The Past, Present, and Future of the Non-Traded NAV REIT Structure

Introduction

More than 15 years ago, on behalf of an internationally recognized financial services firm, Goodwin created the first open-ended non-traded REIT structure that allowed for regular sales and repurchases at net asset value (NAV REIT). That NAV REIT offering was cleared with federal and state regulators but was unfortunately shelved on the eve of the Great Recession, and it took well over a decade for this structure to become well established. Today, NAV REITs are dominating the non-traded REIT space across both registered and private offerings. While the basic NAV REIT structure has not changed significantly since it was first developed, there is currently some variation in product design in the space, and there is room for more variation and improvement. This alert looks briefly at the history of NAV REITs, some of the features of NAV REITs currently in the market, and potential new features to improve upon the structure that may be implemented in the future, particularly with respect to the liquidity feature that is central to its appeal to a wide range of investors.

NAV REIT History

Non-Traded REITs Before NAV REITs

When non-traded REITs were first introduced in the 1990s, they typically shared the following characteristics:

• Their shares were offered at a fixed price for the duration of a continuous offering (usually two to three years), often an arbitrary $10 or $20 per share, whether an investor bought on the first day or the last day of the continuous offering period.
• Their shares were generally sold with up-front selling commissions of 7% and dealer manager fees of 2% to 3%.
• Repurchases were limited to up to 5% of the weighted average number of shares outstanding during the prior 12 months and often reflected either arbitrary or penalizing valuations to discourage repurchase requests save for hardship situations.
• They were designed as finite-life vehicles with a life of five to nine years at which time they would seek a liquidity event.

Due to high up-front loads, illiquidity, cycle-dependent life with arbitrary deadlines for exiting, and other features that hampered growth in net asset value (NAV) absent dramatic cap rate compression, traditional non-traded REITs were not appealing to large swaths of investors. Rather, it is often said that they were “sold not bought” in reliance on a capillary network of brokers and financial advisers for distribution to largely retail investors as a tool for adding “core” real estate exposure to their investment portfolios. Although a number of REITs continue to sell shares with this basic structure, the sales of traditional non-traded REITs now represent a fraction of the total sales in the non-traded REIT space.

Creation of the First NAV REIT

As previously noted, early in the 2000s, Goodwin worked with a client to pioneer a fundamental evolution in the structure and operation of non-traded REITs, designing the NAV REIT to introduce more investor-friendly and institutional-quality features, including:

• Frequent and systematic valuations to establish and disclose NAV on a regular basis, but with less volatility than had come to characterize exchange-listed equity REITs.
• Enhanced opportunity for liquidity via regular repurchases at NAV per share at a time chosen by investors.
• Open-end (indefinite-life) structure.
• Lower and simpler selling fees, including no-load shares, and a streamlined management fee structure.

The initial focus on enhancing the features of this new product class has continued uninterrupted since — from a bold idea on a whiteboard back then to a robust architecture embraced by the market today. See the Goodwin alert “Evolution of the Non-Traded REIT Industry and the Benefits of Perseverance” (February 2012) for more information on the history of NAV REITs.

Current NAV REIT Features

Today NAV REITs are sponsored by a mix of large investment managers and real estate investment firms.¹ Although most NAV REITs currently being offered have the core features that were part of the original NAV REIT structure — (i) frequent and systematic valuations to establish NAV on a regular basis, (ii) enhanced opportunity for stockholder liquidity via regular repurchases at NAV per share, (iii) lower and simpler all-in fees, including no-load shares, and (iv) indefinite life — there is some variation in product design.

NAV

NAV is typically determined and published on a monthly or quarterly basis, based in part on valuations provided by independent third parties, often on a rolling basis with each asset appraised on a rotating cycle. Shares may be available for purchase on a monthly or quarterly basis. The purchase price per share of each class will typically be the prior month’s or quarter’s NAV per share for such class as of the last calendar day of such month or quarter, plus applicable up-front selling fees.

Repurchases/Liquidity

Subject to the aggregate repurchase limits discussed in the following paragraphs, repurchases typically can take place on a monthly or quarterly basis and the per share repurchase price is determined consistent with sales. Most NAV REITs also subject repurchases to short-term trading discounts (e.g., if the shares are held for less than a year, they will be redeemed at 95% of NAV per share).

