A Deeper Dive Into REIT Structures

Long before the current challenges being faced by the non-traded or NAV REITs (real estate investment trusts) started to become headline news, some industry veterans, including our colleagues on the Armada ETF Advisors advisory board, began to raise red flags. They drew attention to the mounting flows of retail capital into illiquid real estate vehicles and the aggressive prices these funds were paying for real estate, even wading into the public REIT market and buying up a handful of publicly traded companies at cycle-high valuations.

Many industry observers from the decades of the 1980s and 1990s witnessed firsthand the impact that real estate syndication and private REITs had on the commercial real estate landscape. Historically, these vehicles preyed upon individual investors charging exorbitantly high fees through broker/dealer networks and offered very little in the way of liquidity when investors tried to exit. Typically, these funds also utilized large amounts of debt to maximize their investment capabilities in order to generate more fees. The structures were lightly regulated and there were few if any checks and balances in the form of independent boards of directors or shareholders’ rights to keep the bad actors at bay. Over time, many of the most grievous sponsors of these investments were either forced out of business through their own greed and incompetence, or lost clout and market share with the advent of the modern REIT era which fostered a new and highly improved structure with much of the transparency and liquidity of a traditional listed c-corporation coupled with the pass-through features of the REIT legislation which helped democratize the ownership of income-producing real estate for the masses.

The rise of the current class of private equity sponsored NAV REITs only goes back about four or five years following the high profile unwind of several leading players that were holdouts from the old days of real estate syndication. These legacy advisors and funds were hit with a barrage of financial and legal troubles which effectively slammed the door on the old business model, but paved the way for an “improved mouse-trap.” The real estate private equity groups have a long and formidable track record in managing real estate investment programs for institutional investors from around the globe and had been looking for a way to access individual investor (retail) capital and they found the opportunity in the form of the NAV REIT structure. The new entrants improved upon the old variant in several important ways, including a fee structure that was still highly lucrative, but less extreme than that of the old regime. They also utilized less leverage and more conservative debt structures overall than their forbears, and provide better fund-level disclosure. This resulted in a formula that was more palatable for the small investor and offered a valuation mechanism which appeared to “smooth returns” relative to traditional stocks and bonds.

There are a handful of notable distinctions attributable to the current class of leading NAV REITs which should be highlighted. While the track records of these vehicles are quite short compared to those of the private equity firms sponsoring the funds, to date, asset allocation has been solid with many of the top sponsors avoiding commercial real estate “value traps” such as regional shopping malls and gateway city office buildings. The sponsors have stuck with property sectors such as rental housing and industrial which have proven to be far more resilient through the pandemic and thus far as the crisis has ebbed. NAV REITs also have the flexibility to diversify their geographic and property sector exposures in a way not typically utilized by traded REITs. Large private equity firms do have the platforms and infrastructure in place such that they can invest opportunistically across various vehicles, including their non-traded REITs. Traded REITs are usually geographically and property sector-focused, having built more of a regional footprint over decades. Also, traded REIT shareholders would prefer that individual companies stick to their respective disciplines as the investor can easily diversify by introducing different REITs into their portfolios. Finally, NAV REITs pay a distribution which can be more tax advantaged than the dividend paid by a traded REIT as NAV REIT distributions have a higher return of capital component to the distribution as it may be funded from sources other than operating cash flow and this type of distribution can be taxed at a lower rate than dividends with a higher return on capital exposure.

Fast forward to today and the levels of capital raised by the newer entrants into the NAV REIT space are large and have been a powerful growth engine for the sponsors. With interest rates now in the midst of an upward trend stoked by Federal Reserve policy, market-priced risk assets across the investable spectrum have essentially correlated to the downside over the past nine or ten months leaving investors battered in everything from stocks to bonds, to REITs and crypto. One of the only asset classes not seeing double-digit losses in 2022 were NAV REITs, which have mostly achieved positive returns due to their pricing methodology, which is predicated on monthly, internally generated discounted cash flow (DCF) models. The non-correlated returns of these vehicles were a great selling point for fund sponsors, but with other assets classes now looking materially “cheaper,” fund inflows have turned to outflows and some sponsors have opted to limit or “gate” redemptions to protect the funds from having to liquidate assets at inopportune valuations. The gating of these large vehicles along with the valuations or “marks” being quoted on the underlying real estate is giving investors pause and drawing scrutiny from multiple sources, including the Securities and Exchange Commission (SEC).

