INSIGHT: In the Beginning Was the REIT

Today, non-traded REITs (NTRs) are on a tear. According to the Stanger investment bank, fundraising is up 137% during the first three quarters of 2019 over the same period in 2018, with 2019’s total as of the end of September standing at $7.6 billion compared with 2018’s same-period total of $3.2 billion. The current projected total raise of $10 billion for 2019, if realized, would more than double 2018’s total of $4.6 billion. Market-watchers not familiar with NTRs ask what is behind this growth, and that is the question this article seeks to answer.

To understand the state of play for NTRs, some history is in order—the history of real estate investment trusts (REITs), real estate limited partnerships (RELPs) and, finally, NTRs. Also pertinent is “ripeness,” the business and sociological concept that a great idea does not manifest itself in the world immediately, but comes into fruition once conditions permit—which has direct bearing on the sudden and widespread domination by the net asset value REIT (NAV REIT) in the retail alternatives space. Lastly, we will discuss what I call the “attribute sphere,” the zone where innovation in product structure occurs, and the crucible of the industry’s future.

The Structure’s Evolution

In 1960, in what today would seem an unthinkable act of bipartisanship, President Eisenhower signed into law the REIT Act, an attempt to use the tax code to encourage small investors to participate in commercial real estate investments.

A REIT is a corporation, trust, or association that, through a deduction for dividends paid, may avoid paying corporate-level federal income tax, thereby effectuating a federal subsidy for investment in critical fixed assets.

Although in 1960 the REIT structure was new and oriented toward smaller investors, there was nothing particularly modern about individuals pooling their resources to finance the construction or acquisition of real estate. From Mesopotamian landholding partnerships to Roman societates for the rental of apartment buildings to the group of prominent New Yorkers that built the Empire State Building in 1931, syndicates for the purpose of real estate investment have propped up economies for thousands of years.

But in fact, although the REIT era began in 1960, saying so is a bit like saying that the U.S. was founded in 1585 with the failed colony at Roanoke. For, while the REIT idea did start percolating in 1960, and the first REIT went public in 1961, the idea was not yet ripe, and REITs did not gain wide acceptance.

By contrast, a different structure for syndicating equity, the real estate limited partnership, took off. For example, the New York Times Sunday business section on March 19, 1972, announced that “the game of real estate syndication, usually played by the wealthy … , is again being opened up to small investors,” in this case “professional men and business executives in the higher tax brackets.”

As suggested by the NYT article, tax minimization was a major motivator for the RELP structure. Unlike today, the mid-century saw high earners potentially subject to a top tax bracket of up to 70%. Also unlike today, they could often use depreciation from real estate investments to offset ordinary income on their tax returns. For promoters, the combination of high tax brackets with liberal depreciation allowances was like pouring gasoline on a wildfire. Syndication upon syndication—generally, publicly registered and private RELPs—hit the street. An ecosystem of real estate sponsors, broker-dealers, investment advisers and service providers blossomed. The music stopped in 1986, when the Tax Reform Act was passed into law by President Reagan. The Tax Reform Act further decreased the top tax bracket from 50% (to which it had fallen in 1981) to 33% and closed a number of perceived loopholes, including certain depreciation provisions.

But a change in law does not always change facts on the ground. In this case, a great deal of intellectual and human capital had gone into the RELP industry. Members of the RELP business community had spent years, if not decades, studying the industry, debating the merits of different structures, shaping a state-of-the-art prospectus disclosure regimen, getting to know the regulators, and, of course, networking with each other at conferences and due diligence meetings. Many participants counted their colleagues in the space among their best friends. Similarly, wealthy taxpayers (now simply “investors,” since the tax shelter aspect had been shut down) had become accustomed to RELPs, and enjoyed cordial relationships with the brokers and wealth managers who had introduced the products to them.

The people in Washington were not going to destroy all that hard-earned intellectual and human capital. Instead, during what might be called the First Dark Age of the modern real estate syndication industry, the leading lights of the industry considered the alternatives to selling RELPs. Over time, they found the REIT to be a viable substitute.

REITs had gotten off to a slow start. As far as I can tell, the first-ever REIT was American Realty Trust, founded in 1961. By year-end 1972, the total market capitalization of the sector stood at $1.5 billion—nothing substantial, even in inflation-adjusted dollars. After falling to a year-end nadir of $700 million during the oil shock/stagflation recession of 1973-74, REIT total market capitalization increased steadily, hitting year-end $1 trillion for the first time in 2016, where it has stayed.