Aggregate repurchases by stockholders are typically allowed up to 5% of NAV per calendar quarter. For some NAV REITs, if repurchases (net of proceeds from sales of new shares) for a calendar quarter do not reach the 5% limit, the unused portion will be carried over to the next quarter subject to certain limits. The repurchase feature is not required by law and can be completely suspended at the discretion of the NAV REIT if it is deemed to be in the best interest of the NAV REIT and its stockholders.

There are differences in how repurchases are handled if the repurchase limit is reached in a period. For some NAV REITs, in the event that the repurchase limit is reached during a period or the NAV REIT determines to repurchase some but not all of the shares submitted for repurchase during any period, shares submitted for repurchase during such period will be repurchased on a pro rata basis. All unsatisfied repurchase requests must then be resubmitted after the start of the next period. For other NAV REITs, if net repurchases in a quarter reach the 5% limit, then proration is applied to open repurchase requests on the day the limit is reached, but no other repurchase requests for the rest of the calendar quarter are accepted and all stockholders have equal access to the following quarter’s repurchase pool. In this structure, NAV REITs begin accepting repurchase requests again on the first business day of the next quarter, but they will apply the 5% quarterly limitation on repurchases on a per-stockholder basis, instead of a first-come, first-served basis, to dampen the risk of a “run on the bank” scenario — particularly when larger stockholders or stockholders acting on a group basis under the advice of investment advisers might cause pressure to build very quickly in the new cycle. In this “flow-regulated” system, each stockholder will be ensured the ability to redeem an equal portion of its investment as of the last business day of the preceding quarter at any time during the in-process quarter. The per-stockholder limit remains in effect for the following quarter if total net repurchases reach a certain threshold during the quarter, thus, in effect, continuing the “dampening” effect for so long as available liquidity remains constrained relative to demand for liquidity.

Share Classes

Following changes in REIT qualification requirements, today many NAV REITs offer multiple classes of common stock that are usually distinguished from each other by the amount and timing of the payment of up-front selling fees and ongoing “distribution fees” that are charged on a trailing basis on each class. Those NAV REITs that are not subject to the Securities Exchange Act of 1934 need to consider whether charging different fees per share class may create preferential dividend issues. The multiple class structure is designed to replicate the à la carte offering by many actively managed pooled investment vehicles in which investors can select the blend most suited to their strategy of front-end loaded versus back-end loaded fees. The bespoke fee structure results in a different NAV per share even though proceeds from the sale of shares of all classes are invested in a single portfolio of assets with no differentiation as to access to liquidity. Although different names for the classes are used by some NAV REITs, the most common naming conventions are Class S Shares, Class T Shares, Class D Shares, and Class I Shares.

Class S Shares and Class T Shares are typically available through brokerage and transaction-based accounts with Class S Shares having higher up-front selling fees than Class T Shares and similar ongoing stockholder servicing fees as Class T Shares but no dealer manager fees. Class T shares will have lower up-front selling fees than Class S Shares, but unlike Class S Shares, they have an up-front dealer manager fee. Class D Shares are generally available for purchase only through fee-based programs, also known as wrap accounts. Class D Shares have lower up-front selling and stockholder servicing fees than Class T Shares and Class S Shares and do not pay dealer manager fees. Class I Shares are typically available to institutional investors and wrap accounts that meet certain higher minimum investment requirements and have no class-specific fees.

Most NAV REITs will also cap their total up-front selling fees, dealer manager fees, and stockholder servicing fees on shares at 8.75% and, in connection with reaching that limit, those shares will automatically convert into a number of Class I Shares with an equivalent NAV as such share. Additionally, shares of other classes will automatically convert into a number of Class I Shares with an equivalent NAV as such share on the earliest of certain events such as a listing or merger.

Open-Ended

NAV REITs are generally open-ended/indefinite-life vehicles. Some NAV REITs have provided a time frame (e.g., seven years after launch of the program) at which time they may consider a liquidity event, but they are under no obligation to do so under their charter or otherwise. Therefore, repurchase at a time chosen by each investor is the mechanism investors can count on to achieve liquidity.

