Starting in 2000, the externally advised REIT structure was adapted to accommodate retail distribution through publicly registered, non-traded REIT vehicles offered to investors that meet applicable income and/or net worth requirements. A non-traded REIT registers its offering of common stock under the Securities Act of 1933, files SEC reports under the Securities Exchange Act of 1934, is not listed on any securities exchange or other trading platform, and typically invests in a portfolio of direct real estate and real estate related assets (including real estate securities) with low to moderate leverage. Non-traded REIT offerings are distributed to individual investors through a variety of financial intermediaries.
Goodwin Procter LLP pioneered a fundamental evolution in the structure and operation of non-traded REITs designed to introduce more investor-friendly and institutional-quality features, including:
- enhanced opportunity for shareholder liquidity via daily redemption at NAV per share
- frequent and systematic valuations to establish NAV on a regular basis
- open-end (indefinite life) structure
- lower and simpler all-in fees, including no-load shares
Goodwin Procter’s work towards the creation of an open-end non-traded REIT structure started in 2004 with a client mandate from an internationally recognized financial services firm. Our role as lead counsel in developing 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. Other law firms have since followed our lead in this segment of the non-traded REIT industry.
In 2005, Goodwin Procter drafted a white paper outlining the core elements of an open-end non-traded REIT (forward-pricing at NAV on a daily basis, continuous daily sales and daily redemptions, and lower/simpler payments for distribution) for the Staff of the SEC’s Division of Corporation Finance. After years of work to establish the legal viability of the structure from first principles under federal and state securities laws, we cleared the first open-end non-traded REIT with regulators for our client. The offering, however, was not launched because of the early warnings of the 2008 recession.
Today’s new-style open-end non-traded REITs are all based on this original product concept. They are increasingly seen in the market as an alternative to “traditional” non-traded REITs – some of which are viewed as lacking in transparency and having dividend payout ratios not reflected in share values, as well as some non-investor friendly fees. The innovative features of new-style open-end non-traded REITs make them attractive for intermediaries like wire houses and registered investment advisors, which have not traditionally recommended non-traded REITs to their clients (mainly due to sales commission loads and illiquidity). The product is also attractive to broker-dealer networks that currently distribute non-traded REITs, including to their “for fee” and wrap account customers.
Key distinctions between “traditional” and “open-end” non-traded REITs are presented below:
|Traditional Non-Traded REIT||Open-End Non-Traded REIT|
|Fixed offering price||NAV per share (forward) pricing|
|Selling commissions: 7%-10%||Selling commissions on load shares: 1%-3%|
|Dealer manager charges (one-time): 2%-4%||50-70 bps/yr trailing distribution fees|
|Advisory fees (trailing):||Advisory fees (trailing):|
|No practical liquidity until wind-down||Significant liquidity through redemption|
|Limited FINRA-mandated annual valuations||Daily NAV|
|7-9 yrs closed-end (finite)||Open-End (indefinite)|
Goodwin Procter has continued to refine and evolve the open-end non-traded REIT structure, particularly its liquidity feature, which involves complex securities law issues as well as a universe of business challenges that are unique in the context of real estate investment vehicles. Careful balancing between a liquid security (redeemable REIT shares) and an illiquid asset class (commercial real estate) is required. Goodwin Procter’s 2006 request for SEC no-action relief under the tender offer rules on behalf of the first open-end non-traded REIT did not include volume limitations, consistent with the business objective of offering investors uninterrupted liquidity via redemptions. That letter was not issued because our client’s 2007 offering was never launched. In 2011, an open-end non-traded REIT not represented by Goodwin Procter introduced a gross 5% per quarter limit on redemptions that replicated the classic structure of traditional non-traded REITs, save for a higher (20% annually, instead of 5-10%) limit, and obtained no-action relief from the SEC on that basis.
We believe that a 5% quarterly limit applied on a gross basis, as opposed to a net basis after deducting proceeds from sales of new shares during a quarter, undermines the core principle that an open-end non-traded REIT should offer meaningful liquidity to investors. Even during periods when the REIT’s assets under management are growing and liquidity is abundant, a 5% gross limit may force a suspension of redemptions. That flaw is compounded by failure to provide for the carryover of unused redemption capacity from quarter to quarter to take into account foreseeable “lumpiness” in investors’ capital reallocation decisions across multiple quarters (i.e., following a quarter with 0% redemptions, the limit for the next quarter should be 10%, not the same 5% as if the prior quarter’s capacity had been used up). Finally, continued application of a first-come, first-served 5% quarterly limit during times of stress creates an incentive for shareholders to queue up early and with sizeable volumes to attract larger pro rata allocations of available liquidity, thus increasing the pressure on liquidity.
Goodwin Procter and our client Cole Real Estate Income Strategy (Daily NAV), Inc. understood the importance of adhering to first principles when structuring the liquidity feature of an open-end non-traded REIT and developed a better set of “redemption gates” that incorporates:
- a net limit on redemptions, such that proceeds from sales of new shares can be used intra-quarter to fund redemptions before consuming the quarterly limit;
- a carryover of unused redemption capacity from quarter to quarter, subject to limitations designed to prevent excessive pressure on liquidity from a ballooning carryover percentage; and
- a switch to a flow-regulated limit (5% per-shareholder per quarter) from a first-come, first-served limit if redemption stress occurs, so as to reassure investors that available liquidity will be allocated fairly over the course of an entire quarter, instead of being burnt up in the early days of each quarter by a ballooning exit queue.
Acceptance of our proposed modifications to earlier no-action relief by the SEC’s Office of Mergers and Acquisitions required considerable effort, analysis and advocacy. Once again, perseverance won the day: we briefed both the technical and the policy issues, as we had done in 2005 on the first principles of the open-end non-traded REIT structure, and on behalf of our client we were able to secure no-action relief from the SEC under the tender offer rules incorporating the enhanced redemption gates noted above.
The vitality of the open-end non-traded REIT structure marks a new era in the continuing development of the REIT industry generally and the non-traded REIT sector specifically. It is helping widen the appeal of REITs to new segments of the broad investing public and to new categories of financial intermediaries.