Mind the Gap

Mind the GapThe question is a common one for many institutions – For the real estate allocation, should we use publicly traded REITs or private real estate?  The usual answer is to mix them.  Yet recent research highlighted by Institutional Investor magazine notes that public “REITs have beaten private funds by almost 5 percent a year over the past three decades.”  For the 30 years ended December 31, 2011, listed REITs returned 11.95 percent annually while private funds returned 6.97 percent. 

That’s a huge performance gap. Continue reading

Alternative Realities

Background. As I have written and discussed numerous times, we remain mired in the throes of a secular bear market, prone to major swings in both directions. This reality has led to much discussion of the alleged “lost decade” for stocks. How much longer this secular bear market will last is impossible to tell. But for as long as it does, we cannot expect much long-term equity appreciation (despite the likelihood of significant cyclical periods of good performance – such as that we are seeing right now).

For most of this past decade, poor stock market performance has been mitigated by an ongoing rally in bonds – a rally that has continued for roughly 30 years.  However, historically low yields most recently have made the bond markets less attractive generally for many investors and especially for those with the need or desire for income.  As John Hussman (among many others) has pointed out, “nearly every traditional asset class is priced to achieve miserably low long-term returns.”

At the same time, as is now well documented, the amount of “safe” assets available for investment has diminished considerably.

 Similarly, the ranks of highly-rated corporate securities have thinned as well.

 These market conditions have pushed many investors into less safe and higher yielding investment opportunities.

In an environment that is fearful and which does not trust traditional diversification strategies to provide the level of downside protection frequently desired, investors also seek better alternatives than they have typically had available to them in order to achieve their goals. As a consequence, advisors and money managers of various types have increasingly used “alternative” investments (which for these purposes I define as investments which are generally non-correlated to the traditional stock and bond markets) so as to reduce portfolio risk and to provide opportunities for outperformance in this challenging times, inspired by the so-called “endowment portfolio” strategy begun and exemplified by Yale’s David Swensen (even though Swensen himself rejects that type of approach for retail investors).

 Comprehensively understood and carefully managed, alternative investments and strategies can indeed offer better ways for advisors to manage risk and to achieve better diversification within their client portfolios. The related desires for both non-correlation and yield have fueled demand for such alternative investments.  Unfortunately, for some advisors and investors, “alternative” has meant almost exclusive reliance upon non-traded REITs and other private investments in “hard assets.”

Investors also like the seeming lack of volatility of such non-traded offerings, which are not marked to market regularly – in large part due to the lack of much of a secondary market.  However, as SEC Attorney Michael McTiernan pointed out to The New York Times:

“One common sales tactic we object to is the suggestion that they [non-traded alternative investments] are eliminating volatility simply because they don’t tell you what the value is. It’s not that it’s not volatile. It’s just that you don’t know.”

Regulatory Climate. Non-traded REITs and similar private offerings, like all investments, have their weaknesses. Consequently, in light of tremendous demand for them, regulators have responded to the growth of this market aggressively.   

In 2009, via Regulatory Notice 09-09, FINRA prohibited broker-dealers from using information more than 18 months old to estimate the value of investments such as non-traded REITs.  Such value determinations must consider the underlying value of the investment’s assets as well as its costs, including commissions paid.  This regulatory change resulted in significant reductions to current market value estimates in many cases.

This past September, FINRA issued proposed amendments to Rule 2340 governing customer account statements that would require that “all per-share estimated values, including those that are based on the offering price, reflect a deduction of all organization and offering expenses.” In other words, the initial value of non-traded REITs and similar products must reflect the value of the shares net of up-front expenses. That means that the customer of a broker who buys a non-traded REIT for par, typically $10 a unit, would receive an initial account statement that shows a value net of brokerage commissions and other expenses. In such instances, non-traded REITs would be valued in the range of $8.70 per unit. Not surprisingly, the North American Securities Administrators Association supported this proposal.  Even the National Association of Real Estate Investment Trusts supports it. I expect it to be enacted in substantially the form in which it was offered.

Shortly thereafter, in October of 2011, FINRA published an Investor Alert, entitled Public Non-Traded REITs—Perform a Careful Review Before Investing, which states that while investors may find non-traded REITs appealing due to the potential opportunity for capital appreciation and the allure of a robust dividend, they should also realize that the periodic distributions that help make non-traded REITs so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal.

Additionally, FINRA’s alert says that early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return. Gerri Walsh, FINRA vice president for investor education, stated it like this:  “Confronted with a volatile stock market and an extended period of low interest rates, many investors are looking for products that offer higher returns in turbulent times.” However, “investors should be wary of sales pitches that might play up non-traded REITs’ high yields and stability, while glossing over the lack of liquidity, fees and other risks.“

Latest Actions. FINRA has now published a 16-page bulletin on its website outlining the priorities and things it is looking carefully at for 2012.  Among the items was a mention of REITs and private placements (Investment News summary). In FINRA’s own words:

“FINRA is informing its examination priorities against the economic environment that investors have faced since 2008, as these circumstances have steadily contributed to conditions that foster an increased risk of aggressive yield chasing, inappropriate sales practices, unsuitable product offerings, and misappropriation and fraud….

