Wednesday, June 23, 2010

Sea Change?
The public, non-traded REIT business is competitive.  I am not sure how many sponsors are fighting for broker /  dealer shelf space and investor dollars, but it must be several dozen, with, I am sure, more programs in registration.  Competition is generally good for consumers, but this has not always been the case in the non-traded REIT business when it comes to fees.  The fees across the various REITs are remarkably similar.  This may be starting to change.

Grubb & Ellis has eliminated internalization fees on its two public, non-traded REITs.  Another REIT sponsor quickly followed suit.  In conversations with more REIT sponsors, the elimination of the fee is being watched.  If Grubb & Ellis can grab market share, you can bet most non-traded REIT sponsors will ditch this fee.

This is a fee that is hard to quantify when a REIT is raising capital, because in all likelihood it won't be paid for years and the amount of the fee cannot be determined until the REIT decides to prepare for listing or liquidation.   These fees are huge, despite the inability to calculate them during the early stages of a REIT.  Some REITs don't even disclose potential internalization costs in their prospectus' fee section, instead disclosing it with amorphous language in the business plan or risk sections. 

Most REITs are advised by an affiliated company.  When a REIT's board of directors decides to list the REIT on an exchange it must acquire its advisor, a process known as internalization.  Therefore, a value must be placed on this advisor, and then the REIT, typically using its shares, acquires this advisor.  The valuations are determined by the advisor, and many REITs will get a rubber-stamp third party confirmation of the valuation.  On large REITs, the advisor can get a windfall of hundreds of millions of dollars while investors get their equity diluted.  Some past internalizations have paid REIT advisors up to $300 million.  It's not hard to see who's the beneficiary in an internalization transaction.

If Grubb & Ellis' move starts a fee war, this is good for investors.  Hopefully other sponsors will follow suit and start lowering or eliminating more immediately tangible fees and expenses, like offering costs, acquisition fees, property management and asset management fees and compensation to brokers selling the REITs.  Lower fees put less pressure on the portfolio to meet dividend coverage ratios and should allow the REITs to acquire better properties.


Anonymous said...

To think that a massive move towards fee reductions is underway is naive. The internalization fee is being dealt with because the sponsors know that this is the one fee they can restructure and it does not impact things in the near term. The sponsors are doing this because they know the winds of change are coming to this industry in terms of regulatory scrutiny and some of them are trying to get out in front of this. The other fees are vital to the sponsors' survival and those will not be touched. If the fee to the financial advisors is cut then the advisors won't sell this crummy product to their clients and the whole industry shrinks, or better yet, goes away alltogether. The ONLY reason these firms are able to raise money is because of the legal kickback to the is a huge amount of money and it is a temptation that these advisors cannot resist. Cutting back or cutting out this bribe would bring about the demise of the non-traded REIT industry.

Rational Realist said...

You're right, until the front-end fees are reduced, elimination of an unknown future fee is not that important. Brokers can't complain about high fees until they cut their compensation. Most of these REITs have five year liquidation windows, so I think the broker commission should be closer to 3% to 4% at max given this short time horizon, about half the current rate. The paradox is that a REIT with low fees should be, over time, able to raise more money because its performance would improve with reduced fees, allowing it and future deals to attract more assets. Unfortunately, no sponsor will willing to make this decision.