In recent months, as the Federal Reserve’s campaign against lingering inflation has led to higher cost of capital and a resulting decline in real estate valuations, the financial press has reported on efforts by large, non-exchange listed real estate investment trusts to limit the amount of shareholder redemptions that these REITs will process. Much of the coverage has suggested that such limits were “surprising” and “unwelcome,” while some have asserted that these limits point to a weakness in the real estate sector.
Not unexpectedly, some regulators have begun to characterize these developments as indicative of poor product design and investor disappointment, if not worse. Some stories suggest, moreover, that these announced limits are akin to the “gates” on redemptions exercised by hedge funds that can shut down redemptions at their discretion and have done so at inopportune times for their investors.
This narrative is neither fair nor accurate. The non-exchange listed REITs in question continue to perform as designed, from everything we can see. There are investors looking to redeem significant numbers of shares of these REITs of late, that part of the narrative is undoubtedly true. And some large REITs have made it clear that their share redemption programs cannot accommodate all of the current and pending redemption requests in the present moment. We do not know, however, know why these investors have decided to redeem now. They might be trying to take gains to match against losses in other parts of their portfolios, or they might be trying to redeem REIT shares in order to allocate to other investments in what has generally been a significantly tumultuous investment landscape, especially for such interest rate-sensitive investments as real estate. All we know is that they are doing so and that the non-exchange listed REITs in question are making it clear to the marketplace that their redemption programs have limits that must be maintained.
It is a significant leap to go from what we know to the idea that limits on shareholders’ ability to redeem constitutes proof that their structure and redemption programs are not appropriately designed or are not functioning as intended. Redemption programs are just one way that investors in real estate that want liquidity can gain more of it. Shareholders can access liquidity through secondary market sales, an increasingly popular alternative and one that does not require the REIT to expend its cash to satisfy. Alternatively, investors desiring total liquidity for their real estate allocations can buy exchange listed REITs. Of course, in doing so they get increased volatility and potentially lose the so-called “illiquidity premium.” They can also buy real estate mutual funds, those vehicles offer daily redemptions, but with a price per share that also incorporates the volatility of the market for exchange listed REITs.
Perhaps more importantly, it is important to keep in mind that these redemption programs were designed to create partial, not total, liquidity for shareholders. Long-standing US tax policy limits redemption programs offered by non-exchange listed REITs to 20% of their outstanding shares measured annually, which translates into a 5% per quarter limit. Exceeding that limit by itself could cause a non-exchange listed REIT to lose its favorable tax treatment under the Internal Revenue Code. These redemption plans give investors a means of accessing liquidity, but not without limits. These elements are carefully designed and fully described in their offering documents; liquidity limits get appropriate focus.
The portfolios amassed by non-exchange listed REITs are made up principally of illiquid real estate assets. It is these assets that produce the income or other benefit that the REIT is trying to bring to shareholders. It is simply not possible to have an investment vehicle that invests to a large degree in illiquid assets turn around and offer substantial liquidity to shareholders without either forcing sales of illiquid assets, taking on additional leverage (borrowing) or distributing illiquid assets to shareholders. Such liquidity is not simply part of the non-traded REIT approach and may not be in the interests of the REIT’s shareholders. Having a non-exchange listed REIT offer higher or unlimited redemption levels would necessarily require them to keep cash or liquid assets to satisfy their redemption programs. Worse, having them sell illiquid real estate assets to meet these redemptions would be like a farmer cutting down a productive orchard for a quick stash of firewood. Even the 20% per annum programs place a burden on non-exchange listed REITs to maintain the cash needed to fund redemptions. One cannot hold cash or sell land for cash while still earning the same level of income for investors.
Non-exchange traded REITs require discipline and a long-term investment approach in order to realize optimal returns. They are marketed as such, with their largely illiquid nature clearly explained in their offering documents. The fact that today’s non-listed REITs offer some liquidity to shareholders shows that sponsors and managers can respond to market demands and to concerns voiced by regulators and others about a lack of investor liquidity. Limits on redemptions are both necessary, from a regulatory and investment management perspective, and beneficial to the ultimate results that real estate investment can provide.
In the end, a portfolio must be matched to the liquidity opportunities offered to shareholders, if a non-exchange listed REIT has an illiquid portfolio, it cannot offer the same liquidity to investors as a fund that owns liquid, and more volatile, assets. To be sure, issuers and distributors of non-exchange listed REITs should carefully describe the limited liquidity features of the fund and ensure that investors and their advisers understand and anticipate the liquidity stipulations involved with non-exchange listed REITs. And regulators should continue to be vigilant in their efforts to make certain that liquidity limits are clearly disclosed and explained to investors before they become shareholders. But let’s not allow a natural, understandable, and purposeful product feature, limited issuer liquidity, to be equated with poor product design. After all, if it were not for the liquidity offered by shareholder redemption programs, no matter the amount, investors would have fewer opportunities for liquidity. As long as the liquidity features are properly disclosed and understood, the result is good for investors.
With more than years of investment management experience, John Grady serves as ABR Dynamic Funds’ chief operating officer and general counsel. The firm is a registered investment adviser, managing several mutual funds and UCITS sub funds using proprietary volatility-driven strategies, as well as certain private funds. John serves as vice president on ADISA’s Board of Directors, as well as co-chair of ADISA’s Legislative & Regulatory Committee.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire. This article was originally published in the Spring 2023 issue of ADISA’s AI Quarterly and is reproduced by permission of ADISA.
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