securities market, while publicly traded REITs traded at as much as a 40% discount to their actual NAV. As the mania faded from the technology revolution, publicly traded REIT prices rebounded to levels in the 0% to 6% discount range. Even though the price/NAV still is slightly negative, this rebound has resulted in high returns for investors who bought and sold at the right time.”

One consequence of increasing demand for publicly traded REITs is that non-traded REITS can consider listing their shares. “Doing so gives investors increased liquidity via the public market without enduring volatility along the way,” Black says. “Any appreciation in the underlying real estate before the REIT is listed should be reflected in the REIT’s price once it begins trading.”

If the market turns down, though, non-traded REITs aren’t obligated to list their shares. As Black states, non-traded REITs provide investors with “reasonably predictable upside potential with less downside risk as compared to publicly traded REITs that face market fluctuations.”

Non-Traded REITs and Recession

Non-traded REITs are not immune from the effects of a recession, however. Black points out, though, that the listing status of a REIT is not as important as the real estate sector in which it invests.

“Given the liquidity of the public markets, investors in publicly traded REIT shares usually attempt to anticipate the future market,” Black says. “Therefore, if particular sectors benefit from a recession, such as discount retailers or grocery stores, the mere hint of a downturn can drive up the market value of publicly traded REIT shares, even though the NAV may not change.”

“However, the market value of recession-sensitive real estate sectors’ REIT shares, including office properties and hotels, may drop in anticipation of a recession relative to NAV,” he cautioned.

“For investors seeking ways to diversify traditional stock and bond portfolios, REITs offer an attractive alternative,” Black says. “But diversification is only part of a well-designed financial plan. Risk management, or reducing portfolio volatility, is just as important. Non-traded REITs can achieve both of these goals.”

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