During the First Dark Age, the RELP community did not take to publicly traded REITs, but rather invented the non-traded REIT—a REIT whose common shares are registered under the Securities Act of 1933, but do not trade on any exchange. This chimera—is it fish or is it fowl?—confuses outsiders to this day, but makes perfect sense if you think about it. By publicly registering, the REIT can tap a broad pool of investors. By contrast, a private placement is limited to accredited investors, those generally with a net worth of $1 million or an annual income of $200,000. By not seeking for its shares to trade on an exchange, the REIT does not need to meet the onerous quantitative listing requirements of the NYSE or Nasdaq. Therefore, the REIT can start raising funds from scratch. In practice, this means a “blind pool,” whereby the REIT specifies in its prospectus the types of assets it may invest in, but whereby the REIT does not yet own, or commit to owning, any particular asset just yet. A blind pool is the holy grail of real estate syndication sponsors, because it is the quintessential asset-light strategy—the sponsor can tap a wide and deep pool of investor capital without needing to contribute much of its own balance sheet upfront. Investors in a blind pool get the benefit of a newly constructed portfolio, unburdened by any legacy or non-core assets.

By some accounts, the first non-traded REIT went public in 1990. Thus ended the First Dark Age of real estate syndication, notwithstanding the relatively mild early 1990s recession, and the RELP community was back in business, now as an NTR-focused guild promoting the economic benefits of its real estate programs rather than their tax benefits. By 2007, at the height of the last commercial real estate cycle, NTRs were raising $11.5 billion per year, according to Stanger.

Unfortunately, 2007 was about the worst time imaginable to be investing in commercial real estate, and some of the largest NTRs suffered the consequences. They had invested heavily in retail and hospitality, sectors particularly susceptible to the sudden economic downturn. The decreased income from increasingly vacant properties and the liquidity concerns raised by the shrinking pool of available financing led several of these NTRs to cut dividends in the hopes of shoring up their balance sheets and maintaining a dependable cash flow. Net asset values, predictably, declined.

This Second Dark Age of real estate syndication correlated with a general panic about real estate prospects. By mid-2009 the MSCI US REIT index had declined by over 40% from its prior peak. The market upheaval even touched the much less volatile NCREIF Property Index, which seeks to track the performance of unlevered institutional-grade commercial real estate. The usually relatively stable index dropped by 10.2% over the last three quarters of 2009. In 2009, NTR fundraising dropped to $6.1 billion for the year, according to Stanger.

Unexpectedly, though, the depths of crisis contained the seed of redemption. With interest rates dropping to theretofore unseen levels, finally hitting the all-time low federal funds rate of 0.25% on Dec. 17, 2008, investors became “starved for yield,” in the jargon of the day. NTRs, with their relatively high distribution rates, became coveted vehicles for driving out of the recession.

This NTR renaissance saw fundraising increase through 2012 by an annualized rate of roughly 17%, before skyrocketing to an all-time fundraising high of $19.6 billion in 2013, according to Stanger.

But 2014 saw some challenges. In October of that year, one of the major success stories of the NTR renaissance—a publicly traded net-lease REIT that had initially gone public through a best-efforts offering using the independent broker-dealer channel—announced that its audit committee believed that the company had misstated a crucial performance metric earlier that year. The fallout from the public scrutiny that followed might have sufficed by itself to put a dent in fundraising. It didn’t help that, at the same time, regulatory changes altered the competitive landscape.

Effective in April 2016, FINRA rules were revised to require that NTR account statements generally show share value based on a valuation of assets and liabilities of the NTR, rather than at the offering price (usually $10 or $25 per share for arithmetic simplicity). This change in regulation, and the noise leading up to it, gave broker-dealers pause before selling a high-load product to their clients, and made NTR sponsors rethink the products’ fee structures. Also in April 2016, the Department of Labor issued a final regulation that would have imposed ERISA fiduciary standards on advisers to IRAs. Like the change in FINRA regulation, the DOL fiduciary rule chilled the market for NTRs considerably, not just because of its substance, but because of the uncertainty it introduced. Although the DOL fiduciary rule was overturned by the courts in 2018, the anticipation of it still inflicted damage between 2015, when the financial industry first caught wind of the proposals, and 2017.

The public scrutiny on the industry, coupled with the regulatory changes, caused fundraising to decline by 35% from 2014 to just over $10 billion in 2015, until it hit a low of $3.9 billion in 2017—the Third Dark Age.

Meanwhile, we should take a step back to the early 2000s. Anyone with eyes could see that—despite its potential for delivering an illiquidity premium—critics saw illiquidity as the major “bug” in the NTR model. This illiquidity, combined with impatient investors, gave rise to a menagerie of private equity and investment firms that would (and still do) conduct so-called mini-tender offers for shares of NTRs at below NAV per share. This practice was, and is, completely legal, but nevertheless irritating to sponsors that must, by law, respond by filing tender offer response materials. A straightforward solution occurred to many industry participants: Offer the shares at NAV per share, not at the artificial $10 or $25 price of yore, and offer to buy them back through a vastly expanded share repurchase program.

