Commercial-property funds for small investors face tougher regulation

BY PETER GRANT | UPDATED AUG 30, 2022 08:00 AM EDT

State securities regulators’ group is scrutinizing nontraded real-estate investment trusts, which raised a record $36.4 billion last year

An association of state securities regulators is poised to step up restrictions on a popular way for individuals to invest in commercial real estate, saying the investments are more costly and risky than many unsophisticated investors realize.

The North American Securities Administrators Association is considering new policies that would establish limits on how much an individual can invest in the funds and other new rules.

These funds, known as nontraded real-estate investment trusts, are one of the few ways for individuals to get direct exposure to office towers, warehouses, hotels and other commercial properties. The funds raised a record $36.4 billion last year and are on track to nearly match that level this year, according to Robert A. Stanger & Co., an investment-banking firm that tracks the market.

While fund documents note risks and list fees associated with the product, the association says these REIT strategies aren't always appropriate for the small investors who typically buy them.

“The product structure poses a unique risk for unsophisticated investors,” said Andrea Seidt, Ohio securities commissioner and chairwoman of the association committee leading the effort.

The association, which hasn’t revised its policy on the funds since 2007, is considering adding rules that would limit the amount investors could buy and restrict REITs from certain practices.

People who work in the industry say that the proposed changes would block investors from pursuing sound investment strategies and that fund sponsors, brokers and financial advisers already have addressed the association’s concerns.

“It is in many ways a solution in search of a problem,” said Anya Coverman, senior vice president of the Institute for Portfolio Alternatives, a trade organization that represents the nontraded REIT industry.

The securities association is a voluntary organization of North American regulators that has no power on its own to change regulations. But many state regulators adopt the association’s recommendations. It now is taking comments on its proposed regulations from industry participants.

If the association approves the policies and they are adopted by most states, fundraising by nontraded REITs could be reduced by more than 20%, according to Kevin Gannon, chief executive of Robert A. Stanger.

Nontraded REITs buy the same type of properties as publicly traded REITs, but they aren’t listed on stock exchanges. Rather, investors buy shares through their broker-dealers and financial advisers. The funds have been around for more than two decades and have clashed with regulators in the past over the degree of risk disclosure and high fees.

The funds’ latest surge in popularity began about five years ago when Blackstone Inc., one of the world’s largest real-estate investors, launched its first nontraded REIT with a new structure that addressed many of the criticisms of the industry.

For example, Blackstone Real Estate Income Trust Inc. charged lower fees and provided more liquidity than many of the previous crop. It also offered a healthy dividend at what was then a time of historically low interest rates. Starwood Capital Group, KKR & Co. and Ares Management Corp. followed with such funds of their own.

Blackstone is among the industry players that have raised objections to the association’s proposed restrictions. “It would be a shame to limit individual investors’ access to the type of investments that have benefited pension funds and endowments for decades,” the firm said.

Ms. Seidt said that despite the improvements, 429 investor complaints involving real-estate investment trusts last year came before arbitration panels run by the Financial Industry Regulatory Authority, a self regulatory body for the securities industry. The figure includes public REITs, but most complaints were related to nontraded REITs, industry officials said. It was the second largest number for any investment product after stocks.

While investors can more easily cash out of the new generation of nontraded REITs, sponsors can freeze redemptions if too many investors want to cash out at the same point, Ms. Seidt said. The fees also are higher than other investment products, although they are lower than what they once were, she said.

A number of new provisions in the association’s proposal have rankled the industry including one that would prohibit a nontraded REIT from paying distributions from money raised from selling shares.

Most controversial is a proposed concentration rule that would limit investors from putting more than 10% of their liquid net worth in a nontraded REIT and other investments offered by the REIT sponsor. This would help protect small investors from suffering too large of a loss if the REIT fails or the sponsor cuts off redemptions, Ms. Seidt said.

Industry officials say the proposed concentration limit would apply an unfair one-size-fits-all standard to all investors. Such decisions should be made by investors and their broker-dealers or financial advisers, Ms. Coverman said.

Ms. Coverman said the new generation of nontraded REITs has held up well during the pandemic. Only a fraction suspended redemption requests. As a result, only a few investors who wanted to cash out at that time were prevented from doing so, she said.

“That doesn’t reflect a failure,” she said. “That’s a good story.”