The Next Frontier: A Better Liquidity Feature

With a variety of institutions contemplating entering the non-traded REIT space and sponsoring NAV REITs, we expect to see more variation in the NAV REIT structure going forward. This is especially true around liquidity, meaning differentiation in the repurchase feature among different classes to better match availability of liquid assets to fund repurchases with the expected timing of repurchase requests. This matching would be done without the disruption of suspensions, queuing, or gating.

Redeemable shares represent an interest in an illiquid portfolio of real estate assets, so liquidity cannot be a guarantee, but it surely must be more than an aspiration. Access to liquidity at a time of each investor’s choosing must rest on a robust foundation that minimizes the risk of a liquidity crisis given the unpredictability of inflows and outflows. That foundation must include (i) a layer of liquid assets to bridge a temporary mismatch between inflows and outflows, (ii) access to committed liquidity lines of credit if the imbalance persists in the short term, (iii) if pressure from foreseeable repurchase requests builds up in the medium term, sufficient runway to evaluate liquidating real estate assets in an orderly manner, and (iv) enough visibility to pursue a strategic exit in the long term via a merger or liquidation.

Each one of these features can be measured using two parameters: cost and time. In a perfect structure, the two would be blended in a continuous, seamless curve to reduce volatility, minimize impact on total return to stockholders, and ensure maximum reliability of the repurchase feature. Unfortunately, not unlike the moon, when it comes to liquidity, NAV REITs have two sides; one side is lit up (monthly or quarterly access to repurchases at NAV), the other one is dark (shutdowns of repurchases). Short-term liquidity has a cost, either the opportunity cost of keeping extra cash on hand or charges for other liquidity buffers, both of which negatively affect total return and interfere with optimal portfolio construction. In the medium term, as more investors seek to access liquidity, possibly at an accelerating pace during times of stress, available liquidity is depleted, leaving a choice between increasing leverage to the extent unsecured or secured financing is available or forcing unanticipated sales of assets. In the longer term, a shutdown reduction of repurchases may be the only way to protect the balance sheet. Each of these phases of a liquidity squeeze pose difficult challenges for sponsors and directors, who are charged with protecting the interests of all investors, rather than allowing those investors who run for the exits first to harm those who are patient or unaware of building pressure.

One does not have to look far to be reminded of the risks posed by the darker side of liquidity. Beginning in late 2022, a number of NAV REITs, such as Blackstone Real Estate Income Trust and Starwood Real Estate Income Trust, experienced a period when repurchase requests consistently exceeded the applicable monthly and/or quarterly limits of their share repurchase plans. Many of these NAV REITs have since worked through this backlog, and repurchase requests are at more normal levels. However, this surge in repurchase requests left a lasting impact on some of these NAV REITs. For example, Starwood Real Estate Income Trust revised its repurchase plan to significantly reduce the repurchases limit from 5% of NAV per quarter to 1% of NAV per quarter, which was later raised to 1.5% of NAV per quarter.

Over its relatively short life, most of which it lived on the light side of liquidity, the NAV REIT structure has experimented with a few devices to make liquidity stress bearable. As previously noted, for some NAV REITs, if net repurchases in a calendar quarter reach the repurchase limit, then those NAV REITs will begin accepting repurchase requests again on the first business day of the next calendar quarter, but they will apply the repurchase limitation on a per-stockholder basis instead of a first-come, first-served basis. Therefore, at any time during that quarter, each stockholder will be able to redeem a portion of the stockholder’s investment on the last business day of the preceding quarter. The per-stockholder limit will then remain in effect for the following quarter if total net repurchases reach a certain threshold during the quarter.

