Lead Story… Regulatory changes are rapidly leading to the demise of one of the seedier portions of the real estate industry: Non-Traded REITs. I’ve written about Non-Traded REITs a couple of times before. For those of you not familiar with the product, Investopedia defines a Non-Traded REIT as (emphasis mine):
A form of real estate investment method that is designed to reduce or eliminate tax while providing returns on real estate. A non-traded REIT does not trade on a securities exchange, and because of this it is quite illiquid for long periods of time. Front-end fees can be as much as 15%, much higher than a traded REIT due to its limited secondary market.
Basically, it’s exactly like a traded REIT, only far less liquid and with much, much, much higher fees. This definition doesn’t even get into the other myriad of above-market management fees that the Non-Traded REIT companies charge their investors. If you can’t already tell, I’m no fan of this “asset class”…or really any other that exists mostly to enrich sponsors and sales people at the expense of unwitting investors. That’s why I was incredibly pleased to find an article earlier this week in Investment News entitled Nontraded REIT sales fall off a cliff as industry struggles to adapt outlining how regulator changes have crippled the third-tier brokerages that traditionally fed capital to Non-Traded REITs. This is not a business with a bright future:
Sales of nontraded real estate investment trusts, the high-commission alternative investments sold primarily by independent broker-dealers, have fallen off a cliff.
Heading into 2016 facing a number of hurdles, namely a flurry of legal and regulatory changes that would quickly impact how brokers sell them, the nontraded REIT industry’s worst fears have come true.
Over the first five months of the year, sales of full-commission REITs, which typically carry a 7% payout to the adviser and 3% commission to the broker-dealer the adviser works for, have dropped a staggering 70.5% when compared with the same period a year earlier, according to Robert A. Stanger & Co. Inc., an investment bank that focuses on nontraded REITs.
Their recent sharp drop in sales is part of a longer cycle. The amount of equity raised, or total sales of nontraded REITs, has been sinking by about $5 billion a year since 2013, when sales hit a high watermark of nearly $20 billion.
Times have changed dramatically. Stanger estimates total nontraded REIT sales in 2016 will reach between $5 billion and $6 billion, or roughly 25% of their level in 2013. That year, former nontraded REIT czar Nicholas Schorsch and his firm, American Realty Capital, were at their zenith, and broker-dealers fattened their bottom lines from REIT commission dollars.
All that has changed as sales of nontraded REITs at independent broker-dealers have dried up. Industry bellwether LPL Financial said in its first-quarter earnings release that commission revenue from alternative investments, the lion’s share of which comes from nontraded REITs, was just $7.8 million, a staggering decline of 86.7% when compared with the first quarter of 2015.
Other broker-dealers are reporting similar results. Sales of nontraded REITs at Geneos Wealth Management are down 60% to 65% year to date, according to Dean Rager, the firm’s senior vice president.
So, what led to fundraising for an investment product like this tanking? Two new regulations. The first one, from FINRA introduced a new rule whereby brokers selling illiquid investments need to make pricing transparent. Seems reasonable. The second, which will come into effect early next year will introduce a fiduciary standard for brokers working with client retirement accounts as opposed to the lower “suitability” standard currently being used. Also seems quite reasonable. The result is a nearly impossible fundraising environment when:
- Brokers have to show clients that the fees that they would pay are exorbitant (and there is no way that a broker would sell Non-Traded REIT shares without the high fees); and
- There is no chance that a broker can recommend an investment where a return of over 17% must be achieved just in order to break even by offsetting the 10% broker fee and up-to 5% upfront fee to the Non-Traded REIT sponsor.
If this industry is going to survive, it will need to change substantially, meaning lower fees and far more transparency. The thing is that, at a certain point, there is basically no reason for it to exist since investors can always buy far more liquid Traded REITs. The good news is that would-be investors are far less likely to be taken to the cleaners. The other good news is that there are other real estate alternatives with a far better alignment of interest between investor and sponsor that will likely to be the beneficiary of capital that would have otherwise gone into Non-Traded REITs. Good riddance.
Yield Curve Update: The yield curve continues to contract. However, unlike in past cycles, it may not be signalling a recession and instead a response to the international hunt for yield spurred on by negative interest rates and foreign economic chaos. Either way, it doesn’t give the Federal Reserve much latitude.
And You Think We’re Bad: The incredible story of how Italian banks used high pressure sales to entice Italian households to load up on their risky subordinate debt during the financial crisis, imperiling their economy today.
This is Why We Can’t Have Nice Things (or Affordable Housing): …..At least not in San Francisco. A proposed housing development in the Mission district lost 85 percent of it’s unit count at planning commission, shrinking it from 26 new units to only 4. The reason: Planning Commission decided that it wanted to preserve the auto body shop that currently resides on the site. Ironically, the same people opposed to this project will continue to shed crocodile tears about how San Francisco has become un-affordable due to a complete lack of common sense or economic literacy.
Crickets: The lack of affordable housing in the US should be a major campaign issue but neither party seems to want to touch it.
Rocket Fuel: Bay Area private bank lenders are offering wealthy techies 0% down mortgages with low interest rates to buy homes up to $2mm, fueling concern about both bubbles and growing inequality.
What’s in a Name? Lenders are continuing their age-old practice of re-branding loans to high risk borrowers. B&C lending became stigmatized so they re-branded it “subprime.” After “subprime” blew up, they started calling it “near-prime.” When near-near prime doesn’t go well, get ready for not-quite-prime.
The Tortoise and the Hare: Video games that are immediate mega-hits often flame out almost as quickly. I’m looking at you, Pokemon Go.
The Machine that Builds The Machine: Take a tour through Tesla’s 5.8 million square foot Gifafactory Sparks, Nevada.
Follow Friday: If you’re on Twitter check out @ It’s a satirical North Korean news feed and one of the funniest things I’ve seen. Here’s a couple of sample tweets:
Chart of the Day
This warms my cold heart.
Born to Ride: Watch a Walmart customer on a Rascal Scooter rob a store an then get away after ramming an employee into a dumpster with his trusty steed. When you see what the employees and customers who tried to stop him look like, the fact that he escaped on a Rascal Scooter will make more sense.
Worse Than Tofu: Cockroach milk could be the superfood that the world has been waiting for. No, this is not from The Onion.
Entrepreneurial Drive: Drug dealers in Rio are selling Olympics branded cocaine to take advantage of their city hosting the games. Who says there is no economic benefit to hosting the Olympics?
Landmark Links – A candid look at the economy, real estate, and other things sometimes related.
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