Observers say DI Industry on the Brink of a Dramatic Expansion
There will be no summer vacation for the acquisition and asset management professionals who operate public non-listed real estate investment trusts (REITs), non-listed business development companies (BDCs) and other direct participation programs (collectively, direct investments). With over $2 billion of new investment funds flowing into these vehicles in June – the largest June on record—the industry’s professionals will be combing asset and financial markets for attractive opportunities to deploy this new capital on behalf of their public shareholders. All indications are that the public direct investment industry will raise over $20 billion for the second year in a row according to Robert A. Stanger & Company, an independent investment banking firm that specializes in direct investment securities. Data developed by Stanger showed that equity capital flows to public direct investments reached $11.7 billion during the first half of 2014 compared with the record-setting pace of $10.7 billion during the same period in 2013.
“There is no motivation more powerful than success to attract capital to an investment sector,” said Kevin Gannon, managing director of Stanger. “The direct investment industry and particularly non-listed REITs have produced that success since the 2007-8 financial market downturn.” According to Stanger, eighteen public non-listed REITs which account for $34 billion of original investment and completed their full investment cycle in the past two years have provided investors with an average rate of return of approximately 9.5%.
The composition of those returns is relevant, as well. “Many financial advisors and their clients have re-oriented the desired composition of their investment returns from primarily capital gains to income following the stock market collapses of 2001 and 2007-8,” explained Keith Allaire, managing director of Stanger. “In part, this re-orientation reflects the desire to avoid speculating on future gains. Current income in hand is being valued more highly than capital gains in the bush.”
This re-orientation also reflects demographics. With the number of retirees and pre-retirees growing at near exponential rates, the focus is on finding income sources to preserve lifestyle. In the current low interest rate environment, the yield advantage of real estate and corporate development loans over more traditional fixed income alternatives makes direct investments appealing as a component of an investment portfolio oriented toward income.
The Cure for “Pamplona Fever”
The unbridled desire to “run with the bulls” has historically been the undoing of many individual investors. “I call it Pamplona Fever,” says Allaire, “buying in when the market has produced a long period of high returns and is approaching historical peaks, only to see investments succumb to the inevitable market correction, followed by a sell-off at substantial losses.” However, the continuing popularity of direct investments in the face of the promising economic and employment news and the breaking of the 17000 barrier by the Dow Jones Industrial Average suggests that a cure for Pamplona Fever is trickling down through financial intermediaries to their clients. That cure is a dynamic asset allocation process which constructs diversified portfolios, and the inclusion in those portfolios of investments which have low correlations with stocks, bonds and other financial assets.
Evolutionary Expansion on the Horizon
Observers believe that the direct investment industry stands on the brink of dramatic expansion. “The evolution of this product in the next few years will be dramatic and will open up new distribution channels and a proliferation of investment options for individual investors,” said Gannon. According to Stanger, this evolution is occurring in four directions: (i) the proliferation of a more diversified suite of product and asset choices; (ii) structural changes to the product to appeal to a broader range of investor needs and preferences; (iii) fee structure changes to provide greater dividend security; and (iv) enhancements to product transparency which will lead to greater market acceptance and improved performance. Among non-listed REITs, the asset types available for investment are more varied than ever before, and include niche asset classes (such as healthcare, data centers, hotels, self-storage, and land), global properties, and a variety of real-estate related debt instruments. Structural changes already occurring in the industry include the emergence of multi-share class offerings which enable investors to choose among alternative ways to defray distribution costs in much the same way as they can when investing in multi-class mutual funds. Fee structures increasingly include subordinations of asset management fees payable to the REIT’s advisor to enhance the cash flow coverage of dividends. Finally, pending regulatory changes in account statement reporting for public DPPs and non-listed REITs will provide improved and earlier valuation guidance for investors in these non-listed securities.
Article by: Robert A. Stanger & Co., Inc., a Shrewsbury, New Jersey-based investment banking firm specializing in real estate and direct participation program securities. The company is a leading source of information and research on the direct investment industry and is regularly involved in real estate mergers and acquisitions, debt and equity financings, real estate appraisals and securities valuations.