## Wednesday, May 1, 2013

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this week, the Investment Program Association (IPA) presented their guidelines for the valuation of publicly registered non-listed REITs. According to the IPA, these guidelines are supposed to "enhance the independence of the valuation process" and "enhance the quality of valuation disclosures to the investing public."  For a discussion of the guidelines, see Brian Louis's recent story on Bloomberg.com.
Non-traded REITs -- real estate investment trusts that are registered with the SEC but do not trade on a public exchange -- have come under a lot of scrutiny in the past few years (see our many posts on the subject).  One of the many criticisms of non-traded REITs is that it is very difficult to determine how much their shares are worth; that is, they have very little price transparency.

Typically, non-traded REIT shares have been sold at a set price.  For most non-traded REITs, that price was $10 per share, and stayed$10 per share even through the real estate collapse of 2007-8.  So while the value of the REIT's assets were declining, the price investors paid was the same.  This was made worse by the high upfront fees and commissions on non-traded REITs, which left as little as 85-90% of the invested capital going towards actually purchasing properties.  Even though the real estate collapse was big news, it was often difficult for investors to know if or how that collapse affected the properties owned by the REIT since there was almost no market analyst coverage of the non-traded REIT industry.

For a while, this lack of transparency was even touted as a feature, not a problem, by non-traded REIT sponsors and brokers.  They claimed that non-traded REITs 'lacked volatility' and weren't susceptible to 'market fluctuations.'*  But just because the price charged for each share didn't change, didn't mean the value of each share wasn't fluctuating -- or plummeting.  When FINRA started requiring non-traded REITs to publish per-share net asset value (NAV) figures, many REITs showed prices per share of less than $7, and some even less than$5 or worse.

Which brings us to today.  The non-traded REIT industry has backed away from their claims about 'lack of volatility' and are now thinking about the best way to calculate NAV for non-traded REITs.  It's actually a tricky problem.  Real estate assets are seldom bought or sold and are appraised only infrequently.  Most valuations depend on assumptions about future vacancy, rent rates, and other factors that are hard to predict.  So it's not so easy coming up with a valuation for a whole portfolio of different types of properties.

For REITs that are publicly traded, this isn't a problem.  Shares of traded REITs are traded just like any other stock, so their market price reflects the demand for shares in a liquid market.  The market essentially values the REIT's portfolio for them, using the public disclosures required of traded securities.

So far, non-traded REIT valuations have been largely at the discretion of the REIT's management, which means each REIT uses a different methodology and per-share values aren't directly comparable.  Also, there is an inherent conflict of interest when a company values its own shares.  This is in addition to the fact that valuations based on the underlying assets are often stale -- based on data many months or even years old.

The objectives of the IPA's guidance highlight the need for quick, independent, and standardized calculations.  But it makes you wonder--if it's so difficult for even the REIT itself to value its portfolio, why are non-traded REITs being sold to retail investors in the first place?  And if greater transparency is the goal, why not list on a major exchange?
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* This claim was specifically addressed by the SEC in disclosure guidelines dated December 2011 (see section "Volatility"):
Some non-traded REITs have proposed sales material that cites their static offering price as evidence that there is no volatility in the value of the security. Unless the offering price is based on a valuation of the security, we object to these statements and instruct these registrants to remove statements in the sales material that suggest a static offering price indicates a stable investment.