Commercial Real Estate Investment Trusts Face Reckoning with High Interest Rates

Non-Traded Commercial Real Estate Investment Trusts (REITs) Face an Uncertain Future as Interest Rates continue to Rise.

What is a Commercial non-traded REIT?

A Real Estate Investment Trust, or REIT, is a company that owns operates or finances income-producing properties. To fund its operations and to receive a tax break, REITs sell shares or interests to investors to raise money to buy or finance properties for its portfolio. There are generally two primary types of REITs: 1) the publicly traded or listed REITs that trade daily on the New York Stock Exchange; and 2) the non-traded REITs which do not trade and are illiquid. Their “share price” is set by the REIT based on the value of the underlying real estate portfolio.  Once your money is locked into Non-Traded REITs, it can be difficult to get any of your money out unless there is a capitalization event, like the REIT sells its portfolio of properties and returns funds to investors. A close cousin to the non-traded REIT is the private REIT, which is not public and is issued through a limited or private offering.

The REIT structure is really a tax shelter for those that actually own the underlying properties.  In exchange for preferential tax treatment, the property owners are required to distribute at least 90% of its taxable income to shareholders. Most REITs use a combination of investor funds and loans to finance their acquisitions, and in order to make its distribution payments to investors, after paying exorbitant brokerage fees, usually means that the distributions investors receive over the years are a “return of investment” and not “return on investment.”

REITs are found in many real estate sectors, but are most common in the commercial property space.  Whether it be office buildings, warehouses, or shopping centers, commercial REITs invest their funds in income producing commercial property.

Why is the Commercial Real Estate Sector at a Tipping Point?

The COVID-19 pandemic changed the way Americans work. Most notably, it changed from where many of us work. After the pandemic, offices across the country have been vacant, with leases being abandoned or being paid through government issued COVID relief packages and benefits.  Three years later, these leases are running out, and there is low demand for new tenants to take their place.  These large office buildings and their REIT ownership must have tenants to pay rent or risk insolvency. As vacancies remain high and interest rates remain high, property owners are running out of options to satisfy investor redemptions, pay distributions, or provide any liquidity to REIT investors. As inflation took off, landlords actually benefitted because rents also increased. As that curve flattens and interest rates remain high, the market could become less favorable.

In order to continue operating these properties, in some instances ownership has to get creative, including converting commercial property space to residential space. This takes funding, and as interest rates continue to increase, the low interest rate borrowing enjoyed for a decade by these real estate moguls does not exist, which creates more financial pressure. Further, given the lower demand for commercial office space post-pandemic, owners cannot sell these properties for enough to pay their investors.  Coupled with much higher borrowing costs for property buyers, the market for commercial real estate is quite bearish.

To add more intrigue to the major issues facing commercial property owners is the fact that many commercial property lenders are mid-sized banks. Recently, the mid-size or regional banking sector has fallen onto hard times as balance sheets have been turned inside/out due to interest rate hikes. Banks like Silicon Valley Bank, Signature Bank, and First Republic Bank have all gone under in recent months, adding pressure to regional banks to unwind their substantial commercial real estate loan portfolios due to over exposure. As access to low-cost lending decreases, as vacancies remain high, and as banks willing to offer loans dry up, Commercial REITs may feel the brunt of this coming collapse.

There are dozens of non-traded Commercial REITs, including but not limited to:

• Highlands REIT, Inc.
• Resource Innovation Office REIT, Inc.
• 1^st stREIT Office, Inc.
• InvenTrust Properties Corp.
• MogulREIT I, LLC
• Workspace Property Trust
• Oaktree Real Estate Income Trust, Inc.
• Presidio Property Trust
• Broadstone Net Lease, Inc.
• Lightstone Value Plus REIT, Inc.
• Lightstone Real Estate Income Trust

If your financial advisor or broker recommended that you invest in any non-traded REIT, you should look closely at your statements and try to determine if what you are invested in, is what you believed it to be.

Why Are Non-Traded REITs Bad Investments and Why Do Financial Advisors Sell Them?

Very few investors actually “need” real estate investment to fully diversify their portfolio. Most investors’ net worth is already concentrated in an illiquid, non-diversified real estate asset – their home!  Because real estate holdings are almost always a substantial piece of a retail investor’s net worth, any competent financial advisor would take that property into consideration when mapping out an appropriate allocation strategy.

Non-Trade REITs are sold by financial advisors not bought by investors, because of the high commissions and fees the brokers and their firms get for selling them. The popularity of non-traded REITs is based on a uniform but false premise that they are a non-correlated asset necessary in any well-diversified portfolio. The non-correlation is only paper-deep. The reason why non-traded REITs appear non-correlated to the stock market, is because they do not report their values on a daily basis; they are not actively traded on an exchange, so there is no “share price” reported.

Non-Traded REITs are also loaded with conflicts of interest which create unique risks and usually results in investor money being sent to various managers, affiliates, and sponsors, long before any of it ends up actually purchasing property. Most REIT issuers actually use affiliated entities to act as advisor, sponsor, dealer manager, limited partner, operating partnership, property manager, and affiliate. The results of these conflicts are higher internal costs, fees, and a lack of internal corporate governance and control over your money.

If your investment adviser of financial adviser truly believes adding real estate to your investment portfolio is necessary to achieve proper diversification, then there are numerous liquid, low-cost options to consider before locking your money into an expensive, illiquid, opaque, complicated, and speculative non-traded REIT.  For example, Vanguard offers real estate ETFs and there are literally dozens of mutual funds that invest in real estate companies. Furthermore, there are hundreds of “traded” REITs that are listed on an exchange and are traded daily to ensure liquidity. Advisers that sell non-Traded REITs will struggle to justify a recommendation to invest in non-traded REITs if you ask them the right questions. Some of those questions could be:

• How much do you or your firm get paid for selling me this non-traded REIT?
• What would you be paid for selling me a real estate mutual fund or ETF?
• Why shouldn’t I just invest in a listed REIT which is liquid and I can get my money out any day?
• Is the reported yield on the non-traded REIT you want to sell me all investor return or are the distributions at least partially funded by other investor money?

Brokers and investment advisers are coached on how to answer many of these questions, so expect them to have an answer and a rationale for making his recommendation to you. When evaluating this advice from your financial adviser, it is important to remember the conflict of interest – unless they close the sale, they don’t get their commissions.

If you were recommended an investment in a Commercial REIT and believe you have suffered investment losses, please call Stoltmann Law Offices, P.C. at 312-332-4200 for a no-obligation free consultation with a securities attorney. Stoltmann Law Offices is a contingency fee firm offering representation to defrauded investors across the country, which means we do not get paid until you do.