Share repurchase programs, consistent with a long chain of SEC no-action positions, had historically capped the number of shares that could be repurchased in a year at 5% of the issuer’s total outstanding shares. But multiple sponsors in the first decade of the 2000s engaged in dialogue with the SEC about increasing that limit, and eventually persuaded the staff to issue no-action relief for annual repurchases of shares whose values amounted to up to 20% of the issuer’s NAV.

With the illiquidity bugbear potentially defanged through a new breed of NTRs—now called “NAV REITs,” in contrast to the older model of “lifecycle REITs”—and with the 2014 accounting scandal in the rearview mirror, the DOL fiduciary rule dead, and the new Financial Industry Regulatory Authority, Inc. (FINRA) rules understood and internalized, the industry emerged from the Third Dark Age, and sales once again took off.

This brings us to the fourth quarter of 2019, with sponsors old and new exceeding their fundraising expectations.

The New Regime

I find several things about the transition to NAV REITs fascinating. One is the concept of ripeness. For decades, “everyone” believed that NTRs were too illiquid. Then, for several years in the first and into the second decades of the 2000s, sponsors tried mightily to rectify the bug through the new NAV REIT model. First, as mentioned above, the effort took place at the regulatory level. But even after approval, and the launch of the first NAV REITs, they still did not take to any notable extent, and old-style lifecycle REITs continued to dominate.

Then, in 2016, Blackstone, the largest alternative asset manager in the world, took its NAV REIT effective with the SEC. Blackstone’s product set the standard for fundraising for the next three years (to present), accounting for up to 63% of the industry’s fundraising totals in a given quarter, according to Stanger.

About ripeness: NAV REITs had already been around for years before Blackstone’s product went public. But suddenly the idea took off. Not only that, but the new structure started to marginalize the older lifecycle model, as NAV REITs gained entree onto the coveted wirehouse platforms that had long eluded promoters of lifecycle REITs.

Similarly to how Facebook did not invent social media—remember Myspace and Friendster?—Blackstone did not invent the NAV REIT. But with the groundwork laid, the technology developed and the infrastructure in place, the time had arrived for a strong operator to establish the new regime. With the model proven, other institutional sponsors—including Nuveen, Starwood, Oaktree, and Cantor Fitzgerald—quickly followed.

Which brings me to a second source of fascination, which is that a space invented by real estate operators and syndicators came to be filled by institutional investment behemoths. Now, I realize that Blackstone, Starwood, and Oaktree are all founder-led firms. But their DNA is institutional, both in personnel and in client base. By contrast, historically, NTR sponsors predominantly sought to do business with retail investors (admittedly including high-net-worth investors).

In a grass-is-greener phenomenon, institutional sponsors crowded into the retail space. Significant tailwinds for the durability of the trend include a perception that retail investors (including the lower end of the private client category) will constitute a growing source of AUM for asset managers in the future; a secular decline of defined-benefit plans; and a shift toward defined-contribution plans, such as 401(k)s and IRAs, and self-help.

Additionally, institutional sponsors, after enjoying fatter margins in decades past, have suffered from increasing fee compression due to heightened competition for institutional AUM.

Arguably, 2016 marked the tipping point where an awareness that “the future is retail” brought NTRs into the mainstream, where institutional players predominate, and success accrues to those who can scale.

The ‘Attribute Sphere’

In the meantime, competition among sponsors is fierce. The competition takes place in what might be called the “attribute sphere.” In his excellent essay about operating systems, titled “In the Beginning … Was the Command Line” (if you notice an echo in the title of this article, then you are very sharp), the futurist Neal Stephenson observes a general tendency for operating systems to become free as the technology is widely adopted and copied. Meanwhile, certain other technologies are still too speculative. Accordingly, competition takes place in what he terms the “technosphere,” or the realm of existing technology that is still novel enough to impress consumers willing to pay for it, while not yet having been copied so much that it has become effectively free. In Stephenson’s telling, as novel technologies become widely adopted and copied, they fall into a sort of technological substrate, overtop of which new technologies are constantly developed, while speculative technologies hover untouchably above the technosphere.

Of course, an operating system is a type of software. Is a REIT a type of software? I won’t make that leap—quite. But I would say that the intricacies of a REIT, similarly to the dynamics of Stephenson’s technosphere, are built on layer upon layer of “code,” including inert, widely copied, boilerplate concepts.

