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.