“Given the low yields on Treasuries, we are concerned that investors may be inadvertently taking risks that they do not understand or that are inadequately disclosed as they chase yields.

“…The lack of a deep secondary trading market for certain investments make them unsuitable for many retail investors who have strong liquidity needs.”

“…Transparent and accurate financial details should be available at the time an investment is made to ensure that investors are making an informed decision. The classification of cash flow returns is particularly important so investors know when returns are being paid from their own principal or from capital raised in subsequent offerings….

“Although non-traded REITs may offer diversification benefits as a part of a balanced portfolio, they do have certain underlying risk characteristics that can make them unsuitable for certain investors. As an unlisted product without an active secondary market, these products offer little price transparency to investors and little liquidity. The related financial information for these products may often be unclear to the investor, which makes the true associated risks and value difficult to ascertain. With many products, there are questions about valuation and concerns that in some cases distributions to investors are paid with borrowed money, over a lengthy period of time, with newly raised capital, or by a return of principal rather than a return on investment. The source of the distribution may not be transparent.”

That same recent bulletin also noted that suitability reviews will continue to be important in 2012, as the new Suitability Rule (FINRA Rule 2111) and Know Your Customer Rule (FINRA Rule 2090) become effective on July 9. Thus all broker-dealers transacting with clients or making investment recommendations to them must comply with new suitability standards established by. This rule, modeled upon NASD Rule 2310 (Suitability), requires that a firm or associated person have a “reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”

A representative’s recommendation is still the trigger for the rule’s application, and uses a “facts and circumstances” approach in its determination, but makes a number of changes to the institutional investor exemption and clarifies which sorts of information brokers must ask for and analyze before they make recommendations. Previously, the only factors representatives were required to consider when offering investments to customers were investment objectives, tax status and financial status. Under the new Rule, they must also take into account age, risk tolerance, time horizon, liquidity needs, other investments and experience.

FINRA also provided the following guidance concerning the definitions of “risk tolerance,” “time horizon” and “liquidity needs.”

Risk Tolerance: “A customer’s ability and willingness to lose some or all of [the] original investment in exchange for greater potential returns.”

Time Horizon: “The expected number of months, years, or decades [a customer plans to invest] to achieve a particular financial goal.”

Liquidity Needs: “The extent to which a customer desires the ability or has financial obligations that dictate the need to quickly and easily convert to cash all or a portion of an investment or investments without experiencing significant loss in value from, for example, the lack of a ready market, or incurring significant cost or penalties.”

In the case of multiple customer accounts, it is possible for different accounts to have different investment profiles. However, FINRA is clear that “a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made.” Therefore, if an investor has two accounts, one with high risk and one with low risk, broker-dealers cannot use the high-risk profile to justify recommendations for the low-risk one.

New Rule 2090 is modeled after former NYSE Rule 405 and requires member firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” The obligation arises at the beginning of the customer/broker relationship, independent of whether the broker-dealer has made any recommendation, and continues through termination of the relationship. We should take careful note of the new requirement to “retain” the “essential facts” concerning every customer.

According to Rule 2090′s “Supplementary Material,” “essential facts” are those facts that are required to:

  • Effectively service the customer’s account;
  • Act in accordance with any special handling instructions for the account;
  • Understand the authority of each person acting on behalf of the customer; and
  • Comply with applicable laws, regulations and rules.

Essential facts for knowing the customer are defined when read in connection with Rule 2111′s requirement that reasonable efforts be made to gather expanded categories of information about the customer’s “investor profile” (discussed above) in order to evaluate suitability.

Taken together, these new suitability and “know your customer” rules effectively negate the possibility of a “product sale.” Sales now need to be justified essentially as part of a comprehensive and well-documented plan.

While I hope you have read them before, you might also be interested in several of my publications on this general subject from my blog and elsewhere:

The Questions to Ask about Non-Traded REITs

Analyzing Non-Traded Investments

FINRA Issues Investor Alert re Non-Traded REITs

Full and Fair Disclosure

Morningstar to Cover Non-Traded REITs

Morningstar will begin coverage of non-traded REITs next year and is likely to use its “star system” as part of that process. Added focus and attention can only be a good thing for this industry.   I have written about it most recently here and here.

Analyzing Non-Traded Investments

FINRA recently issued an investor alert with respect to non-traded REITs which outlined the products’ features and potential drawbacks, such as high fees and illiquidity.  In that these products have been frequently mis-sold and their risk levels are high, that action is understandable.  I wrote about it here.