As part of a recent exercise to better understand the value of a large non-traded NAV REIT, we created a “representative portfolio” of publicly traded REITs that provide approximate property sector and geographic exposure as the NAV REIT. The rep portfolio included two publicly traded apartment REITs as a proxy for the 50%+ exposure that this vehicle has to the rental housing segment. It also included weights to seven additional subsectors including industrial and net lease to further replicate the portfolio of assets held by the non-traded vehicle.

Net Asset Value (NAV)

The NAV REIT is structured such that its NAV is calculated on a monthly basis. This NAV calculation is important not only because it represents shareholder return for the period, but also is the valuation then used for raising new capital and for redeeming shares of existing holders. The NAV REIT in our exercise has achieved a NAV return of over 8% for the first eleven months of 2022. Publicly traded REITs do not typically publish an expectation of NAV, but do provide the disclosure necessary for investors and Wall Street analysts to derive a NAV utilizing their own assumptions. In the case of our rep portfolio, the Wall Street consensus NAV has trended down over the course of 2022 by approximately 8.5% and the portfolio was recently trading at a 9% discount to that assessed NAV value. In terms of interpreting the NAV movements of the non-traded REIT versus the rep portfolio, we would highlight the wide “spread” driven by the upward move in value for the NAV REIT and the downward movement in consensus NAVs and stock prices for the rep portfolio.

Adjusted Funds From Operation (AFFO)

AFFO is not a GAAP-derived calculation, but is a commonly used metric for assessing free cash flow for an income-producing real estate vehicle. The major adjustments to arrive at AFFO are typically the addback of straight-line rents and maintenance capital expenditures. A NAV/AFFO multiple can then be derived as a measure for valuation. In examining this metric, the NAV REIT would be trading at an approximate 47x multiple on 3Q22 annualized AFFO. While this multiple is high by traded REIT standards, it would be multiples higher (almost 400x) if the vehicle did not add their management fees and performance fees back to cash flow in order to calculate AFFO. NAV REITs have chosen to add back these sizeable fee streams on the basis that they can be settled in stock and not only cash, thus providing leeway on the add-back determination. In our opinion, it is highly unlikely that an independent arbiter of this tactic would agree with the methodology. To put these numbers in more perspective, the rep portfolio is trading at a 22x multiple on 2022 estimated AFFO.

Implied Cap Rate

The concept of implied cap rate is another tool used in real estate valuation. This implied value is a yield on rental real estate derived by annualizing the most recent quarter of net operating income (NOI) divided by the current value of the enterprise. The calculation is not GAAP defined either and thus can be open to interpretation. For the purposes of the NAV REIT, we looked at 3Q22 NOI and adjusted that number upward to account for recent investment activity. This resulted in an implied cap rate calculation of 3.8%. The sub-4% value in and of itself could be viewed as aggressive, or an exceedingly low number, even in an environment when interest rates were close to zero like prior to the Federal Reserve’s rate-lifting initiative. In the current environment, we believe this valuation has to be viewed as quite “rich”. The rep portfolio is currently trading at an implied cap rate of 5.5%. Applying the 5.5% cap rate to the NAV REIT, which is roughly 60% levered, would result in a reduction in NAV of approximately 40%.

Notable Takeaways

The new breed of high-fee, externally advised, non-traded or NAV REITs jetted onto the investment scene several years ago attracting investors to these vehicles with brand name sponsorship, high distribution rates and the promise of non-correlated returns which were immune to the whims of market-based pricing. The sales pitch went on to justify aggressive sales loads and performance fees in return for the smoothed returns of an appraisal-based valuation methodology.

The sales pitch also casts these structures as proxies for publicly traded REITs which we view as valid but with important differences. The underlying assets are fungible and both vehicles typically own income-producing real estate such as rental housing units, industrial facilities and long-term leased properties. Publicly traded REITs are perpetual life organizations structured much the same as any publicly listed corporation. These firms are run day-to-day by a senior management team which is responsible for executing on a business plan including all aspects of investment, financing and operations. The management team reports to a board of directors which is accountable for strategic planning and oversight of the management team. All of these various players ultimately report to shareholders and other constituents which include employees, customers, banks and bondholders. There is a high level of accountability with this structure and managements, and in the past, boards have gotten “fired” by constituents for not following through on their fiduciary duties. Both groups are incentivized by receiving meaningful amounts of compensation in the form of company shares.

