Comparing 17 “full-cycle” nontraded real estate investment trusts with two customized benchmarks, the study found that just five such REITs outperformed each of those market indexes. That means 71% of the REITs included in the study underperformed the study's customized benchmark, in large part due to fees.
Performed by consultant Blue Vault Partners LLC and The University of Texas at Austin McCombs School of Business, the study is likely the first systematic examination of the realized returns for investing in nontraded REITs. Released June 1, it is titled “Nontraded REIT Industry Full-Cycle Performance Study.”
LOWER RETURNS
Although the nontraded REITs posted “respectable total returns,” according to the study, with an average internal rate of return of 10.3%, that was 140 basis points lower than the two customized benchmarks used in the report.
The benchmarks, one based on a portfolio of properties from the National Council of Real Estate Investment Fiduciaries and the other using broad indexes of publicly traded REITs, returned 11.7%.
“Clearly, the fees associated with nontraded REITs account for performance difference,” the study said.
By adding back a standard 12% fee or sales load, the typical annualized return for the nontraded REIT in the study is boosted to 12.5%, from 10.3%.
The fees on nontraded REITs, which can be as high as 15%, are particularly egregious, one industry executive said.
“An investor gives $100,000 to a program, and he's immediately at $85,000,” said Wes Tellie, director of operational risk due diligence and independent broker-dealer due diligence with Duff & Phelps Corp. “That's a hell of a hurdle rate.”
Fee structures of nontraded REITs increasingly have come to the attention of investors and regulators recently as a number of the largest REITs in the industry struggle with valuations. Although some of the illiquid REITs have held relatively steady valuations, other notable REITs in the past year have revalued at 25% to 50% less than the original $10 a share that investors paid.
VALUATION "COMEDY'
Nontraded REITs gave “great access” for retail investors to invest in commercial real estate, but the industry is changing, Mr. Tellie said.
“The industry is going through a maturation period because of the recession and other big events. A lot of programs have turned up dry, and valuations are at a point of comedy,” Mr. Tellie said, noting that some nontraded REITs have seen valuations drop up to 50%.
The study covers only a segment of the nontraded-REIT industry.
Although a total of 21 nontraded REITs had “liquidity events” between 1990 and May 2012, performance for only 17 such REITs was included because the four other REITs haven't completed IPOs or other transactions to make them fully liquid.
Seven of the 17 nontraded REITs had their IPOs, mergers or asset sales at the top of the commercial real estate market in 2006 and 2007.
The 17 nontraded REITs in the study had a median internal rate of return of 10.85%. But the numbers were less flattering when compared with their benchmarks.
The five nontraded REITs that outperformed their respective NCREIF-based benchmarks were Apple Suites Inc., Cornerstone Realty Income Trust Inc., Carey Institutional Properties Inc., Corporate Property Associates 10 Inc. and American Realty Capital Trust Inc.
The five nontraded REITs that performed better than their respective publicly traded benchmarks were Apple Hospitality Five Inc., Apple Hospitality Two Inc., Apple Suites Inc., CNL Hotels & Resorts Inc. and Apple Residential Income Trust Inc.
Just one nontraded REIT, Apple Suites, outperformed both benchmarks, according to the study. That REIT merged in 2003 with a related REIT, Apple Hospitality Two.
In May 2011, the Financial Industry Regulatory Authority Inc. filed a complaint against broker-dealer David Lerner Associates Inc., alleging that the firm misled investors about returns of a later Apple offering, Apple REIT 10. Finra also alleged that the firm sold shares in the $2 billion Apple REIT 10 without conducting a reasonable investigation of the products' suitability for investors.
Lerner Associates has denied those allegations; the case is pending.
The study is particularly timely, as the initial-public-offering market for nontraded REITs has heated up. Since March, three nontraded REITs have listed on exchanges, with more likely to come.
At the same time, an increasing number of institutional real estate and money managers have taken notice of the money raised by independent broker-dealers since 1990, when the first nontraded REIT was launched.
According to an executive summary of the study, the nontraded-REIT industry had $84 billion in assets under management at the end of last year. Such managers are developing new alternative investment products for those brokers and advisers to sell.
Stacey Chitty, a managing partner at Blue Vault, didn't return a call Thursday seeking comment.
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