This article is republished with permission from TreppTalk.
The departure of AR Global Investments from the nontraded real estate investment trust (REIT) world, coupled with uncertainty surrounding substantial pending regulations, has put a sizable damper on the ability of the nontraded REIT sector to raise capital. According to Summit Investment Research, $4.8 billion of equity was raised by sponsors of 35 entities last year. That was the lowest volume in 14 years, and pales in comparison to the $10.2 billion of equity that was raised in 2015.
New Millennium, New Sector
Although the nontraded REIT sector has been in existence for more than 25 years, the sector did not shift into high gear until the mid-2000s. In 2004, $6.3 billion of equity was raised by companies such as Behringer Harvard, Cole Capital Corp., CNL Income Corp., and Hines. The firms that raised equity took advantage of improving real estate markets, as well as a growing appetite among retail investors to put money into the sector. As a result, capital raising ballooned.
Three years later in 2007, $12.2 billion of equity was raised. Just about every major sponsor in the sector launched a nontraded REIT vehicle that year. Real estate of all stripes, driven by abundant liquidity in both debt and equity, was increasing in value almost daily.
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Then the capital markets collapsed. Equity raising by sponsors of nontraded REITs started declining. In 2008, $10.4 billion was raised. That figure then fell to $6.6 billion in 2009 as liquidity dried up.
Property values started to deteriorate and property owners were reeling, often as a result of having too much debt on their holdings. The confluence of weakened values, dissipating equity raising, and debt-heavy property owners brought out opportunistic investors. American Realty Capital Trust, formed in 2007, took advantage of the market turmoil as it launched no fewer than five entities in 2010 and 2011.
King of the Equity Hill
With market conditions recovering, American Realty started to orchestrate a series of acquisitions and mergers. The firm often used American Realty Capital Properties Inc., a publicly traded REIT formed in 2011, as an aggregator. The idea was to provide liquidity in previous entities to investors in the hope that they would invest in subsequent offerings. To make reinvestment more enticing, American Realty formed companies with very specific focuses. It launched a company that only sought properties in New York City, another that pursued hotels, and one that specialized in grocery-anchored shopping centers.
That feeding frenzy resulted in some $20 billion of equity being raised in 2013, the sector’s high-water mark. American Realty—by then known as AR Capital—was responsible for more than one-third of that total.
Now known as AR Global, AR Capital is no longer actively raising capital for nontraded REITs, having quit the business in late 2015 because of pending regulations. In addition, AR Global’s flagship company, American Realty Capital Properties Inc., disclosed an accounting irregularity in 2014 that resulted in the departure of its chief financial officer and chief accounting officer.
Regulation: To Pass or Not to Pass?
Two pieces of pending regulation likely spurred AR Global to stop raising capital for nontraded REITs: the U.S. Department of Labor’s fiduciary rule and the Financial Industry Regulatory Authority (FINRA) regulatory notice 15-02. The Department of Labor’s fiduciary rule would force most financial advisers to adhere to the standards of fiduciaries if they are or were selling financial products or advice to a client for their retirement account. FINRA 15-02 requires sponsors of nontraded REITs to include estimated values of investors’ holdings in their regular statements.
The implementation of the fiduciary rule has been postponed and could very well be overturned. That uncertainty is sure to continue affecting the sector. So it is certainly possible that capital raising for the nontraded REIT sector will remain subdued this year. Of course, that could all change if the uncertainty is resolved.
Meanwhile, the sector is transforming, providing investors with greater liquidity and offering shares, some of which do not have the onerous fees that typical nontraded REIT offerings historically carried. Even with the cloud of uncertainty continuing to loom, the quality of the segment’s offerings is certainly top-notch.
* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com.