We would portend that NAV REITs are more akin to private fund vehicles than traditional companies. They typically do not have employees, or only a handful who are charged with executing on the administrative dealings of the vehicle. The real power lies with the sponsor, who created and runs the business on a daily basis and is responsible for growing the asset base and fee stream which accrues back to the sponsor. In our opinion, the only real alignment of interest in this scenario is that the sponsor will presumably act in the interest of investors such that they can continue to attract more investors. It is also notable that in many instances, sponsors and their employees are investing across multiple fund structures at any given time, making it difficult to avoid conflicts of interest.

Even though NAV REITs have been around for a fairly long time, we have found it difficult to compile consistent and reliable return data on these vehicles and we are unaware of any independent industry body that tracks and follows the sector. The wall street analyst community, while not without its faults, does serve a valuable function in “covering” industry segments such as publicly-traded REITs. They have considerable resources to provide industry-level commentary and analysis as well as company-level analysis on a sizeable number of constituent companies. Sell-side analysts also assist with corporate access by sponsoring property tours and conferences widely attended by company managements, institutional investors, and other industry specialists. The REIT industry trade association, NAREIT, also sponsors conferences and other investor outreach initiatives which help to educate and inform all types of investors.

We are of the view that publicly traded REIT managements are incentivized to be as transparent and forthcoming as possible with investors, as their capital structures and business models are predicated on raising new equity and debt capital at the most attractive costs possible to enhance shareholder returns. Recall that REIT legislation requires companies to distribute 90% of taxable income to investors in the form of dividends. This unique pass-through structure means that REITs cannot retain as much capital as traditional c-corporations and thus must maintain an open line of communication with investors of all sorts for when they need to enter the equity or debt markets for capital, and these companies have become quite efficient at raising all types of funds via public/private debt and equity channels.

In their current iteration, NAV REITs have had limited access to alternative forms of equity capital and the business model is predicated on selling common stock to new investors, primarily through broker/deal channels where the investor, not the REIT is paying the price of admission to own new shares. We believe this structure not only disadvantages the new investor from day one, but also incentives the sales force and the sponsor to raise as much capital as possible as this maximizes fees to both parties. It can also disadvantage the investor in a second way, as the return on invested capital may become a secondary objective to the sponsor, with asset gathering being paramount.

The most noteworthy takeaway from our vantage point today is the widening valuation gap between traded REITs and NAV REITs which has expanded precipitously since the start of the current interest rate cycle earlier in 2022. The rapid adjustment to interest rates coupled with a widening expectation that the global economy is headed for a recession in coming quarters is currently being reflected in public stock and bond markets across the world and should eventually have to also be reflected in valuations for NAV REITs. Our concerns for NAV REITs, however, go deeper than a valuation disparity relative to traded companies. Traded REITs have been around for decades, and have been developing, purchasing, selling and managing portfolios across a multitude of environments and cycles. The current class of NAV REITs has only been around for 4-5 years, and it is our opinion that the structures are not cycle tested.

Also, these funds have invested the bulk of their capital during the post-Covid period, when global interest rates were essentially zero and asset pricing in several property sectors hit all-time highs. NAV REITs also utilize considerably more leverage than their traded counterparts, typically taking leverage levels up to 60-65% on cost (when values were very high) compared to traded REITs which are levered 35-40% and we have found NAV REITs started to put the brakes on new investment around the second quarter of 2022. Also, with fund flows into NAV REITs now starting to slow and sponsors electing to gate their funds from redemptions, we would not be surprised if more investors opt for cash distributions, whereas up until recently, shareholders were happy to take their distributions in fund shares. With this in mind, a haircut to distributions may not be out of the question for some funds.

We believe that a primary driver of demand for NAV REITs has been the promise of smoothed returns predicated on monthly valuations and an annual appraisal of the portfolio. The monthly valuation exercise, however, leaves much discretion to the sponsor and many of the discounted cash flow assumptions undisclosed. This is a process fraught with the potential for unreliable results.

With investors now better informed of the challenges and risks associated with NAV REITs, they need to also understand that publicly traded REIT vehicles such as mutual funds and ETFs can offer superior structures that are more cost-effective and with fewer potential conflicts of interest and the added bonus of daily liquidity. Studies have shown that while annualized stock market returns can be highly volatile over a one-year period, or even on a five-year basis, the longer the holding period, the smaller the delta of returns. Thus, for long-term investors, at least partially negating the need to “pay up” for non-market-based schemes.