However, other NAV REITs are silent on (or choose not to acknowledge) the dark side and have less robust repurchase programs in place and could potentially reward investors for being the first to seek repurchases before other investors are aware that there is a liquidity squeeze developing. Those repurchase programs may also incentivize investors to seek a repurchase during a liquidity squeeze so they at least get their pro rata share, and that pro rata share would continue to shrink the more that investors line up to seek repurchases. All NAV REITs have the option of reducing or completely suspending repurchases, but that may come at a great reputational cost to the NAV REITs and their sponsors. As prior experience has shown, once pressure builds, there are no safe choices: (i) shutting down or reducing the repurchase limits is a blunt instrument that shocks investors no matter how clear the disclosure of illiquidity risk was in offering documents; (ii) gating tools are never seen as treating all investors fairly and equitably; and (iii) pricing tools can be arbitrary and are fraught with unintended consequences. Surely the inevitable fact of life is that REIT shares represent an interest in an illiquid pool of real estate and some NAV REITs will be better equipped to address liquidity pressure in any given market cycle than others.

We have come to believe that there is a better way. The non-traded REIT structure was created for a simple mission: to appeal to a single, relatively flat universe of investors served by networks of commissioned retail brokers paid within a “wash and repeat” closed-end fund structure. The NAV REIT structure has evolved to appeal to an increasingly diverse range of investors represented by a growing set of advisers executing different investment strategies. What if the NAV REIT classified share structure could be enhanced to offer investors not only a menu of selling load choices but also a menu of liquidity options to produce a seamless liquidity curve that blends the cost and time parameters, rather than the current two-sided liquidity moon?

Many of the investors in NAV REITs do not want or need the ability to redeem their shares on demand — their time horizons are part of their capital allocation models. However, these investors are bearing a share of the cost of monthly/quarterly liquidity on demand, which inevitably means lower total returns as the NAV REIT either holds more liquid assets at a low yield to meet unexpected repurchase requests or subsidizes repurchases for investors with near-term expectation of liquidity by making suboptimal portfolio management choices.

What if each share class were divided into subclasses allowing for progressively longer notice requirements for liquidity via repurchase and higher dividend rates for those less liquid share classes? For example, subclass X could allow for monthly/quarterly repurchases subject to current flow-regulation mechanisms (the Liquid Shares), subclass Y could allow for repurchases only to the extent that inflows or flow-regulation mechanisms allow (the Tier Two Liquidity Shares), and subclass Z could allow for repurchases only with a long notice period on an annual or a biannual basis (the Repurchase Notice Shares). Liquid Shares would offer the lowest dividend rate to account for the cost of on-demand liquidity as measured by the drag on returns of keeping cash available or the financing costs of liquidity lines. Tier Two Liquidity Shares would pay a higher dividend than Liquid Shares, and that dividend rate would account for the foreseeable impact of rebuilding the liquidity buffer, including the cost of unplanned sales of assets to relieve pressure on the “ordinary” repurchase queue if imbalance persists. The dividend rate on the Repurchase Notice Shares would be the highest because they provide the least drag on returns and the sponsor could manage the portfolio to provide liquidity if their request for access to liquidity comes with sufficient advanced warning. Each subclass could be exchanged for a higher or lower liquidity subclass on a forward basis, possibly with the same notice requirement of Repurchase Notice Shares to prevent arbitrage. The same mechanisms in place for many NAV REITs to discourage frequent trading could be extended to prevent frequent exercise of the exchange feature to game the “staggered liquidity” structure. These structuring devices would allow NAV REITs to better anticipate the foreseeable volume of repurchase requests, plan their liquidity buffers accordingly, and ultimately optimize asset management.

The NAV REIT’s investor-friendly features have helped widen the appeal of non-traded REITs to new segments of the investing public and new categories of financial intermediaries. Goodwin understands that developing innovative product design in the NAV REIT space is complicated — our first approach to the SEC many years ago was met with great enthusiasm (e.g., “This is a great structure to protect investors”) as well as stiff resistance (e.g., “How is the NAV REIT structure legal under the federal securities laws?”). We persevered, and we ultimately succeeded in convincing the SEC of the legal viability of the NAV REIT structure. REITs in general and NAV REITs in particular sit at the intersection of federal and state securities regulation, the regulation of investment vehicles and their managers/advisers, and tax requirements. NAV REITs are complicated structures that require disciplined business and legal thinking, but with additional improvements to the structure, they can surely work better for investors in all market conditions to further widen their appeal.