Take the so-called excess share provision. A REIT must not be subject to greater than 50% ownership by any five or fewer individuals during the last half of its taxable year. To avoid blowing its REIT status, a typical REIT’s organizational documents will prohibit ownership of more than 9.8% of its interests by any individual, subject to certain exceptions. As a means to motivate compliance, if any holder exceeds the ownership limit without the board’s permission, he will find himself holding “excess interests,” which automatically lose their voting rights and are transferred to a charitable trust trustee for the benefit of a charitable trust that then disposes of the interests in a REIT-compliant manner. It is an elegant mechanism. Lots of care went into its devisement. But it is so institutionalized, and so well-known, as to be universally copied and effectively free. No competition occurs in the structuring of excess interest provisions.

Another example is the noncompliant tender offer provision seen in NTR organizational documents. Under that provision, if a mini-tender bidder does not provide disclosures to stockholders similar to those mandated by Regulation 14D of the Securities Exchange Act for a registered tender offer, as well as provide withdrawal rights and follow the all-holders and best-price rules, then the tendering stockholders will have an opportunity to rescind the tender of their shares, and the noncomplying bidder will need to pay the REIT’s expenses in connection with the transaction. Variants on this type of provision can be found throughout the universe of NTRs, primarily but not exclusively among lifecycle REITs, which, with their more limited liquidity profile, are common targets for mini-tender bidders. In any event, like the poison pill, the noncompliant tender offer provision is exceedingly clever, and was once novel. But now, like other older REIT technologies, it is ubiquitous, free and widely copied.

A final, more general, example goes to the length of corporate documents. Businesspeople make fun of lawyers for “legalese,” and wonder why REIT charter documents might stretch to 70 pages, and why a REIT’s prospectus might feature 10 (or 20, or 50…) pages of risk factors. Much of it, no doubt, is “crufty,” meaning superseded or useless. But if you are a corporate lawyer or a businessperson, ask yourself whether you want to be the one to remove what seems like a boilerplate provision, only to have that provision be the one missing from the exhibit when the REIT gets sued on that very subject. Most corporate lawyers and businesspeople do not want to be that person, so legal provisions tend to stick around, and documents get longer, not shorter, over the decades.

Conversely, other REIT-like structures are so wild or speculative that they exist far above the realm of the agon, so competition does not happen there either. Examples include prodigies such as exchange-traded buildings. A few sponsors have tried, virtually without competition, to launch exchange-traded buildings. At some point, I believe that exchange-traded buildings will happen. But at least so far, the early adopters have arrived too early, before the time of ripeness.

Where competition does happen, and innovation does run fast and deep, is in the attribute sphere. From the early 2000s until now, the attribute sphere has included the features of NAV REITs, including periodic valuations, wider gates (share repurchase programs), lower upfront commissions and reduced management fees. Inevitably, however, what was once an innovation gets trampled under the feet of the competing sponsors and gets pushed down to the inert, dead layer of free technologies. Eventually (or maybe it has already happened), NAV REITs will become so ubiquitous as to have their terms and provisions mindlessly copied. The attribute sphere, where competition happens and new intellectual capital is developed, will drift upwards and elsewhere.

To compete, NTR sponsors will need to conduct sophisticated temporal arbitrage, which, in Stephenson’s words, “hinges on the arbitrageur knowing what technologies people will pay money for next year, and how soon afterwards those same technologies will become free.” So, like software purveyors, NTR sponsors will introduce new features almost constantly, as yesterday’s innovations become today’s inert substrate.

Lastly, allow me to mention something that is not a new feature. It has existed in the inert layer precisely since 1960, although sponsors that don’t know better will still promote it as if it were a shiny new thing. That feature is “democratization.” Perhaps the most overused and misused word by sponsors, democratization—or, more aptly, massification—took form during the Eisenhower era. If there is anything new under the sun, it is not the fact of opening up real estate investment to the masses. What is new(ish) is NAV REITs, where investors may gain access to institutional-grade real estate in a non-market-correlated package, while enjoying the benefits of pricing at NAV and, barring a liquidity crisis, extensive redemption opportunities.

Unavoidably, though, NAV REITs will become not-new, and the same sponsors, minus whoever exits the space, plus whoever enters, will find different ways to deliver institutional real estate to retail investors. Regulatory boundaries will change, the attribute sphere will evolve and market-watchers will ask industry participants what is behind the growth of whatever new structure happens to emerge from the inevitable next Dark Age of real estate syndication.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Evan Hudson is a partner at Stroock & Stroock & Lavan LLP in New York.

The author wishes to thank John Sottile, Associate, Stroock & Stroock & Lavan LLP, for his research assistance in preparing this article.