How to Evaluate Non-Traded REITs

by Timothy J. Seneff

Over the past decade financial advisers have discovered the value of real estate investments for their clients. At the same time, investment program sponsors have created a wide range of offerings that enable investors to meet different investment goals. Historically, financial advisers have treated non-traded real estate investment trusts (REITs) as an alternative to other income-oriented products such as bond funds, which have typically offered competitive yields.

Innovative new offerings now allow financial advisers to take advantage of real estate's strengths to meet other goals, including growth and international diversification. For some financial advisers, it may no longer be a question of whether to include non-traded REITs in a portfolio, but which ones will best serve an investor's objectives.

State of the Market

There are a variety of ways to invest in commercial real estate, including purchase of commercial property, partnerships, and investments in traded and non-traded REITs. (See the sidebar for details on the differences between traded and non-traded REITs.)

Non-traded REITs were first made available to broker-dealers in the mid-1990s. In 2000, the sector raised about $725 million in equity, according to Robert A. Stanger & Co., Inc., an investment banking and securities valuation firm. Fueled by a strong commercial real estate market and low interest rates, the sector grew over the next several years. Robert A. Stanger & Co. data also shows that in 2009, the sector raised about $6 billion; in 2010, it continued to grow, raising approximately $8 billion.

During this period of rapid growth, several non-traded REITs have gone full cycle, meaning they have progressed from initial capital raise, to building a portfolio, to a liquidity event that returned capital to investors. Also, the number of non-traded REIT sponsors has grown from four in 2000 to 28 in 2011, according to Robert A. Stanger & Co., Inc.

Meeting a Variety of Investment Objectives

Non-traded REITs can offer a variety of return objectives. Most REITs aim to provide current income, some offer the potential for capital appreciation, and others offer a hybrid of income and growth.

Growth versus income. Non-traded REITs focused on current income may offer a higher dividend, but likely will have a lower total return upon liquidation. Offerings that lean more toward the growth side are likely to offer a lower dividend, but aim for a higher total return upon liquidation. Income and growth investments offer a blend of the two. Each strategy offers a trade-off for its benefits, and depending on an investor's objectives, one of these strategies may be a better fit than another.

Geographic diversity. Non-traded REITs can invest in properties in the United States, internationally, or both. Though the United States offers a large and diverse real estate market, a REIT with a portfolio of properties spread over multiple countries can hedge against the risk associated with an economic downturn in any one country. Plus, with 70 percent of commercial real estate located abroad, REITs that can invest in these properties have a larger number of potential assets to select from. Adding multiple REITs with varying geographic strategies may provide stronger diversification benefits than investing in one category alone. Geographic diversification has become increasingly important as the global investment universe grows.

Evaluation Criteria

In addition to return characteristics and geographic diversity, there are other factors financial advisers should consider when evaluating non-traded REITs.

Management. Management experience and philosophy are important when reviewing non-traded REITs. Among the items to consider are:

• The experience of the management firm
• Whether or not the management firm has taken non-traded REITs full cycle
• Whether or not it has managed REITs through recessions
• The firm's expertise in acquiring and managing assets in different geographies and commercial real estate segments (i.e., office, industrial, lifestyle, etc.)

Although the amount of capital going into non-traded REITs over the last 10 years has increased dramatically, only a few companies have managed multiple non-traded REITs through recessionary environments and have ultimately taken them through their full life cycle.

Financial strength. A second consideration when evaluating a non-traded REIT is the strength of the REIT's balance sheet. Being overly aggressive with leverage created problems for some REITs during the financial crisis of 2008-2009. With REITs that aim to generate current income, examining how much of the portfolio's modified funds from operations (MFFO) is paid out as dividends or distributions is important.

Portfolio composition. Financial advisers should review the type of properties a REIT has invested in and whether management has effectively minimized risk within the portfolio. Simply considering how much diversity is expected within the REIT (in location of property, property type, debt maturities, and lease structures) will give you a good sense of whether a REIT is well positioned to withstand the ups and downs of the economy.

Liquidity framework. Finally, advisers should consider the offering's liquidity framework. Non-traded REITs are considered illiquid and are generally not appropriate for investors who may need access to their principal in the short term. However, exit strategies and maturity dates may vary among REITs, enabling you to build a portfolio comprising multiple non-traded REITs that mature in succession over time. Nonetheless, advisers should treat non-traded REITs as long-term, illiquid investments to ensure they are appropriate for their clients and of course, carefully read the prospectus to identify fees, expenses, and potential conflicts of interest.

Real estate investments such as non-traded REITs can provide unique advantages to investors. Carefully evaluate how the diverse investment characteristics of non-traded REITs available today may offer you increased flexibility in meeting your clients' long-term goals.