FINRA’s action correlates with an increasing interest in non-market correlated assets, which include non-traded REITs.  Non-traded investments typically fall into this category and have characteristics significantly different from traded assets.  We have seen many non-traded investments suffer impaired performance recently and, therefore, over the short-term at least, not achieve their intended results.  Moreover, in a yield-starved investment world, assets that purport to pay out high dividends seem particularly attractive.

Consequently, I want to share some thoughts about evaluating non-traded offerings. This analysis should help you make better informed decisions about non-traded investments going forward.

1. Estimate the proposed investment’s intrinsic value carefully.  Investors can be all over the map on how they do so.  For example, some use discounted cash flow, some use relative valuation and some look at book value.  The process and the result offered by the issuer are rarely transparent.

2. Compare the issue price to the ascertained intrinsic value and then consider the margin of safety offered.  This margin needs to cover up-front costs and ongoing expenses with an additional margin on top of that for a profit to be reasonably expected.  Moreover, it should not be a fixed number, but should be reflective of the uncertainty in the assessment of intrinsic value.

3. The underlying assets should be acquired at favorable prices in light of current market capitalization rates, occupancies, leasing rates, sales comparables, replacement costs, etc. Paying too much is a primary reason that, as time passes, many non-traded investments (think Wells II and Inland REITs, for example) underperform.

4.  Analyze costs carefully. Even excellent underlying collateral can be severely hampered by the upfront, ongoing and backend fees of an investment (even though higher fees seem to attract at least some clients). Indeed, ranking investment funds according to fees (with lower fees being more highly rated) provides the best indicator we have of future performance. With most non-traded investments, the upfront load includes sales fees and commissions, acquisition fees, origination fees, and the like. The maximum amount most non-traded vehicles can pay for offering expenses is 15% (and FINRA is seeking to cap the others at 15% too). Most issuers have offering costs in the range of 10% to 12%.  Many of these products also have far too many ongoing fees. These can even be more difficult to overcome than the upfront load. 

5. Watch for “legacy assets” — assets purchased at market-highs (e.g., real estate during 2005-2007).  Sometimes such assets can appear in newer deals following acquisition from a related entity.

6. Although each PPM indicates where the funds to be used for distributions come from, the strongest offerings pay their distributions from operational cash flows. You should look to see how and when operations create the cash flows so as to diminish and ultimately eliminate the significance of continuous fund-raising to cover distributions.

7. Alignment of interests is vital. Make sure that the investment structure actually incentivizes the sponsor to go full cycle and to make its profits on the back-end.  Invest in funds where the managers have a significant ownership stake. Finding out which those are is much easier than it used to be. Since 2005 the SEC has required all funds to disclose manager ownership of fund shares in their annual Statements of Additional Information in seven ranges.   Funds with substantial manager investment significantly outperform their peers (more here, here and here).  As Georgetown University endowment head Lawrence E. Kochard puts it, “The managers should make money only when the investors make money.”  David Swensen of Yale repeatedly makes the same point.  If the issuer makes its money overwhelmingly via fees rather than equity, look out.

8. There is also a significant positive correlation between manager investment and manager tenure.  Therefore, look at management tenure closely.

9. Make sure the acquisitions and investment staff, along with the executives of the fund/asset, have particular experience in the types of assets that they are acquiring. They should have a lengthy track record in that asset class, through good times and bad.

10. Screen for issuers that meet good company criteria: solid management, good product and sustainable competitive advantage.

11. Be extra-careful in the current interest rate environment.  I recognize that it is tempting to reach for yield amidst low rates. However, “[t]here is almost no way to invest large amounts of money in today’s market — specifically in today’s real estate market — and not be set up for a major disappointment sometime soon,” stated Ethan Penner, founder and president of CBRE Capital Partners. during his keynote address at the recent Commercial Real Estate Investment & Finance 2012 conference. “The major disappointment may take the form of economic non-recovery, it might take the form of very, very high interest rates, which will render your returns very, very inadequate,” explained Penner. “I don’t know what [factor] it is going to be, but I can tell you the byproduct of investing money today for most investors is going to be a lot of crying going forward.”

12. Size matters. Look for deals where more assets do not keep getting added just because it is possible to do so. For example, the non-traded REITs that have cut dividends and eliminated share buyback programs have, in general, been the larger ones. This is what hedge fund legend (24% average annual returns over 28 years) Michael Steinhardt calls “diseconomies of scale“. Elephants cannot dance.

Overall, investors should be looking for “bedrock stability” rather than “bicycle stability.”  A bicycle has to keep moving to stay upright and to support its rider.  Some investments will only remain stable if they keep moving, i.e., if operating cash flow continues at its projected pace. That is bicycle stability – the issuer has to keep pedaling. On the other hand, bedrock is solid.  Only a severe event will cause it to fail to support that which is built upon it.  Investors are much better off with companies that could survive a setback in earnings, and even lose money for a time. That is bedrock stability, and in today’s markets, it’s well worth finding.