In May, Barry Sternlicht capped investors’ ability to exit his $10 billion real estate fund—a strategic move to avoid a fire sale of properties at a less-than-ideal time. Sternlicht lowered the limit on monthly withdrawals from Starwood Real Estate Income Trust (SREIT). That limit, previously 2 percent, went to 0.33 percent of net asset value (NAV), the value of SREIT’s assets minus its debt.
The move unsettled investors and drew media criticism as a failure to provide promised liquidity. But according to John Grady, co-chair of the Alternative & Direct Investment Securities Association’s Legislative and Regulatory Committee, criticism of redemption caps stems from a misunderstanding of the nature of non-traded REITs (NTRs)—among them, SREIT and Blackstone’s BREIT.
NTRs, Grady says, were never meant to be liquid. Unlike volatile funds that trade on exchanges, NTRs were designed to give investors stable, long-term returns and allow issuers the ability to wait out the market and sell assets only at peak prices. Commercial property assets are, after all, much different from stocks by being fundamentally illiquid.
“You can’t buy back all of your interest on any given day because where would you get the money to do that if it’s all sitting in illiquid real estate?” Grady explains.
In theory, financial advisors communicate the illiquid nature of NTRs to investors and demonstrate that they benefit those who seek more stability than exchange-traded REITs can provide. Somewhere in the evolution of NTRs, however—between their origins as vehicles investors could exit only in extreme circumstances and their status as investments that allow a limited amount of liquidity—that message got lost.
“This nice benefit [came to be] thought of as an unlimited one,” Grady says of the reaction to Sternlicht’s redemption caps. “It’s not. It never was.”
An ‘inverted market’
In late 2022, investors panicked over falling or uncertain property values amid a slowdown in commercial real estate transactions. They withdrew $12 billion from NTRs in 2022 and $18 billion in 2023, according to Robert A. Stanger & Co.’s chairman report. The firm estimates that investors will redeem $16 billion this year.
According to Kevin Gannon, Stanger’s CEO and chairman, high interest rates relative to cap rates have created an “inverted market,” making real estate less attractive to investors. The redemption fest is likely to continue until current market challenges subside, putting pressure on NAV REITs’ cash reserves, Gannon says. “This is not the time to sell,” he says, adding that, under the circumstances, he would have done exactly what Sternlicht did.
According to a Stanger report, in the last two and a half years, Starwood paid roughly $4.2 billion in redemptions, tapping more than $1.3 billion of its unsecured credit facility since the beginning of last year to do so. As of April 2024, it had $315 million in unmet requests.
“The redemptions have been excellent,” Gannon says. “[It shows that NAV REITS] do meet redemptions in a big way—not perfectly, but in a big way. They’re just a little long in the tooth right now.”
By avoiding premature asset sales, Sternlicht aims to maximize value for existing shareholders, Gannon says; too many exits pressure NTRs to sell prime assets at reduced prices, which could lead to portfolio deterioration and prompt more investor withdrawals—a vicious cycle.
Bridging two extremes: the NAV REIT era
Grady argues that today’s generation of NTRs has already provided liquidity that would have been unthinkable in the era of traditional NTRs, also known as lifecycle REITs.
When emerging in the 1990s, these NTRs had a set lifespan, usually up to seven years. At the end of this period, Grady says, issuers would list their company on an exchange, sell it to another entity, or liquidate the portfolio. Back then, investors did not expect liquidity. To get out sooner, an investor would need an extreme cause, such as “death or disability,” he says.
“Most people were sold these instruments with the understanding that they would not be able to control the timing, price, or form of any exit,” Grady says. “They were going to hold them and hope for something, whether it was price appreciation followed by a merger or price appreciation followed by a liquidation as the properties were sold and cash was distributed.”
According to Grady, investors, financial advisors, and regulators pushed back against the illiquidity of lifecycle REITs. “They were calling them ‘roach motels,’” Grady says. “They were saying, ‘You can get in, but you can never get out.’”
The engineers of NAV REITs, which emerged in the early 2000s, “tried to bridge the two extremes and create something that offered some liquidity, [but] not unlimited [liquidity],” Grady says. NAV REITs limit redemptions to 20 percent annually. Reporting on valuations, which was opaque in the lifecycle era, also improved and became a FINRA requirement in 2016, forming the basis of NAV REITS’ redemption programs.
According to Grady, the industry and regulators agreed on the 20 percent cap not as the ideal amount for investors to redeem but as the maximum allowed for NTRs to maintain their regulatory classification as non-listed entities. “I think [redemptions] always have to be understood as an adjunct to the essence of a non-traded vehicle, which is mostly invested in illiquid things,” he says.
Weathering challenges with innovative solutions
According to Gannon, NTR issuers have yet to correct NAVs in response to high interest rates. NAV evaluation is also more complicated, due to stalled transactions. Until NAVs correct, investors and their advisors will probably continue exiting due to short-term decision-making driven by uncertainty. Gannon expects redemptions to peak by mid-year in 2025. He predicts that once the current redemption backlog clears, NAV REITs are likely to hit fundraising strides, reaching $20 billion to $40 billion annually.
Sternlicht’s move may push other NTR decision-makers to adopt similar measures if those measures prove to benefit investors, Gannon says. SREIT’s competitors have avoided caps thus far, however, by navigating the challenges of liquidity in an illiquid asset type via creative strategies. BREIT paid $25 billion in redemptions over two and a half years through such methods as a $4 billion cash infusion from the University of California and offering low-rate seller financing, which makes higher-than-ideal prices easier for buyers to stomach.
KKR addressed redemption issues by injecting capital into its NTR, KREST, thus subordinating as much as $200 million of its investment and committing an extra $50 million to meet redemption requests.
Liquidity solution?
Issuers currently fund redemptions through cash reserves, real estate securities, or credit facilities. According to Grady, establishing a “functional” secondary market would help NAV REITs avoid a future cash crunch and bolster investor confidence.
A secondary market where third parties trade at issuer-set prices could enhance liquidity without relying on issuer funding, Grady says. “The issuer runs into limits at a certain point, both in terms of how much liquidity they can offer and how much cash they can put aside to fund it,” he says.
